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"People are always asking me where the outlook is good, but that’s the wrong question. The right question is: Where is the outlook most miserable?" -- Sir John Templeton.

Where can we find misery today? UK financials for one. Even though the storm in US banks seemed to have calmed somewhat, there is still plenty apathy and fear in Europe and UK. This is my preferred hunting ground, while trying not to be naively contrarian. Importantly, retail banking is still a good business (steady market shares and >20 ROEs) and can be resilient if done right. Lloyds is one of the highest quality banks in Europe and I see about 170% upside (2.7x).

Lloyds holds the number one deposit market share in the UK of about 25%. This matters as having low-cost transactional retail deposits is the main source of moat. While online banking has weakened the moat, the money is still very sticky. Lloyds is trading on a 5-6x consensus P/E, which signals either a great opportunity or a value trap. To decipher which one it is, I believe we need to address the following three questions: 1) Why has its historic value creation been so poor? It's total return is -10% over the last 10 years! 2) What is Lloyds' exposure to the main risks in banking: Credit, funding, and asset-liability-mismatches? 3) Can it withstand the current headwinds: Deposit outflows, peak in net interest margin, and a potential recession resulting in high credit losses? Let's tackle these one by one.

1) Value Creation Over The Last 10 Years

As we all know, banking went through a big boom-to-bust during the Great Financial Crisis. Lloyds was right in the centre of this, having committed various sins of banking. It had to be bailed out by the government and was only returned to full private ownership in 2017. Digesting a big boom-to-bust tends to take about a decade - a bit less in the US and more in Europe.

On top of that, there was a huge mis-selling scandal in the UK about a product called payment protection insurance (PPI). Everyone living in the UK will remember the frequent cold calls asking you if you had ever purchased this product. In total, Lloyds spent £22bn to address this over the years. Total 'exceptionals' to clean up the sins pre GFC were £39bn over the last 10 years, or ~140% of today's market cap of about £27bn! All this money could have gone to shareholders otherwise. Fortunately, this finally seems to be mostly behind us.

2) Main Risks in Banking

A) Credit Risk

While banks are somewhat of a black box, there are a ways to weed out the bad apples. I generally like to stick to the highest quality banks: The best deposit franchises and highest asset quality. In the UK, that is Lloyds. They might not go up the most in a recovery, but you are protected in a downturn. A few signposts on Lloyds' credit risks are:

• In general, lending standards have been very high in the UK since the GFC as everyone had to clean up their act.
• Lloyds had to delever, which allowed them to pick the highest quality loans. This is the opposite of chasing growth with 'The Power of Yes' like Washington Mutual back in the days.
• Primary consistently indicates that they are one of the most conservative underwriters in the UK.
• The majority of the book consists of boring retail mortgages. The LTV on those is 41.6%, thereby providing plenty of buffer against losses.
• While interest rates are up a lot, UK regulators had already required banks to test mortgages on a 3ppts higher rate.
• Exposure to commercial real estate (CRE) is limited. This category tends to get banks into trouble. Lloyds exposure is £11bn, which is 34% of their common equity tier 1 capital, among the lowest among peers. If you were to assume 20% ultimate losses, that £2.2bn would be easily covered by its pre-provision earning power. Only <£1bn of that exposure is in development projects, predominantly to large residential homebuilders who are probably fine given the shortage of housing. The rest is in investing properties that generate real cash flows. The LTV on this book is 44%. Offices are 14% of the portfolio, so again manageable. Note that return to office rates are higher in Europe than the US.

B) Funding Risk

Lloyds is retail deposit funded. The majority is from primary accounts and government insured balances. This is as low-risk as it gets in banking.

The bank has about $100bn in wholesale funding, but that is perfectly fine in the context of a very liquid balance sheet (£145bn liquidity portfolio). Just over half of this has a maturity of >2years.

C) Asset Liability Mismatch

European banks have not committed the same sins as some of the US regional banks. That is maybe because we don't have the same 30-year mortgage structures. Therefore, unrealized losses on securities at amortized cost are negligible.

3) Current headwinds

A) Deposit outflows: Covid subsidies have resulted in inflated deposit. At the same time, rising rates suddenly makes deposit valuable again, meaning customers start shopping around more. While outflows seems to have stabilized somewhat already, we shouldn't be surprised to see some continued outflows. My estimate is a roughly 10% decline. Again, the majority of funding is from small balance transactional accounts, so this should be nothing more than a blip.

B) Net interest margin peaking: Every investor in financials was waiting for rising rates to lift profits. Now that this has finally occurred a decade or so later than expected, the fear is that it has peaked already. I mostly see central bank interest rates as an external input cost. As it moves up and down, the bank passes it on to customers. I expect net interest margins to revert to historic levels.

C) Recession will trigger wave of provisions: Without making a macro forecast, a severe recession is clearly possible. Earnings can be volatile in the next two years. If you think the bank will get through it without needing to raise equity, which I do, then Lloyds is probably still cheap.

Potential Upside

'Adjusted net profits' over the last 10 years were on average about £5bn p.a. As mentioned above, using adjusted numbers was hugely misleading given the clean-up costs post GFC for PPI and a few other misbehaviours. That period, however, is finally over and continued 'remediation' costs should be maybe £250m per annum (£255m in 2022). This means that those adjusted profits will finally translate into real profits that can be returned to shareholders.

Assuming low single-digit growth in interest-earning assets to £515bn, a 275bps net interest margin (vs >300bps this year), and 30bps of sustainable provisions results in a normalized earnings power of roughly £5.5bn in five years (after interest on preferred). That's a £55bn market cap on a 10x P/E. Adding £20bn of capital returns = £75bn total return, or 2.7x over five years.