Wednesday, July 11, 2018

Why Bank Investors Should Shudder with Each Rate Increase

The Globe and Mail, Ian McGugan, 11 July 2018

The Bank of Canada’s interest-rate decisions, often a rather humdrum affair, are becoming downright fascinating. The announcement on Wednesday of a hike, and the growing probability of more before year-end, suggest that the future will be very different than the past for Canadian banking stocks.

While the latest increase was widely expected, the tone of the announcement “was more hawkish than markets expected,” according to Derek Holt of Bank of Nova Scotia. He is counting on at least one more rate hike this year and would not be shocked to see two.

If this occurs, it would mark a significant turning point, both for the BoC and for the Canadian economy. Over the past quarter-century, and even more so over the past decade, Canadian households have borrowed with abandon as rates have generally headed lower.

Now that the economy appears to be running close to capacity, the central bank is faced with the difficult task of raising rates at a time when household debt burdens are massive by historical standards. Every upward tick in interest rates magnifies the burden of carrying all that borrowing. But the BoC appears increasingly confident that consumers can bear it.

Others have their doubts. The Parliamentary Budget Officer (PBO) warned in a report last year that “the financial vulnerability of the average Canadian household would rise to levels beyond historical experience” if rates climb as it expects over the next few years.

Some investors have their issues as well. In a report last month, Veritas Investment Research in Toronto said the pass-through of higher interest rates to highly indebted households will “drive higher delinquency rates and credit losses among Canada’s Big Six banks.”

The math behind these predictions is straightforward. It rests on the debt-service ratio (DSR), a measure of how much of a household’s disposable income goes to paying off loans, both in terms of principal and interest. The DSR was typically around 12 per cent in the 1990s and early 2000s. After the financial crisis, however, as rates tumbled and borrowing became more attractive, it jumped up to about 14 per cent.

What will happen if borrowing rates tick up by a percentage point over the next couple of years? Canadians owe an average of 168 per cent of their disposable incomes, so, all things being equal, a one-percentage-point bump in interest rates would result in a nearly 1.7-percentage-point increase in the DSR. This would leave the DSR close to 16 per cent, a level not seen in Canada before.

For its part, the PBO report predicts the DSR will hit 16.3 per cent by the end of 2021. To be sure, this ominous forecast could be disrupted if Canadians suddenly start vigorously paying off their debts or incomes jump upward. But whichever number you choose, the logic is clear: As more and more money goes to servicing existing debt at higher rates, less will be left for spending on everything else – or for servicing new debt.

For investors, this suggests Canadian bank stocks should be approached with caution. The Big Six and other lenders have thrived over the past quarter-century as households have more or less doubled their debt levels in relation to their disposable incomes. But if we’re entering a period in which loan growth will be slower, and default rates will rise, bank stocks look distinctly less shiny.

The housing market, too, is likely to feel headwinds. And there’s also the effect on the broad economy as the DSR grows. Veritas calculates that consumers are likely to see a significant slide in their spendable incomes as a result of higher borrowing costs. “We would expect these income effects to have materially negative implications for Canadian household discretionary spending and Canada’s overall economy,” it says.

To be sure, the BoC is aware of all these issues. Governor Stephen Poloz gave a speech in May in which he examined the issue and expressed confidence the central bank can manage the risks. Other countries, such as Norway and Australia, have even higher levels of debt in relation to incomes, he pointed out.

The central bank continued its confident tone on Wednesday, arguing that higher oil prices offset increased trade tensions and that the housing market is stabilizing nicely. So everything is good? Perhaps. But investors counting on a continuation of bank stocks’ endless good fortune may want to temper their expectations.

Tuesday, July 10, 2018

The Next, Crucial Battle in Wealth Management: Banks’ Concentration of Power

The Globe and Mail, Tim Kiladze, 10 July 2018

Six years ago, Canada’s securities regulators stunned Bay Street by launching a review of mutual fund fees. Justifying the probe, they cited research showing these fees are “among the highest in the world” and noted that many advisers do not tell their clients about these costs.

In late June, after multiple rounds of consultations, the watchdogs finally released their recommendations. They landed with a splat.

