Contributing editor Tom Slee joins us this week. He's been taking a close look at one of his favourite sectors, the banks, and he likes what he sees. Tom managed millions of dollars in pension money during his career and is an expert in taxation as well. He lives in Toronto. Here is his report.
Tom Slee writes:
Canadian banks are finding it tough to impress investors. Take their recent third-quarter earnings for example. All six major players turned in excellent results. There was strength right across the board. Markets should have hailed the numbers. Instead they shrugged. Jeered would be a better word!
CIBC and TD Bank both racked up earnings well ahead of expectations, only to see their stocks fall sharply. Scotiabank and Royal not only beat consensus forecasts but increased their dividends as well. First class performances, but both stocks sold off. A lot of the media treated the results as a non-event. Some analysts even downgraded the sector. The bankers must be scratching their heads.
My first thought was that the banks' figures were deceptive, perhaps misleading. But that was not the case, quite the contrary. As I dug deeper, it became apparent that the results were even more encouraging. Balance sheets are in good condition, notwithstanding a 7% asset growth year-over-year for the industry. The all-important return on equity (ROE) averaged an impressive 17.6%, up from 16.6% in the third quarter of 2013. Industry operating earnings per share growth year-to-date came in 11%, well ahead of the 7% some forecasters were looking for. It was an encouraging performance.
Capital ratios, which have caused some concern, are also in good shape. The new Basel III international regulations require our leading banks to establish Equity Tier 1 Ratios (CET1) of approximately 8% but a minimum of 10% is recommended. Calculation of this capital is stringent and has led to creation of new preferred shares, convertible by regulators into common stock. Previously outstanding conventional preferred shares no longer qualify. As a result, there have been warnings that Canadian banks would postpone dividend increases and buyback programs until their revised capital ratios met the new standards. In fact, the industry's CET1 is now 9.8%, up 70 basis points from third quarter 2013 and, as we have seen, distributions are still growing. Equally important, the banks have been able to keep building their risk-weighted assets.
So why was there a negative reaction to third-quarter results? I think investors greeted them with a yawn because they were unexciting. We have been spoiled. These days earnings and other business announcements are a public relations exercise and the banks and other major corporations have only themselves to blame.
At one time people waited for companies to announce their annual results, allowed time for analysts to decipher them and then responded. Later we went to quarterly statements and the tempo picked up. Analysts started trying to forecast earnings, sometimes to the third place of decimals, all based on various assumptions. Companies got into the act by introducing guidance and orchestrating market reaction to their announcements. To some extent it became a game.
By aiming low, managers found they could make even dismal numbers acceptable because they "beat" the forecasts. Highly paid investor relations experts helped to spin results as well as any other press releases.
Over the years, however, people have become wise to all this window dressing. The banks now have a history of beating estimates and that is what everybody expects. It's built into the market. As a result, the third-quarter results were greeted with a yawn, especially as a lot of improvement was buried in capital calculations that failed to grab the headlines. There was an impression that the industry is to some extent marking time. Forecasters talked of slower growth in the years ahead. I disagree. This sector has a lot going for it.
Given the current economic recovery, Canadian banks are extremely well positioned to do well in 2015, mainly because of their core business. Because of surging markets, pundits have been focused on trading and wealth management income but retail and commercial banking still account for more than 50% of the industry's earnings. This is the bedrock and right now it's sound. Domestic loan growth is resilient and this, along with contributions from acquisitions, is more than offsetting compressed interest rate spreads. Loan loss experience continues to improve due in part to stable Canadian employment. Industry operating earnings per share has been growing at 11% and that is likely to continue.
My feeling is that at present levels bank stocks are not fully reflecting this promising outlook. There is upside potential. The shares are also going to be buoyed by continued foreign investor buying, which has already boosted the industry's price/earnings multiples. At the end of August, the Canadian bank index was priced at 12.1 times earnings, up 16% from 10.4 a year before. Attractive dividend yields are another plus. The index currently yields 4% compared to about 2.6% from a 10-year government bond.
Finally, I think bank stocks provide a defensive hedge against any serious correction. They should be an important part of all portfolios.
