Encounter

Why aren't bank stocks trading at higher multiples?
By Sonita Horvitch | 11/11/16

Editor's note: This week's coverage of Morningstar's Canadian equity roundtable concludes today with the portfolio managers praising Canada's top railway companies and explaining why they view dividend-rich bank stocks as undervalued.

About the Author
Sonita Horvitch is a Morningstar columnist who specializes in reporting on money managers and their strategies. A veteran financial journalist, she was formerly with the National Post and its predecessor, the Financial Post. At the Post she was best known as the author of the popular Buy & Sell column, which she wrote from its inception in 1994 to December 2008. She holds a master's degree in business economics from the University of the Witwatersrand in Johannesburg, South Africa.

Our panellists:

Michael O'Brien, managing director and head of the core Canadian equity team at TD Asset Management Inc. His mandates include that of lead manager of TD Canadian Equity and TD Balanced Income.

Daniel Bubis, president and CEO of Winnipeg-based Tetrem Capital Management Ltd. Bubis and his team manage a range of mutual funds for CI Investments Inc., including CI Canadian Investment and CI Canadian Investment Corporate Class.

Mark Thomson, chairman of the board and managing director, equities at Beutel, Goodman & Co. Ltd. Thomson and his team are responsible for a range of mandates including Beutel Goodman Canadian Equity, Beutel Goodman Canadian Dividend and Beutel Goodman Balanced.

Morningstar columnist Sonita Horvitch convened and moderated the roundtable. Her three-part series began on Monday and continued Wednesday.


Q: Can we talk about industrials? At the end of September, this sector represented 8.8% of the benchmark. Like materials and energy, industrials staged a turnaround over the 12 months to the end of September. Industrials produced a total return of 15.2% versus its negative total return of 10.4% in the prior 12 months. The railways are a significant weight in this sector.

Daniel Bubis: We own  Canadian National Railway Co. (CNR). The stock has done well this year. It's another company where you pay for quality. The stock is not cheap, particularly relative to some of the U.S. rails. Despite the challenges of slower oil, grain and intermodal movements, CN has still been able to achieve good pricing. It shows the value of its economic moat. Quarter after quarter, the company keeps improving its operating ratio. You try to buy the stock when it's out of favour.

Michael O'Brien
Michael O'Brien

Michael O'Brien: I'm a huge fan of the rails. CN is one of the best of the blue chips. It's a core holding. The rails are not that cheap, at this stage. A lot of the commentary about CN applies to the Canadian banks. Even in difficult times, their resilience shows through.

Mark Thomson: The Canadian rails have among the best operating ratios in the world. We own both CN and  Canadian Pacific Railway Ltd. (CP). Their management is shareholder-focused. The companies have returned a lot of capital to shareholders. Having said that, the stocks are not cheap.

O'Brien: No one thinks of CN as a dividend stock. But in 2005, its dividend per share was 25 cents and today it's $1.50.

Q: What about the Canadian financial-services sector? At the end of September, financials had a 33.1% weighting in the S&P/TSX Composite Index. They slightly underperformed the benchmark in the 12 months to the end of September 2016, with a total return of 13.2%. They outperformed in the prior 12 months with a negative total return of 1.5%.

Thomson: This year, the bank stocks, with their exposure to energy, were probably discounting a much lower oil price than the stocks of energy producers. This approach to the Canadian banks was largely formulated outside the country. The banks are extremely stable businesses and their exposure to all credit, including oil, is relatively modest in the context of their historic exposure. These are among the best businesses in Canada and the stocks are among the cheapest in Canada. The stocks are highly liquid.

O'Brien: They are resilient businesses. We do have significant exposure to the banks. Also, where else are you going to find a 4% dividend yield, with a dividend that grows every year? This is in a world where government bonds are yielding 1%. Paying 11 times earnings per share for these stocks is attractive.

Daniel Bubis
Daniel Bubis

Bubis: Why are the banks not trading at a higher multiple? When you look at the rest of the world and see what you get for 16 times earnings, the banks are good investments. There is also the potential for increased earnings if there is a steeper yield curve or higher interest rates. The equity market is not factoring this in. There will not be a rerating of Canadian bank stocks until we get through the question of an overheated Canadian housing market.