After so many years of study, the only major proposal was a ban on deferred sales changes. Trailer fees − controversial, annual charges paid by investors to financial advisers, for simply investing in mutual funds − live on.

The verdict is a blow to investors. These annual fees often consume 1 per cent of assets invested in a fund, and they serve as a steep tax on them.

Although the study now feels complete, it shouldn’t be the end. There are still other avenues for regulators to pursue. At the top of that list: the increasing concentration of power in wealth management among the Big Six banks.

Historically, Canada’s banks were second-rate players in this corner of the financial-services industry. Wealth management used to be dominated by non-bank fund managers such as AGF Management and Mackenzie Financial and independent brokerages such as Nesbitt Burns and Wood Gundy.

Methodically, the banks bought and built their way into a dominant position over a few decades, first by scooping up full-service adviser networks in the 1980s and 1990s, then by turning their attention to asset managers such as Phillips Hager & North (acquired by Royal Bank of Canada in 2008) and DundeeWealth (bought by Bank of Nova Scotia in 2011). Toronto-Dominion Bank’s plans to purchase Regina-based Greystone Managed Investments Inc. for $792-million in cash and stock is a continuation of that trend.

The Big Six now account for almost half of long-term mutual fund assets − a proportion that continues to grow − as well as 53 per cent of net mutual fund sales so far this year, according to Strategic Insight, a consultancy that studies the asset management industry.

Has the banks’ newfound power and scale resulted in a better deal for investors? Hardly. The Globe and Mail recently studied the 100 largest mutual funds in Canada, a list dominated by the banks, and found their fees have barely dropped over the last five years. The average decline in management expense ratios (MERs) for the 100 largest funds was just 0.05 of a percentage point, and the average MER is still 1.99 per cent.

About half of those funds are managed by banks. At the top of the list were two RBC fund portfolios that, incredibly, held a combined $55-billion in assets as of Dec. 31. As these megafunds have grown, their expense ratios have not dropped at all, The Globe’s examination found.

A few independents, such as CI Financial Corp., maintain the heft, sales force and name recognition to compete with the big banks in asset management. But overall, independent firms’ ability to provide honest competition is weaker than it was, which makes it harder for startups with lower fees, such as Wealthsimple, or sometimes even global giants with low-cost funds to attract investors dollars.

The banks have such size that they can use their massive networks of bank branches and financial advisers to promote their own funds – and squeeze out rivals in the process.

“Being an independent in investment management isn’t easy,” said John Ewing, chief investment officer at Ewing Morris & Co, an independent asset manager. “The Canadian banks have a lot of different ways to influence investors.”

Sometimes, they take it too far. When asked about the issue of banks selling their own proprietary funds in 2013, Dave Agnew, head of Canadian wealth management at RBC, told The Globe: “We do not force any product, whether it’s in-house or not … to the clients within our wealth businesses in Canada.” This claim now has an asterisk on it. In June, the Ontario Securities Commission fined RBC $1.1-million for paying some of its advisers a better commission to sell the bank’s own funds between 2011 and 2016.

RBC says Mr. Agnew’s comment was not misleading. Non-RBC funds are still sold within the bank’s system. But while the bank may not “force” a fund on its customers, it was caught offering some employees 10 basis points more in commissions to sell in-house funds. Over five years, the OSC found that the enhanced compensation added up to $24.5-million.

“Money talks,” said John O’Connell, who runs independent asset manager Davis Rea Investment Counsel and was formerly a top financial adviser at RBC Dominion Securities. And the banks know it, he argues. “They have always used compensation as a behaviour control.”

This matters more than ever. Despite all the hype around low-cost, exchange-traded funds, mutual funds are still a big deal in Canada – they account for 36 per cent of the country’s $4.5-trillion in financial wealth, more than bank deposits. And the banks are becoming ever more powerful in this market, as they continue to scoop up competitors. Bank of Nova Scotia has been particularly acquisitive lately, buying Jarislowsky Fraser Ltd. for nearly $1-billion and MD Financial for $2.6-billion this year – two respected independents.

