Canadian bank stocks hit record highs last week after five of the biggest banks reported upbeat fourth-quarter profits and announced a couple of dividend hikes. Now what?
While it is tempting to shy away from a sector that has surged 20 per cent this year, there are three compelling reasons to stay put.
Read more: Are you getting good value from your adviser fees? Here's how to tell
1. The rally follows a two-year break
It would be one thing if bank stocks had risen into nosebleed territory this year, but the reality is they have merely nudged above their previous highs in 2014.
This suggests that this year's gains aren't as fantastic as they initially appear.
The S&P/TSX banks index, which consists of the Big Six and four smaller banks, fell 22 per cent between September, 2014, and February, 2016. That's a nasty bear market over 17 months.
It also coincides with the dramatic decline in the price of crude oil, which raised deep concerns about bank exposure to struggling energy companies and worries that the broader economy could suffer.
The price of oil began to recover in February, and Canadian bank stocks have followed after suffering nothing more than flesh wounds from defaulted loans.
Yes, the recovery in bank stocks has been sharp, but it took the banks index until November to break above its 2014 peak and it is now just 4 per cent above it.
What's more, two big banks – Bank of Nova Scotia and National Bank of Canada, which had the biggest share of loans to the energy sector – are still shy of their respective peaks.
Share prices no longer look like bargains relative to profits. But the average dividend yield for a Big Six bank stock is 4 per cent, which is hard to pass up when dividends are rising (and they are).
2. The banks are getting better
If you haven't visited a branch in some time, you're not alone. You're also not alone if you've been using Apple Pay on your smartphone or if you've considered shifting some of your financial assets to a robo-adviser.
Consumer preferences are shifting, forcing the banks to confront what is arguably the biggest challenge of the past century to their retail banking operations. But they are surviving – and improving.
You can take issue with their approach, which can involve shuttering some branches and laying off workers who were tied to traditional banking. But as investors, you can appreciate the results – even if you must digest the occasional restructuring charge.
At Royal Bank of Canada, the efficiency ratio (which compares expenses to revenue) at its personal and commercial banking division has improved for three straight years, to 45.5 per cent in 2016 from 47.8 per cent in 2014 (for this ratio, lower is better).
The number of full-time employees in this division – which generates about half the bank's profit and is arguably the most exposed to consumer trends – has fallen by about 7 per cent over this three-year period, while revenue has risen by more than 12 per cent. That's encouraging.
And that's just one example.
Toronto-Dominion Bank, Canadian Imperial Bank of Commerce and Bank of Nova Scotia have taken restructuring charges totalling about $2-billion in recent years, related to significant job cuts.
National Bank of Canada booked a $175-million charge in the fourth quarter, tied to 600 job cuts and smaller branches. Its efficiency ratio has improved for three straight quarters.
3. The backdrop is improving
If 2016 was defined by low interest rates, weak economic growth and tumbling oil prices, 2017 looks considerably brighter.
Sure, the Canadian economy is still weak, but the rebound in the price of crude oil has removed one overhanging threat.
Even better: In the United States, the Federal Reserve is gearing up for another interest rate hike, which should make bank loans more profitable.
That's good news for Canadian banks with substantial U.S. operations, such as TD, BMO and RBC. But the move is also promising more profitable lending in Canada as well, as government bond yields follow U.S. Treasury yields higher.
David Berman