Solid reasons to keep owning Canadian bank stocks

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There is a lot of heavy sighing coming from Canadian banks these days. Revenue growth is slowing, bad loans to the energy sector are piling up, nimble technology firms are nipping away at bank services and layoffs have become a regular occurrence.

It adds up to a difficult environment. And investors who have long counted on bank stocks to deliver strong returns must now be asking themselves whether the stocks are worth holding through these difficult times.

They are. But investing in bank stocks right now requires some adjustment in expectations and a willingness to tune out some of the more alarming headlines on stories written by – cough, cough – banking reporters.

Here's how to approach the sector:

Put the bad news into perspective

Yes, these aren't ideal conditions for the banks, but it's important to remember that these are solid, diversified and well-managed businesses that are here to stay.

Take the threat from energy loans. It is likely that banks will have to write off close to 10 per cent of these loans as struggling energy companies fail to meet their obligations owing to low oil prices. But energy loans represent on average just 2.2 per cent of total bank loans, so the banks should be able to digest the write-offs.

The threat from financial technology companies, or fintech, is harder to quantify given that it is still emerging. However, banks will likely partner with or absorb some of the more promising fintech companies.

Fintech companies that compete will take some market share and force the banks to drop their fees to remain competitive. But the banks are transforming themselves to become more efficient (this is what's driving many of the layoffs), which should offset much of this fintech-driven turbulence.

Keep in mind that in a low-return world, plodding banks look attractive relative to the alternatives

The stocks have delivered an average return of more than 10 per cent a year for the past two decades, after including dividends, outpacing the benchmark S&P/TSX composite index by a wide margin.

Over the past two years, this average annual return has slipped to about 5 per cent, suggesting that the banks' golden years are fading. To be sure, the years of explosive loan growth, driven by falling interest rates and a hot housing market, are probably over.

But the banks still look better than most other investments. The Canadian benchmark index is no higher today than it was two years ago as investors digest the implications of slow global economic growth, volatile commodities and high stock valuations.

U.S. stocks are stuck in a similar rut as high share prices look out of sync with weaker corporate profits. Companies within the S&P 500 are on track to show a decline of more than 7 per cent in their first-quarter profits.

Against this backdrop, Canadian bank stocks look good – and cheap. Bank stocks trade at just 11.2 times estimated profit per share, or slightly lower than the historical average, according to RBC Dominion Securities. That's a deal compared with the S&P/TSX composite index, whose price-to-earnings ratio is higher than average, at 18.4.

Mutual-fund managers are taking note. According to Montreal-based LuxArbor Institutional Positioning, funds are underweight financial stocks – but the top-performing funds, or those that have outperformed their peers over the past three months, are now slightly overweight financial stocks. Perhaps they sense an opportunity.

Check out those dividends

It's hard not to. The banks are making big profits and have been passing the gains along to investors in the form of higher dividends. Canadian Imperial Bank of Commerce has raised its dividend for six consecutive quarters.

The result: Dividend yields among the Big Six banks average 4.4 per cent. Analysts expect the banks will continue to hike their dividends, driving either higher share prices or higher yields – or both.

Again, the banks stand out next to the alternatives. The average yield for stocks in the S&P/TSX composite index, after you strip out the Big Six, trails at just 2.9 per cent, according to LuxArbor. And the yield on the five-year Government of Canada bond is a mere 1.3 per cent.

Sure, the banks are dealing with some bad news these days. But investors should ignore it.

Disclosure: The author owns units of BMO S&P/TSX Equal Weight Banks Index ETF (ZEB).