Credit Suisse analyst Kevin Choquette believes Canadian banks are both oversold and undervalued, making now the perfect time for domestic investors to add bank stocks to their portfolios.
Valuation levels in the bank sector, notably price-to-book-value (P/BV) ratios, are the main driver of Mr. Choquette's optimism. The S&P/TSX bank index currently trades with an average price-to-book ratio of 1.5 – the most attractive levels since April of 2009. The market is pricing the sector for expected loan losses that are far beyond what will actually occur, according to Mr. Choquette.
"The major correction in P/BV to 1.5 times represents implied credit losses of $32-billion or 1.34 per cent of loans, which is two times our severe stress scenario," he wrote in a report Thursday.
The chart below, which compares bank valuations and forward-market performance, supports Mr. Choquette's argument. (Note that price-to-book values are plotted inversely on the chart to better show the trend). The grey line shows the average P/BV ratio for the sector for each week in the past 10 years. The orange line shows the market returns in the subsequent year for the bank index. For instance, the first data point for each line indicates that on Jan. 13, 2006, the average P/BV ratio for the sector was 2.9 times (grey line). The bank-index return for the subsequent 12 months – from January, 2006, to January, 2007 – was 12.6 per cent (orange line).
The chart strongly implies that low price-to-book levels successfully predict stronger performance for bank stocks. The most obvious example is the end of the financial crisis in late February, 2009. The average P/B value for the sector had dropped to 1.1 times – the lowest level in the past 10 years. In the 12 months following that reading, the S&P/TSX bank index jumped 99.9 per cent.
The last available data point for bank-index forward performance is for the Jan. 2, 2015, to Jan. 2, 2016, showing a loss of 8.4 per cent. The declining P/BV measure for the sector (reminder – the price-to-book value is plotted inversely on the chart) since September, 2014 – a drop from 2.2 times to the current 1.5 – makes it very likely that performance in the domestic banking sector will steadily improve in the coming year.
The risk to Mr. Choquette's view is that the market has more accurately forecasted upcoming credit losses as the Canadian credit cycle slows. As noted, the market is pricing the sector for $32-billion in upcoming losses whereas Credit Suisse believes losses will be far lower.
Nonetheless, the bullish view has market history on its side – low price-to-book levels have almost always signalled higher returns. Mr. Choquette's top picks in the sector are Royal Bank and Bank of Montreal.
Follow Scott Barlow on Twitter @SBarlow_ROB.