The quest for yield in 2011 led many investors to put their cash to work in the major Canadian banks, which sport attractive yields of between 3% and 5%.
Last year BMO Covered Call Canadian Banks ZWB and BMO S&P/TSX Equal Weight Banks ZEB together attracted well over $1 billion in net new assets. Newly minted Horizons Enhanced Income Financials HEF also pulled in roughly $32.7 million in the back half of the year. In light of the massive flows the banks have attracted, we dug a little deeper into their current valuations and prospects to assess whether the group is still ripe for new investments today.
What we found is that while Canada is home to a structurally attractive banking industry, the banks still face a tall order in trying to replicate the success they've enjoyed over the past few years. Despite the recent pullback in the bank stocks, we think current multiples of two to three times tangible book value offer investors little margin of safety. As well, Morningstar's equity analysts recently lowered their economic moat rating for the Big Five banks from wide to narrow, expressing concerns over the viability of their long-term competitive advantages. Furthermore, we think there is a reasonable likelihood of slower growth and higher loan losses in the near future.
This is by no means a recommendation to go and sell all your exposure to bank stocks. Rather, we're suggesting a more tempered outlook for future earnings growth. If you bought into the banks in order to collect the juicy dividends, then there's no reason to bail now. We simply think that the banks could see limited capital appreciation over the next few years. That doesn't mean we can't collect a generous yield while we wait for the situation to improve.
Outlook for the major Canadian banks
There are a number of factors that we believe will lead to slower loan growth and dampen earnings growth for the Canadian banks. For some of them, loan growth has averaged nearly 10% over the past five years. We think the slower macroeconomic environment, along with historically high consumer debt levels, will slow loan growth. More recently, investment banking revenue has come under pressure, given the recent turmoil in world markets. While the Canadian banks have little direct exposure to Europe, their trading revenue has not been immune to recent events.
Flat yield curve to weigh on profitability
First, we think the flattening of the yield curve will put pressure on net interest margins. Flatter yield curves generally negatively affect revenue for banks as they decrease the differential between banks' lower short-term borrowing rates and higher longer-term lending rates. With the yield curve at historic low levels, there is little room for banks to earn yield on loans or fixed income. For instance, in the five-year portion of the curve, where mortgages are typically based, yields are nearly 100 basis points lower than last year. Canadian consumers' limited ability to prepay their mortgages has cushioned the impact on banks for now. But we think that over time, if these low rates continue, net interest margins will be hurt.
Shaky foundation in the housing market
Canada has experienced its own housing boom whereby the home ownership rate has risen to 69%, similar to the U.S. at the peak of the housing bubble. Household debt as a percentage of disposable income has risen to 147% from about 90% in 1990. By comparison, household debt to disposable income for the U.S. peaked in 2007 and has been falling ever since as the U.S. consumer deleverages. We think the growth of household debt to disposable income for Canadians is unsustainable, which will result in lower loan growth for the banks.
Interestingly enough, in the latest round of earnings reports we've even heard the CEOs of both Bank of Montreal BMO and Royal Bank of Canada RY refer to the Canadian housing market as "over-heated." However, less than a week later, most of the large banks (BMO and RBC included) began to offer a special rate of 2.99% on a four-year fixed product to qualified borrowers (1.40% below the "normal" rate) and 3.99% on a seven-year product (2.36% below "normal"). If these banks are worried about excessive home pricing, offering cheaper financing is a strange way of showing it. To us it looks like an attempt to maintain higher loan growth in order to make up for lost loan yield in this rate environment. While Canadian banks have proven to be prudent lenders in the past, we will monitor these attempts to maintain historical loan growth.
Despite the ballooning debt, we have yet to see the same excessive home price appreciation as experienced in the U.S. Real estate is still appreciating in Canada, but we don't expect it to reach U.S. crisis levels. Still, given the high debt levels of the consumer and unsustainable increases, we expect downward pressure on prices when the Canadian consumer decides (or is forced) to deleverage.
Dealing with the debt burden
Even as consumer debt levels have risen rapidly, Canadian debt service ratios--debt payments to disposable income--have remained fairly stable (and well below that of the U.S.) That's because the increase in debt has coincided with deep interest rate cuts. But we expect Canadian debt service ratios to start moving higher over the next five years or so, as mortgage loans re-price at potentially higher interest rates. Remember that Canadian mortgage terms tend to be typically in the five-year range. In our view, historically high debt levels, combined with higher debt service ratios will serve as a long-term damper on loan growth.
New frontiers, new challenges
Let's face it; Canada is one of the most attractive markets in the world for banks. But, with a maturing Canadian landscape that's approaching saturation, many of the banks are looking to fuel earnings growth through acquisitions and expansion into new geographical markets. This heightens risk, in our view, as the banks will face integration and operational challenges by branching out into lower-return markets governed by different regulatory regimes.
With the recent flurry of acquisition activity, particularly in asset management, we think there is an increased risk that banks will destroy shareholder value by overpaying for assets. For example, the soundness of Bank of Montreal's acquisition of M&I appears to depend on the favourable resolution of problem assets it acquired in the deal. As with most of the asset-management acquisitions, we think this deal further depends on the acquired advisors staying with the new company and not leaving for another firm. While Canadian banks' foreign bank acquisitions offer access to markets with much higher GDP growth, there is increased credit risk, given the higher nonperforming loan levels at these target institutions. We don't think stock market prices fully incorporate this risk.