High-flying Canadian banks still good bet for investors
Loan loss provisions will be lower next year
w ith Canadian banks just 5% off their record highs and having surpassed their pre-crisis peaks, in-vestors may be wondering if the sector has run too far, too fast. The S&P/TSX Banks Index is up nearly 20% in the past two months.
Some of this strength can be attributed to the fact that Canada’s banKIng sector was singled out as a shin-ing star among its global peers throughout the finan cial crisis. More recently, the rally is a result of a solid round of first-quarter earn-ings from the Big Six.
“They’ve maintained a level of profitability through the crisis and after the crisis that is far superior to the peer group in the United States and Europe,” said Murray Leith, director of research at Odlum Brown in Vancouver.
While valuations for Can-adian banks are near the mid-level on a price-to-earn-ings basis, he noted that they do look pricey relative to global peers on price-to-book. The average Canadian bank is trading at more than two times book value, while a typical U.S. or European bank trades closer to book value.
“The premium book value is warranted rieht now be-cause we’re much more profitable; we nave much higher return on sharehold ers’ equity,” Mr. Leith said. “I think our banks will remain very protitable
— in large part because it’s an oligop oly here in Canada but I
— don’t think the gap is going to remain that wide.”
Alter the banks wrapped up their results earlier this month, RBC Capital Mar-kets analyst Andre-Philippe Hardy expressed confidence that share prices had more room to run. If the econ omy continues to improve, he suggested that Canadian banks stocks could return between 11% and 19%, in-cluding dividend yields.
The banks had lower provisions for credit loss-es when compared to the tourtfl quarter of fiscal 2009. However, they re mained high relative to nor-ma! environments, due in part to U.S. exposures. Mr. Hardy warned that while high loan losses could keep profits below normal levels throughout 2010, lower pro-visions for credit losses in 2011 should lead to an profit improvement.
“We believe that the next catalyst to the upside could be the market gaining clarity on loan losses having peak-ed, which we expect in mid-2010,” he said in a recent report. “The decline in the pace of job losses in North America and improved mdi-cators of business loan loss-es seen in recent quarters
irp th rplnnv wp think that loan losses will have peaked by mid-2010.”
The next catalyst after that will likely be greater clarity on capital rules. Proposals outlined by the Basel Committee on Bank-ing Supervision in Decem ber 2009 are expected to be finalized late in 2010.
The uncertainty sur rounding international cap-ital requirements has put dividend increases on hold, with many analysts not see-ing the first hike until early 2011. While nobody knows what the new capital rules will be, Canadian banks look to be in a good position to deal with them.
Mr. Leith notes that their average Tier 1 capital ratio is around 12%, up from about 10% a year ago and well above the regulatory mm-imum of 7%. He also points out the attractiveness of dividend yields in the sector, particularly when compared to government and corpor ate bonds.
Typically, the average bank yields about 50% of what a 10-year Government of Canada bond does. That figure is currently more than 100%. Canadian banks also usually yield 40% to 50% of what investment-grade cor porate bonds do, compared to 75% these days.
CIBC currently lies at the high end of the range with a dividend yield above 4.5%, while Toronto-Dominion Bank falls at the low end at about 318%. That’s afar cry from the sector’s Febru ary 2009 lows, when BMO’s yield rose above 10%. How-ever, current yields are nonetheless appealing.
“Short-term interest rates, T-bills and GICs are still going to remain very Un-attractive relative to a bank dividend yield.’ Mr. Leith said. “I think the reach for yield is going to drive bank shares up further?’