Contributing editor Tom Slee is with us this week, back from a relaxing vacation in warmer climes. But even while sunning himself on a beach, he couldn't stop thinking about the stock markets and the banks in particular, as he explains in this report. Tom managed millions of dollars in pension money during his career and is an expert in taxation as well. Over to him.
Tom Slee writes:
For all their faults Canadian banks anchored us during the worldwide financial crisis. They not only remained reassuringly strong and profitable, they also instilled consumer confidence. A recent PriceWaterhouseCoopers study shows that 85% of Canadians have faith in our banking system. Now, however, there are a few question marks hanging over the sector. Investors are becoming concerned about personal debt levels and new capital requirements. Analysts are issuing warnings, marking down their earnings forecasts. Is it time to put bank stocks on hold for a while?
I think that the short answer is no, although the banks are certainly facing a few serious challenges. So I am not suggesting a blanket buy recommendation. Some of the major players are likely to mark time. We will have to choose carefully. However, a lot of the so-called concerns are more noise than substance. Sure, there is a far less favourable backdrop but the industry's fundamentals are in excellent shape. Canadian banks are well equipped to solve the looming problems, some of which may never materialize. Let's take them one at a time.
First, it's possible that the European banking crisis could deepen and a ripple effect seriously damage Canadian banks, especially Royal Bank which has the most exposure. This casts a pall over the stocks because of the continuing media coverage. In fact, it's a limited threat. Certainly the banks would sell off if Greece defaults or there is a similar setback, but there would be relatively few Canadian losses. Our five major banks have a net exposure to Europe of about $110 billion but $75 billion or so of that involves loans to Germany, Britain, France, and the Netherlands, the low-risk countries. Moreover, the IMF and the European Central Bank provide offsetting safeguards.
Second, it's argued that Canadian house prices are overheated, especially in Vancouver and Toronto, and the banks, having funded the demand, could incur mortgage losses when the bubble bursts. Here again, we are dealing with a lot of high-profile spin. It's true house prices have soared and Canadian banks are heavily involved. They now hold $270 billion of uninsured residential mortgages and $115 billion of uninsured home equity lines of credit. That is a substantial amount of exposure. We have to keep in mind, however, that Canadian credit managers are much more conservative than their U.S. counterparts. They put these loans on their books carefully to hold, not repackage and sell. Just take a look at the numbers.
According to the Bank of Canada, the market value of Canadian privately-owned land and buildings is about $3.1 trillion. Mortgages total $1.2 trillion for a 40.3% loan to value ratio. We are certainly not drowning in real estate debt. Ten years ago the ratio was about 36%. As far as the banks are concerned, the $270 billion of mortgages are secured by property worth approximately $500 billion. Analysts estimate that the average loan to value is about 55%, hardly a nail biting, high-risk situation.
Third, the new Basel 3 requirements come into effect next January and, the critics say, they are going to require more capital and stunt bank earnings growth. The truth is only one major Canadian bank, Scotiabank, fails to already meet the Basel 3 capital needs. Scotia is busy coming up to scratch and has recently filed a $1.65 billion share offering prospectus. There is no doubt that the new rules will require much more liquidity and could dampen returns on equity. Analysts, however, believe that our banks will soon adapt, realign their services, and continue to generate significant profits.
Finally, and perhaps most important, Canadian consumers are now overloaded with debt. They are likely to retrench, borrow less, and slow domestic banking business. Here I agree there is some cause for concern and we have to factor that into our earnings projections. As a matter of fact, Canadian retail banking revenue growth was already slowing late last year. Interest rate spreads were declining. Therefore, 2012 profits will be governed by tighter cost controls. There is still a lot of money to be made. The banks will just have to work harder to earn it.
So much for the more obvious problems: I think they are manageable and that the industry will surprise us by posting a 7% growth in profits this year. This, coupled with the fact that the stocks are cheap and the yields attractive, makes me mildly bullish on the sector.
