Another reason to stay invested in Canadian bank stocks

Share

Canadian bank stocks have barely budged since Warren Buffett announced last week his investment in Home Capital Group Inc., removing a concern that has lingered over Canada's housing market and financial system for the past two months.

If Mr. Buffett can't spark a rally in bank stocks, what will?

Here's one idea: The factors that have eroded the banks' return on equity, a key measure of profitability, over the past decade should stabilize this year and start edging higher.

The improvement could drive bank stock valuations higher and boost stock prices in the sector, which has been underperforming the benchmark S&P/TSX composite index for the past four months.

Robert Sedran, an analyst at CIBC World Markets, noted bank ROEs have been under near-constant pressure since the global financial crisis.

However, he added: "We think the power of the factors that have caused these declines is beginning to fade, which suggests a better outlook than we have seen in some time."

Bank stocks enjoyed a strong run-up after the price of crude oil began to recover from decade lows in February, 2016, silencing worrywarts who fretted over the quality of bank loans to energy companies.

The stocks continued to rise following the election of Donald Trump last November, as investors embraced the new President's promises of stronger U.S. economic growth and relaxed financial regulations.

After hitting highs in early March, though, bank stocks have drifted lower. The S&P/TSX commercial-banks index has slipped 6.2 per cent over this period, underperforming the broader index by about four percentage points.

Since Mr. Buffett's Berkshire Hathaway announced last Wednesday night a deal to acquire a $400-million equity stake in Home Capital, the beleaguered alternative-mortgage lender, bank stocks have risen a mere 0.7 per cent.

Bank stocks have been awesome long-term investments, but investors are no doubt wondering when the "awesome" will return.

Mr. Sedran's bullish argument for the sector rests on stable-to-improving ROEs, a ratio that compares a bank's profit with shareholder equity.

Big Six bank ROEs were above 20 per cent, on average, before the financial crisis, which means they delivered a profit of $20 for every $100 in equity. But the average has since fallen to about 15 per cent, weighed down by slower asset growth and strict global financial regulations that placed targets on leverage and capital.

The banks have done well over this period: Share prices have rallied 250 per cent from their bear-market lows in 2009. But higher ROEs, no doubt, would have delivered stronger gains, which is why any improvement from current levels should be welcome.

What would provide a boost?

Mr. Sedran outlines a number of potential factors. U.S. interest rates have been rising and a sunnier economic outlook in Canada has increased the possibility of rate hikes here, too. When rates rise, banks make more profit on their loans in the form of rising net interest margins.

Mr. Sedran estimates that for each five-basis-point (there are 100 basis points in one percentage point) improvement in interest margins, ROE would improve by 15 to 20 basis points.

As well, the banks' common equity Tier 1 ratios, a measure of how much capital the banks have to absorb potential losses, now average more than 11 per cent, which is above the level regulators require.

If the banks stop squirrelling away capital and their capital ratios flatten out, Mr. Sedran estimates ROEs would get an 18-basis-point boost.

Lastly, the banks are cutting costs – shedding branches and employees – as they adjust to a shift in consumer preferences toward online banking. For every 50-basis-point improvement in the banks' efficiency ratios, ROE should rise by 19 basis points.

Altogether, Mr. Sedran expects ROE could improve by 54 basis points, or about half a percentage point, next year. He thinks if ROEs reclaim some lost ground, then valuations should reflect this improved profitability as well: Price-to-earnings ratios should rise by 10 per cent to 15 per cent, giving stock prices a boost. Add that to profit growth in the mid-single digits and attractive dividend yields of about 4 per cent and the banks should produce solid returns, Mr. Sedran said.

Bank stocks have served investors well. Consider this one more reason to stay invested.