Canadian bank stocks have outperformed the benchmark by more than 10 per cent year-to-date, leaving the sector fairly valued relative to market history. Investors in the sector can expect solid returns over the next five years.
The S&P/TSX Banks Index (TXBA) has provided a 26.1-per-cent total return in 2021, easily outdistancing the S&P/TSX Composite’s 15.9-per-cent mark. I took a closer look at valuation levels relative to history to assess how far the sector had to run higher.
BofA Securities identified price to forward 12-month earnings (P/E) ratios as the valuation method that most successfully predicted future returns for U.S. banks stocks. Applying this to Canadian bank stocks, we do indeed see a significant correlation between Canadian bank forward P/E ratios and future five-year returns.
The S&P/TSX Banks Index’s current forward P/E ratio is 11.2 times, marginally more attractive than the 11.7 times average since 2003 (the most data available).
The accompanying scatter chart shows the predictive ability of bank P/E ratios since 2003. The dots represent the P/E ratio for every month-end since February, 2003, and the subsequent five-year average annual return for the sector.
I coloured a dot light blue in the upper left for the purpose of showing how the chart works. The light blue dot shows a data point when the forward P/E ratio was 8.2 times (x-axis) and the y-axis indicates that the index’s total return averaged 28 per cent annually in the following five years. (The data point is from Feb. 27, 2009, but dates are not used in scatter charts).
The trend line on the chart, the product of linear regression calculations, allows us to estimate future expected returns. If we find the current P/E level of 11.2 on the x-axis, and then follow that point up to the trend line, the y-axis tells us to expect simple returns of between 7 per cent and 8 per cent annually in the next five years.
Performance at this rate, plus an average dividend yield of 3.6 per cent for the sector, would be welcome in most portfolios, particularly given the low volatility of bank profit growth.
Like any single analytical method, regressions aren’t foolproof and the chart should be used as a general guide only. I would prefer, in addition, to have a longer history of bank P/E ratios than the 18 years available to make the results more credible.
Those caveats aside, past performance patterns imply a bright outlook for domestic bank stocks.
Bank stocks: Solid returns seen
over next five years
30%
25
S&P/TSX Banks Index
Fwd. 5Y avg. ann. return (%)
20
15
10
5
0
-5
-10
8
9
10
11
12
13
14
S&P/TSX Banks Index: forward P/E ratio
THE GLOBE AND MAIL
SOURCE: bloomberg; scott barlow
Bank stocks: Solid returns seen over next five years
30%
25
S&P/TSX Banks Index
Fwd. 5Y avg. ann. return (%)
20
15
10
5
0
-5
-10
8
9
10
11
12
13
14
S&P/TSX Banks Index: forward P/E ratio
THE GLOBE AND MAIL, SOURCE: bloomberg; scott barlow
Bank stocks: Solid returns seen over next five years
30%
25
20
S&P/TSX Banks Index
Fwd. 5Y avg. ann. return (%)
15
10
5
0
-5
-10
8
9
10
11
12
13
14
S&P/TSX Banks Index: forward P/E ratio
THE GLOBE AND MAIL, SOURCE: bloomberg; scott barlow
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Scott Barlow