As we go to press the banks are announcing their first-quarter results which, at first glance, seem slightly better than expected. BMO, first up, earned $1.42 a share compared to the $1.36 consensus forecast. Royal did better, posting a profit of $1.25 a share, well ahead of the $1.14 analysts were expecting. National also surprised on the upside, earning $2 a share compared to $1.82 Street estimate. TD's numbers were a bit of a mixed bag but bottom line operating profit of $1.86 a share was ahead of the $1.73 forecast (all of these numbers have been adjusted to eliminate non-recurring items). CIBC and Scotiabank have yet to report.
It's too early to get a handle on these numbers or identify industry trends but I was particularly encouraged by TD and National's retail banking growth. Dividend increases from TD and Royal, both rather a surprise, reflect management confidence and are a shot in the arm. On the downside, year-over-year performance was disappointing.
I am leaving our earnings forecasts and stock price targets unchanged for the moment.
There are bound to be a few bumps on the road as the recovery splutters but the banks are strong. Here are some thoughts regarding the individual stocks.
TD Bank (TD)
Originally recommended on Feb. 12/07 (IWB #2706) at C$69.85, US$59.59. Closed Friday at C$81.78, US$82.68.
TD Bank remains my number one choice in the banking sector. Fourth-quarter earnings of $1.76 a share easily beat the $1.54 analysts were expecting as the bank continues to gain market share in each of its divisions. Merchant Banking was particularly strong, while Wealth Management reported an impressive 18% jump in profits to $139 million.
Looking ahead, TD's aggressive marketing should pay off and enable the bank to continue making inroads into the domestic retail market. At the same time, its tight controls are already in place to maintain margins even if loan demand slackens.
A big plus is that there are signs of a continuing resurgence in North American auto sales and TD is well positioned to benefit from this through its recently acquired Chrysler Financial operation. CEO Ed Clark hopes to originate US$1 billion a month in auto loans despite increased competition from U.S. banks. It's interesting to note that auto loans performed better than mortgages during the recession. People would rather abandon their home than surrender their car.
TD should earn about $7.25 a share this year and as much as $7.65 in 2013. Priced at C$81.78, US$82.68 with an 11.3 multiple and paying a $2.88 dividend to yield 3.52%, the stock is excellent value.
Action now: TD Bank is a Buy with a target of $87. I have set a $72 revisit level.
Bank of Nova Scotia (BNS)
Originally recommended on Jan. 17/11 (IWB #21102) at C$56.83, US$57.34. Closed Friday at C$53.65, US$54.30.
At Scotiabank the outlook is mixed. The bank seems to have cleared the Basel 3 hurdle but chose to issue dilutive stock rather than selling investments or adjusting its international portfolio. That may weigh on the share price. There is also the problem that in these difficult days investors are less impressed by the bank's overseas investments. They prefer domestic earnings.
On the other hand, BNS continues to report solid earnings. Fourth-quarter profit came in at $1.10 a share, up from $1.02 the year before and slightly ahead of the $1.08 consensus forecast. Its Global Wealth Management division reported earnings of $249 million, up 34% year-over-year largely due to the acquisition of Dundee Wealth. The all-important Canadian banking earnings grew 5% to $472 million.
My feeling is that management is going to be concerned with Basel requirements this year so BNS may tread water for a while. Earnings of about $4.75 a share are expected but I think that we should step back for a while and monitor Canadian business growth for the next few quarters.
Action now: Scotiabank becomes a Hold.
National Bank (NTIOF)
Originally recommended on April 11/11 (IWB #21114) at C$76.69, US$80.22. Closed Friday at C$78.32, US$79.20.
I have no reservations about National Bank. Fourth-quarter operating earnings of $1.80 a share were a 10% improvement over $1.63 the year before and ahead of the $1.65 analysts were expecting. Management celebrated by announcing a 6% dividend increase and we could see another 10% hike in 2012.
A 12% growth in personal loan revenues in the period suggests that National is continuing to grab market share. Wealth Management numbers were also encouraging. New acquisition Wellington West added $2 million to the bottom line while overall loan losses remained stable.
NA looks set to earn about $7.40 a share in 2012 with an increase to the $7.90 range next year as the HSBC advisory acquisition comes on stream. Analysts expect the bank to comfortably exceed the Basel 3 requirements by internally generating capital.
Action now: National Bank remains a Buy with a target of $85. I will revisit the stock if it dips to $70.