O'Brien: Housing is the most obvious domestic issue in Canada that we have to navigate.

Thomson: If you look at some of the other dividend-paying areas, like the pipelines and the telecommunications stocks, some of the companies' dividend-payout ratios are through the roof. The banks have a 40% to 50% payout ratio.

Bubis: What is so nice about Canadian bank stocks is that even if there is not multiple expansion, if they grow their earnings per share at 2% to 3% a year and you get a 4% dividend yield, that is a 6% to 7% total return a year. This is a high return in a mid-single-digit return world.

Q: Can we discuss the impact of the Liberal federal government's tightening of the residential mortgage rules on the banks? This government has, for example, upped the mortgage stress-test requirements. It has also raised the prospect of lender risk-sharing. This would require mortgage lenders to manage a portion of loan losses on insured mortgages that default. Consultations are under way on this.

Michael O'Brien
Michael O'Brien

Thomson: The Canadian government, under all parties, has been tightening the mortgage rules for quite a while. The new rules introduced by the Liberal government will help to mitigate the potential risks in the Canadian housing market. The banks have a lot of high-quality mortgages, whether they have insurance on them or not. I don't see this whole initiative as being material. Also, we're dealing with an oligopoly, and if there is shared risk, the banks will price this into their mortgage rates.

Bubis: Why are the banks trading at 11 times earnings? Investors are worried about the Canadian housing market. Now, the federal government is introducing regulations to help stabilize the housing market, and ironically investors are concerned that these measures are bad for the banks.

Q: Time to talk about your holdings in the financial-services sector.

Thomson: We particularly like  Toronto-Dominion Bank (TD) and  Royal Bank of Canada (RY). We have a 9% weighting in each of them in our Canadian large-cap equity portfolio. Between the two of them, they have about a 50% share of the Canadian market. Management is good at both banks. The two banks are taking market share from their competitors. Their size will enable them to have better operating leverage, so that their bottom line will grow faster than their top line. Royal is not so price-sensitive on acquisitions, but its purchase of Los Angeles-based City National Corp. a year ago was a good move. TD has continued to be a value buyer of good businesses. We also own  Bank of Nova Scotia (BNS) and  Canadian Imperial Bank of Commerce (CM). Scotiabank punches above its weight. In the case of CIBC, the hope is that its Canadian franchise will gain the ascendancy that it deserves.

Bank of Nova ScotiaRoyal Bank of CanadaToronto-Dominion Bank
Nov. 9 close$71.63$84.34$60.56
52-week high/low$72.56-$51.17$85.86-$64.52$61.92-$48.52
Market cap$86.2 billion$127.4 billion$114.7 billion
Total % return 1Y*22.215.215.2
Total % return 3Y*7.510.011.3
Total % return 5Y*10.516.914.0
*As of Nov. 9, 2016
Source: Morningstar

Bubis: Coming into the summer, we upped our holding in Royal. It's now our largest weight in CI Canadian Investment. The stock was trading at a valuation in line with the other banks. We thought it deserved a premium.

O'Brien: Royal is our biggest holding in TD Canadian Equity. Royal is about 7.5% of the portfolio. TD is about 7%, as is Scotiabank. We have smaller positions in  Bank of Montreal (BMO) and CIBC. Since the summer, we reduced our holding in CIBC. Some of the proceeds have gone into Royal, TD and Scotiabank and some into the life insurers.

Q: The insurers?

Thomson: These are stable businesses, despite how the stocks have traded historically. The decline in interest rates in 2008, combined with their exposure to the stock market, gave them a more volatile tone than the underlying businesses would merit. Investors are not appreciating the importance of their strong wealth-management businesses. We own  Manulife Financial Corp. (MFC) and  Great West Lifeco Inc. (GWO). Manulife has its very attractive Asian franchise, which is about one-third of the company. Great-West is extremely well run, risk-averse and is a strong cash-flow generator.

Bubis: We also own Manulife. It's a good franchise and the stock is inexpensive. The low-interest-rate environment is a challenge for these life-insurance companies. One of the reasons why they have been doing well recently is the prospect of rising interest rates.

Photos: Paul Lawrence Photography

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