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He Lloyds The (LSE:LLOY) share price has seen a long-awaited recovery over the past 12 months. It has been great for long-suffering investors like myself.
However, according to several analysts, Lloyds shares could rise even further in the coming years – and there is a reason that may have been overlooked.
Let's take a closer look.
Unrolling the hedge
Major UK banks are set to benefit from higher interest rates for years to come, thanks to a financial strategy called structural hedging.
Structural hedging, which banks use to protect their profits from sudden changes in interest rates, involves investing some assets in fixed-income products.
Today, most of these investments are in low-yield products from when interest rates were lower.
However, as these investments mature, banks can reinvest them at today's higher rates, gradually increasing their income over time.
This process is expected to take several years, with the benefits spread over an extended period. In essence, while this strategy has curbed short-term gains, it will become a significant advantage in the years to come.
To put this into context, the yield on a five-year UK government bond is currently 70 basis points higher than Lloyds' net interest margin.
What is the impact?
According to some analysts, notably Jonathan Pierce of Deutsche Numis Research, unhedging (the movement of fixed-income investments from lower to higher rates) could generate profits for UK-focused companies. FTSE 100 Index banks such as Lloyds and NatWest increase by 80%.
In turn, this would mean Lloyds is trading at around four times forward earnings (there is no date for when this 80% increase might be achieved), but analysts have suggested it could take “a few years” for this to happen.
So what could this mean for investors?
Well, if profits rise by 80%, Lloyds will not be trading at 60p, but at £1.
What is this based on? Lloyds earned 7.5p per share in 2023 and an 80% increase would take us to 13.5p.
This is a price-earnings ratio of just 7.4 times, assuming a share price of £1.
We can't always trust the forecasts
Pierce's forecast that earnings could rise 80% in the next few years is one of the most optimistic I've read. And forecasts can be wrong.
It's also worth remembering that banks have a very nuanced relationship with interest rates. For example, higher interest rates can lead to higher impairment charges on bad debts.
The final result
While Pierce remains optimistic about Lloyds, several analysts have returned to “neutral” on the bank in recent months.
And I think this indicates that the UK economy continues to face risks, with a war on its doorstep and some uncertainty about interest rates. Lloyds is really a barometer of the UK economy.
For me, the crux of the matter is valuation. The stock is certainly not expensive, if you calculate it at nine times forward earnings. There is also a margin of safety when using growth-adjusted metrics.
If my shares in Lloyds were not already large enough, I would consider investing more.