This consolidation is playing out against a new backdrop. For many years, banks have benefitted from a lending boom spurred by ultra-low interest rates. That phase is coming to an end. The lenders now refer to the “decade of wealth,” noting that baby boomers will be retiring in waves and they will need help with investments, which should drive growth.

Independent financial-advisory firms still have the highest number of advisers – about 30,000 of them. However, this segment of the market usually has clients with much smaller account sizes, according to Strategic Insight.

The banks, meanwhile, now have roughly 10,000 advisers located in their branches, who mostly sell mutual funds to the “mass affluent” market, or clients with, say, $50,000 to $250,000 in investable assets. Within the branches, banks can try to cross-sell funds to their banking clients, and credit cards and mortgages to their wealth-management clients. Facebook, some others – wield immense power. But abusing that scale, to the detriment of investors, should never be allowed to fly.


Monday, June 11, 2018

Scotiabank's 2017-2018 Acquisition Binge

The Globe and Mail, David Berman, 11 June 2018

Bank of Nova Scotia’s acquisition binge is weighing on its share price amid concerns about the bank’s ability to digest new assets valued at a whopping $7-billion.

But while some analysts are growing nervous about the stock and slashing their outlook, contrarians should see the recent turbulence as a gift.

You can certainly understand why Scotiabank’s pace of deal-making is drawing attention: Five deals in seven months mark the bank’s most significant streak of takeovers in recent memory.

In terms of dollar totals, the recent spending spree is equal to seven years’ worth of previous deals, which included the takeovers of ING Bank of Canada in 2012 and DundeeWealth Inc. in 2010.

Scotiabank, which has been focusing on its substantial international operations in Mexico, Chile, Colombia and Peru, kicked off its latest deal-making in late November, 2017, when it announced a $2.9-billion deal for a 68-per-cent stake in BBVA Chile.

In January, Scotiabank announced a $435-million deal to acquire Citibank’s retail and small-and-medium sized business operations in Colombia. In February, it snapped up Jarislowsky Fraser Ltd., the Montreal-based independent investment firm, for $950-million.

In early May: a $130-million deal for a 51-per-cent stake in Peru’s Banco Cencosud. And near the end of May, Scotiabank announced an agreement to acquire MD Financial Management, an Ottawa-based wealth management operation that caters to doctors, for nearly $2.6-billion.

In yet another financial transaction, the bank closed a $1.7-billion equity offering last week to help fund the latest deal – its first public offering in nearly six years.

Analysts acknowledge that the deals are consistent with Scotiabank’s regional focus and interest in expanding its wealth management operations. But the hefty prices paid, along with some concerns that deals are being struck when the economic cycle may be nearing a peak, have driven some notable downgrades.

On Monday, RBC Dominion Securities lowered its recommendation on the stock to “sector perform” from “outperform” – its first downgrade in four years − and cut its target price on the stock to $86 from $95 previously.

The brokerage said the downgrade was a response to “heightened execution risk, dilution, and uncertainty related to several acquisitions.”

It added: “Scotiabank has deployed upwards of $7-billion of capital at very high prices that require significant synergy to create value for shareholders. It is our view that synergies are far from certain and most likely far into the future.”

National Bank Financial also lowered its recommendation to “sector perform” and cut its target price to $85 from $88.

To be fair, these are just two killjoys compared with 10 upbeat analysts who recommend the stock as a “buy.” But the dimmer outlook, at a time when Scotiabank’s share price is down more than 6 per cent year-to-date and trailing all of its Big Six peers, must make some investors wonder whether the shares are best avoided.

Near term, they may be: If there are additional downgrades, investor sentiment is going to be challenged, especially if economic ripples undermine the value of the bank’s financial assets.

Longer term, though, an underperforming bank stock should excite investors – and Scotiabank is no exception.

Why? Scotiabank completed its equity offering last week at a price of $76.15 a share, 10 per cent below the stock’s record high but hardly a distressed sale. Indeed, given that the shares are up 35 per cent since the start of 2016, you could argue that the bank is tapping the market at a time of strength – which is smart.