TD Bank (TSX:TD, Financial)(NYSE: TD)
Originally recommended on Feb. 12/07 (#2706) at C$34.98, US$29.80 (split-adjusted). Closed Friday at C$54.14, US$48.09.
TD reported third-quarter earnings of $1.15 a share, comfortably beating the $1.10 consensus forecast. All of the bank's operating divisions contributed but Canadian retail was particularly strong. This domestic segment, which includes some wealth management and insurance, turned in a profit of $1.4 billion, up 54% year-over-year. Business lending growth remained strong at 11% and credit card business surged 26% over 2013, partially as a result of the CIBC Aeroplan account acquisition.
As one analyst put it, this was a quarter when virtually all the bank's moving parts functioned well. U.S. retail profit of $485 million was up 9.2% from $444 million a year ago, while wholesale banking numbers jumped 46%. Most important, loan loss experience improved, especially in the U.S. auto loan division. Canadian condo mortgage exposure remained stable at $35 billion, 68% insured.
Overall, the fundamentals are solid and likely to improve as the U.S. economy continues to gain strength. Earnings of $4.50 a share are expected this year with an increase to the $4.75 range in 2014. The bank's excellent capital ratio allows room for share repurchases as well as further acquisitions.
Action now: TD Bank remains our first choice amongst the banks and is a Buy with a revised target of $64. I have set a $52 revisit level.
Bank of Nova Scotia (TSX, NYSE: BNS)
Originally recommended on Jan. 17/11 (#21102) at C$56.83, US$57.34. Closed Friday at C$68.54, US$60.83.
Scotiabank also turned in an impressive third quarter, although there were some blemishes. Earnings of $1.41 a share were better than some analysts' projections but here the numbers were bolstered by securities gains as well as basic banking results. As a matter of fact, loan growth in Scotiabank's important International operation, while still a respectable 8%, has moderated.
On the plus side the bank boasts an impressive 10.9% capital ratio. The dividend was increased to $2.64 per annum.
Scotiabank offers an attractive combination of a rock solid Canadian major bank and meaningful exposure to Latin America, the Caribbean, and Asia. As a matter of fact, this stock is an excellent way for more conservative investors to play the emerging markets.
That having been said, there are going to be occasional disappointments because of the uncertainties associated with foreign operations. In the third quarter, lower margins and higher credit costs in the Caribbean dampened overall results. Nevertheless this offshore business has great potential.
We should see cash earnings of about $5.50 a share in 2014 and as much as $6 next year. The stock bypassed our target of $72 in mid-September before pulling back. It looks very attractive at current levels.
Action now: Scotiabank is a Buy with a revised target of $80. I will revisit the stock if it dips to $67.
National Bank (TSX:NA, Financial)(NTIOF)
Originally recommended on April 11/11 (#21114) at C$38.35, US$40.11 (split-adjusted). Closed Friday at C$50.81, US$45.56.
National Bank continues to report solid progress and earned $1.16 a share in the third quarter. Revenue was higher than expected due to a strong contribution from capital market operations. The trouble is that these divisions now account for 35% of National's net income, well above management's 25% -30% target. Bread and butter Personal and Commercial bank earnings growth, however, is starting to lag a little. Volumes during the quarter were up 7% year-over-year but increased costs squeezed these margins.
In February, we downgraded National to a Hold because it was fully priced at $44.44. Since then the shares have risen as high as $53.95 and closed on Friday at $50.81, up 32.5% from our original recommendation at $38.35. It's a move that more than reflects recent results and consequently I still think the stock has limited upside potential.
Moreover, there are now several other factors that concern me. National's CET1 ratio of 9.1% is lower than the industry average and unlikely to reach a projected 9.7% until late next year. That means any stock buyback program is going to be hampered. At the same time, the bank is now heavily dependent on unpredictable capital market income. National is also going to encounter strong competition as it expands loan business outside the Quebec base.
None of these possible problems is serious. National Bank is an excellent stock. At this stage, though, it is vulnerable and likely to move sideways. I think we should take our profits.
Action now: National Bank is a Sell at $50.81. Including dividends of $5.83, we have a total return of 47.7% on this one.
