Is the Lloyds share price a bargain or a wolf in sheep’s clothing waiting to bite you?

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The slide in the Lloyds Banking Group (LSE: LLOY) share price has been relentless this year and it’s down around 24% since January. Meanwhile, the firm has rebuilt its earnings over the past few years and reinstated dividend payments. As the share price has been falling, earnings put in a hefty double-digit percentage rise during 2018, so why does the share-price action seem to disagree with the operational performance of the underlying business?

Soft, white and fluffy numbers

It’s simple, right? Lloyds has fallen out of favour with the market for whatever reason and the current share price represents a bargain. We should be brave and buy the firm’s shares based on what the numbers are telling us, shouldn’t we? After all, the current share price around 55p means the company is trading close to its tangible book value, which seems fair. The price-to-earnings ratio sits at just over seven and the dividend yield at around 5.8%. Everything about the numbers screams ‘bargain,’ so what’s there to not like?

Well, that description of Lloyds today fits the ‘sheep’ part of the metaphor in this article’s headline. Nearly everything about the valuation numbers looks soft, white and fluffy – baaaa! However, I think there’s one clue that opens the possibility that this sheep could actually be a wolf in disguise. The clue is that the company expects its earnings to flatline next year. After a strong recovery from making a loss as recently as 2012, it looks like growth in earnings is about to stall. So here we are sitting at what could be the top of the earnings cycle for Lloyds. Earnings have staged a recovery – hoorah! But what happens next?

That’s the question I think the market has been asking itself about Lloyds. One thing we do know is that the underlying banking business is as cyclical as the most cyclical businesses come. It follows that when earnings are high, there’s an increased probability that earnings will fall again as they cycle down into the next dip. The stock market doesn’t know when that will happen, but based on all previous experiences it’s pretty certain it will happen again, I reckon. So, the stock market does the only thing it can do to try to mitigate the effects of Lloyds’ cyclicality – it keeps the valuation down as profits rise. The more they rise, the more it squeezes the valuation.

The wolf could bite

However, despite the stock market’s best efforts to discount for volatility in the firm’s earnings, I think a plunge in earnings will take the share price with it. If and when it comes, the wolf in Lloyds will bite you! So, to me, Lloyds today looks like it has maximum downside risk and a capped upside potential. In my opinion, all the other stuff about Lloyds – conduct issues, PPI mis-selling etc – are all a distraction and the main issue is that the firm operates an out-and-out cyclical business.

So, a growth proposition it isn’t. A dividend-led investment candidate it isn’t. A short-term trading prospect it could be, to capture the next up-leg. But the safest way to handle Lloyds today is to avoid it altogether, in my opinion. And why wouldn’t you with so many other decent trading businesses with great dividend and growth prospects available on the London stock market?

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Kevin Godbold has no position in any of the shares mentioned. The Motley Fool UK has recommended Lloyds Banking Group. Views expressed on the companies mentioned in this article are those of the writer and therefore may differ from the official recommendations we make in our subscription services such as Share Advisor, Hidden Winners and Pro. Here at The Motley Fool we believe that considering a diverse range of insights makes us better investors.

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