Second, the stock’s valuation is compelling. According to Bloomberg, the shares trade at 10.8 times estimated earnings – a bargain next to Royal Bank of Canada, Toronto-Dominion Bank and Bank of Montreal, and well below its 10-year average valuation. Perhaps concerns about Scotiabank’s acquisitions weighing on the bank’s profitability are already factored into the share price.

And lastly, as I've noted before, today's underperforming bank stock tends to be tomorrow's outperformer. Okay, not literally tomorrow, but big Canadian banks have an uncanny ability to catch up within a year or so.

Scotiabank is lagging its peers. But for nimble investors, this can be good news.


Monday, January 22, 2018

Rising Rates Add to the Allure of Bank Stocks

The Globe and Mail, David Berman, 22 January 2018

Canadian big bank stocks have continued to rise since the Bank of Canada raised its key interest rate on Wednesday, highlighting a nice safety feature for dividend-loving investors: Bank stocks can actually benefit from rising rates.

This is becoming an important feature in today's market, when some dividend stocks are struggling.

As rates rise, bond yields are also moving higher. The yield on the 10-year Government of Canada bond is now above 2.2 per cent, moving toward a four-year high and up from about 1.8 per cent just one month ago.

Rising bond yields offer competition to dividends and are dragging on stock valuations in some rate-sensitive sectors. Utilities, real estate investment trusts and telecom stocks have been looking particularly vulnerable over the past six weeks: BCE Inc. is down more than 7 per cent, RioCan Real Estate Investment Trust is down about 5 per cent and Fortis Inc. is down 9 per cent.

But Canada's big banks have been immune to this trend. The sector hit record highs on Monday, and is up 3.7 per cent over the past six weeks, suggesting that investors believe these dividend-paying stocks remain compelling investments when interest rates are rising.

The reason? Higher rates tend to coincide with a stronger economy, which means more bank loans, low loan losses and increased capital markets activity – all of which drive bank profits and feed into dividend increases. Higher rates can also drive fatter margins on loans, providing a tailwind to the banks' lending activities.

In other words, if bank stocks were attractive dividend gushers when interest rates were very low, they look even better as rates start to rise – as long as these increases don't raise alarms about the ability of consumers to service their debts.

So if the big banks look like ideal dividend stocks in the current interest rate environment, which particular bank stocks should investors consider?

It's worth repeating that one compelling strategy for choosing the best overall bank stock is to simply buy last year's underperformer: Canada's biggest banks have an uncanny ability to narrow the performance gap very quickly, turning laggards into outperformers. Given that Bank of Montreal lagged in 2017, it stands a good chance of leading in 2018.

But whatever your stock-picking strategy, bank dividends are hard to ignore, especially when so many other dividend-paying stocks are struggling.

Based on straight-up dividend yield, Canadian Imperial Bank of Commerce stands well above its Big Six peers with a yield of nearly 4.3 per cent. The average yield for the other five banks is about 3.6 per cent.

However, dividend increases are another important consideration. All of the big banks have been hiking their quarterly payouts at a brisk pace, but the increases have varied by bank.

In 2017, Royal Bank of Canada and Toronto-Dominion Bank led the way by hiking their respective dividends by 9 per cent each. CIBC trailed with an increase of 6 per cent.

The longer track record reveals a similar trend. According to data from RBC Dominion Securities, RBC hiked its dividend by an average of 11 per cent per year between 2000 and 2017, for a total increase of 574 per cent. CIBC trailed the frontrunner with a total increase of 333 per cent over this 18-year period.

The takeaway: Buying a bank stock with the biggest dividend yield today might not give you the best payout over time if other banks are raising their dividends more aggressively. Indeed, though RBC trails most of its peers with a current dividend yield of 3.4 per cent, history suggests it is the dividend king over time.

And what does the immediate future look like? One way to predict near-term bank generosity is to look at their payout ratios, which compare dividend payouts with profits.

In recent years, the big banks have tended to pay out, on average, 45 per cent of their profits in the form of dividends (again, according to a report from RBC Dominion Securities). In 2017, RBC, CIBC and Bank of Nova Scotia had above-average payout ratios of 46 per cent each, while TD had a payout ratio of just 42 per cent.

