For the past four years or so, we have been hearing from various quarters, including US-based short- sellers, that the Canadian banks are in trouble. According to the popular narratives our banks are too expensive for the following reasons:
1. The Canadian housing market is vastly over-valued and in “bubble” territory in Toronto and Vancouver. This will lead to a significant drop in housing prices, and the Canadian banks will ultimately be on the hook, as were banks in the US in 2007-09.
2. Canadian energy companies can’t make money with oil at $40. Alberta is bound to enter into a depression, energy companies will go bankrupt and default on their loans, leaving banks on the hook.
3. Technology companies are creating innovative financial products and services that will steal businesses away from the banks. “Fin tech” and automated solutions will sap profits and future growth will be stunted.
4.Capital requirements (so called Basel III) are so onerous that Canadian banks won’t be able to both meet increased capital levels and continue to return capital to shareholders.
However, in the over eight years since the end of the great recession, all the Canadian banks have delivered consistent rising profits, along with rising dividends and have provided excellent returns to shareholders. This simply continues a longer trend that has lasted, so far, all of the current century. Those who were smart enough to buy shares in the five big Canadian banks on December 31, 1999, and continued to hold them until today, would have a compound rate of return of 10.2% per year. For example, an investment of $20,000 into each of the big five banks on December 31, 1999, a total of $100,000, would be worth $521,000 today; and that is without reinvesting the dividends.
Of course Canadian banks will be hurt if the housing market has a significant price drop. However, they are well diversified, so a drop in one business line may be balanced by gains in another. For example, National Bank of Canada has diversified its business into wealth management; TD Bank has diversified in a big way into the U.S.; Scotiabank has many assets in Latin America. You get the idea.
In our opinion, the Canadian banks have too much capital (this is a good problem to have!). Their balance sheets are in the best shape we have ever seen. This bodes well for future shareholder returns in the form of buybacks, rising dividends and potential acquisitions. The Canadian economy is now humming along, and interest rates are rising. This is exactly the type of news you want to hear if you are a bank shareholder. Most importantly, the Canadian banks trade at an inexpensive valuation. We would argue that they should be valued at a premium to the overall market. We know that the naysayers will say that they must trade at a low multiple, given that they have always traded at a low multiple. That argument doesn’t work for us, especially in light of the consistent performance that the banks have delivered. We can’t say for certain that the future for the Canadian banks will continue to be this good, but we are comfortable with the risks and believe that we have significant margin of safety given the current valuations.
September 18, 2017