Feb 14, 2017

Caution on Owning Canadian Banks

Canadian banks have been stellar performers over the last 14 years, however, some factors are working against the banks, which we believe will negatively impact the banks' performance and create volatility for this investment in 2017 and beyond.

RBC. TD. Bank of Nova Scotia. BMO. Four out of the Big Five Banks make the list for the top 10 constituents in the S&P/TSX Index (Figure 1).

 

 Top 10 Holdings S&P/TSX Index (By Weight)
 1. Royal Bank of Canada
 2. Toronto Dominion Bank
 3. Bank of Nova Scotia
 4. Canadian National Railways
 5. Suncor Energy
 6. Bank of Montreal
 7. TransCanada
 8. Enbridge
 9. BCE
 10. Manulife Financial

 

Source: Bloomberg

Many investors have been benefitting from their proven long-term performance, only underperforming twice in the last 14 years (Figure 2). With this track record, investors are “banking” on these stocks to continue to outperform the market.

Figure 2: Canadian Banks have only underperformed the S&P/TSX twice, once in 2007 during the financial crisis and the second in 2010.

Chart showing total returns from 2003 to 2016 for S&P/TSX vs Banks

 Source: Bloomberg


Their outperformance was also partly driven by a growing stream of tax-efficient dividends (Figure 3).

   Current Dividend Yield  1-Year* 3-Year*  5-Year* 
 RBC  3.51% 5.13%   8.05%  9.12%
 BNS  3.77% 5.80%   6.17% 7.03% 
 TD  3.25% 7.84%  9.73%  10.42% 
 BMO  3.55% 4.88%  4.90%  4.20% 
 CIBC  4.38% 9.50%  8.21%  6.46% 
 Average  3.69% 6.63%  7.41%  7.44% 

*Compounded annual dividend growth rate
Source: Bloomberg


So, it may appear then, that underweighting Canadian banks would be a losing proposition. Why would we bet against a sector with such a profitable record? In our Quarterly Outlook Commentary, released to our clients last month, we went into detail on the different factors that are working against the banks, and how this will negatively impact the banks in 2017 and beyond. Summarized below in point form are these factors:

  1. Tighter restrictions on mortgage lending: With the new qualification process, mortgages will be approved based on a higher posted rate. This means the maximum allowed mortgage for every level of income will decline by roughly 20%.
  2. Pending regulation on risk sharing of mortgages with CMHC: Mortgages insured by CMHC were considered risk free. If loans were to default, CMHC would cover it. The risk sharing regulation will require banks to share the risk of mortgages with CMHC, which will result in the banks allocating more capital against them.
  3. High debt to disposable income of Canadians: The current debt-to-disposable income for Canadians is 168%. The financial crisis in the US started when this ratio was 135%. Though there are hardly any similarities, eventually borrowers’ capacity to borrow will be curtailed, leading to substantially slower loan growth.
  4. IFSR9 will create provision volatility: An accounting regulation will require banks to provide or release provisions against loan losses faster, creating higher earnings volatility.
  5. High current valuations of bank stocks: We consider the banks to be expensive as they are currently trading at a 10-year high (Figure 4).

Chart showing average P/E ratio of big five banks from 007 to 2016

Source: Bloomberg

The banks make up 24% of the Canadian Index, so we caution those who own them to tread carefully, especially if investors are looking to mirror, or invest directly in the index. At CWB McLean & Partners, we are comfortable underweighting Canadian banks to protect our clients from less favourable outcomes in the banking sector. That is not to say that we won’t hold banks at all – our team is looking to find opportunities to buy select banks, all in accordance with our process.