The lower payout ratio suggests TD might have more room to raise its dividend than other banks. But investors can expect hikes from all the banks, ensuring that the sector will continue to be a dividend powerhouse.

Thursday, December 28, 2017

New Manulife CEO Roy Gori Veers from Alternative Assets

The Globe and Mail, Tim Kiladze, 28 December 2017

Three months into his tenure as Manulife Financial Corp.'s chief executive officer, Roy Gori is taking on the role of insurgent.

As an outsider who joined the Canadian insurance company in 2015, he is largely free from internal politics or long-standing loyalties. Hardly anything in his path appears untouchable – not even a signature bet of his predecessor.

Late last Friday, the last business day before Christmas, Manulife Financial Corp. unveiled two charges worth $2.9-billion. The first, a $1.9-billion writeoff, was beyond the insurer's control, stemming from new tax laws in the United States. The second charge, worth $1-billion, is the product of a significant shift in investment strategy. Mr. Gori has decided to lessen Manulife's dependence on alternative assets, such as timberland, agricultural crops and oil and gas wells – a decision that reverses one of former CEO Don Guloien's expansion strategies.

In the past five years, Manulife's exposure to "alternative long duration assets" nearly doubled, to $35-billion from $18-billion. The company had also launched a business to emphasize them. Because interest rates remained so low for so long, alternative assets soared in popularity and Manulife hoped to persuade other institutions to invest alongside its own bets.

Alternative assets account for 11 per cent of Manulife's $325-billion investment portfolio and they have caused some headaches. In 2015, the oil and gas collection generated $875-million in writedowns after energy prices plummeted and the total portfolio's value is generally volatile, which can be a problem because Manulife must continually mark it to market prices.

Mr. Gori's plan is reduce the insurer's exposure to these assets over the next 12 to 18 months. Once the transition is complete, Manulife will have freed up $2-billion in capital that currently acts a safety cushion in case of losses. That money will be redeployed into other business lines.

We believe that alternatives are still, and will be, an important asset class for us," Mr. Gori said in an interview. "However, given the nature of the asset class, they can be more risky." His decision, then, is a trade-off: The repositioning will hurt long-term asset returns, but it will reduce volatility and improve capital efficiency – the latter being one of his five major strategies.

Mr. Gori appreciates that actions such as this one can cause internal dissent. But he is adamant that they are necessary. And more change is coming, both at Manulife and in the life insurance business.

"There is this sense of complacency in the industry," he said in an interview.

To get everyone on board, Mr. Gori said, "it is critical we clearly map out what we want to change." When he hits roadblocks, he must remember that outsiders, namely shareholders, are desperate for action. He believes Manulife trades at a discount and he said one message was repeated when meeting with all types of stakeholders over the past six months: "There was a real, strong readiness to embrace change."

Underlying that is the notion that shareholders seem ready to swallow a billion-dollar writedown so long as it is for the long-term good. Manulife's shares have barely fallen since the charges were announced after markets closed on Friday – albeit on lower holiday trading volumes. Over the past 10 years, Manulife's shares have delivered a total return, including dividends, of negative 6 per cent. Rival Sun Life Financial's equivalent return is 47 per cent.

Although Manulife's alternative asset exposure had been questioned for some time, Mr. Gori has other pressing issues. The insurer's U.S. long-term care business is widely seen as its biggest problem. People are living longer, healthier lives and claims for home care often aren't made until 20 to 40 years after a policy was first purchased. It is tough for any insurer to manage its risk and generate adequate returns to cover those costs in an era of low rates.

Manulife's John Hancock subsidiary is also stuffed with variable rate annuities that tend to guarantee policy-holders a fixed-return or payment. Mr. Gori has said the returns from that business aren't good enough. But the new CEO said the timing of his retreat on alternative assets was partly pegged to the U.S. tax changes. Manulife had already been studying what to do with the exposures, but wasn't sure just how far it wanted to go if it cut back. Getting a final answer on the U.S. corporate tax rate, which will boost future earnings, helped determine the "quantum" of the pullback.