Toronto skylineFred Lum/The Globe and Mail
The Canadian banking sector entered 2010 facing high earnings expectations. So far, it has been delivering.
With four of the country's Big Six banks having reported their fiscal first-quarter earnings - and another, Toronto-Dominion Bank, set to report today - the results have been generally better than analysts anticipated. A key contributor has been lower-than-expected provisions for losses on bad loans - a money pit that has swallowed bank profits in recent quarters.
The results are lending support to an earnings recovery story that bank stocks are going to need if they expect to continue to rise in 2010. In the wake of 90-per-cent price increases and a sharp increase in price-to-earnings multiples for the group last year, analysts feel earnings growth may provide the only impetus to push the stock prices much higher in the coming months.
"A lot of positive expectations are already priced in," said CI Capital Markets analyst Brad Smith. "The price appreciation from here is much more likely to be from earnings exceeding expectations than from multiple expansion."
The S&P/TSX banks subindex is trading at a multiple of 12.8 times the forward 12-month consensus earnings forecasts - almost double the price-to-earnings multiple of a year ago, and nearing the long-term historical peak of about 14 times. And that valuation is based on already lofty earnings growth forecasts of 20 to 25 per cent for the coming year.
Mr. Smith said that unless the banks are able to top those forecasts, their stocks will have a hard time generating more than single-digit percentage gains in 2010.
However, the surprisingly small loan-loss numbers in the first quarter have thrown open the door for profits to blow past those projections if the banks are able to substantially reduce those provisions in the coming quarters.
"If the credit deterioration is in fact behind us, I'll be eating my words," Mr. Smith said.
George Vasic, chief strategist at UBS Securities Canada Inc., said that despite the price gains of the past year, Canadian bank stocks still look well positioned relative to other sectors as the economic recovery takes hold.
"Across all the economic scenarios, they'll perform neutral to somewhat better," he said, adding that this means less downside risk to their growth outlook. "The earnings certainty is pretty high."
Mr. Vasic noted that despite the market-beating gains in bank stocks over the past year, much of that took place in the first half of the market rally. The sector hasn't been running ahead of the rest of the market - or ahead of itself, for that matter - for months now.
"The outperformance has already been met by a period of consolidation. For four or five months, [bank stocks]have lagged the rest of the market."
National Bank Financial technical analyst Dennis Mark recently noted that the S&P/TSX financials index - of which the banks are the dominant components - has been stuck in a fairly narrow trading range for the past eight months, but is now testing the top of that range.
He said that with the three technically strongest bank stocks - Bank of Nova Scotia, TD and National Bank of Canada - on the verge of breaking out above their trading ranges and the three other big banks not far behind, the sector "has good potential" to finally break through its technical resistance and move higher in the near term.
If it does, he said, the banks could be looking at a near-term upside of 5 to 8 per cent.
Analysts said the big wild card for bank stocks remains their dividends - which offer an attractive yield in the 4-per-cent range, yet have been stuck in neutral as the banks have worked through the credit crunch and focused on expanding their capital bases.
Many experts believe dividend increases may still be out of the question in 2010, as the banks continue to preserve capital and err on the side of caution. But Mr. Vasic believes the prospect of dividend increases could begin to resurface as the year progresses, lending support to the stocks.
"We're not that far off that discussion starting up again," he said.
****
S&P/TSX Banks Index
Yesterday's close 1,902.50, down 8.58
52-week return: 91.5 per cent
Year-to-date return: 2.5 per cent
Price-to-earnings*: 12.7
Price-to-book: 2.1
Dividend yield: 3.9 per cent
*Based on forward 12-month estimates
THE GLOBE AND MAIL / SOURCE: BLOOMBERG
David Parkinson