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.

Friday, December 22, 2017

US Tax Overhaul is a Present for Big Canadian Banks

The Globe and Mail, James Bradshaw, 22 December 2017

By overhauling corporate taxes, American legislators have delivered a gift to some of Canada's largest banks that's potentially worth hundreds of millions of dollars a year in added profits.

The sweeping tax cuts hastily passed by the U.S. House of Representatives and Senate and signed into law by U.S. President Donald Trump on Friday are expected to boost earnings per share at four of Canada's largest lenders by 1 per cent to 3 per cent, according to a report by analysts at Citigroup Global Markets Inc.

Bank of Montreal stands to benefit the most: With its extensive banking network in the American Midwest, it is estimated to receive a 2.6-per-cent lift to earnings per share. At Toronto-Dominion Bank, with its network of more than 1,200 branches stretching the length of the U.S. East Coast, EPS is projected to rise by 2.3 per cent. Royal Bank of Canada and Canadian Imperial Bank of Commerce, which have both acquired banks focused in private banking and commercial lending to build out their U.S. presence in recent years, can expect increases of 1.6 per cent and 0.9 per cent respectively, according to Citigroup.

Spokespeople for BMO, CIBC, RBC and TD declined to comment for this story.

That's a welcome tailwind, but also a far cry from the boon expected for the largest U.S. banks, which will see EPS climb by anywhere from 8 per cent to 17 per cent. That's largely because they do the lion's share of their business in the United States, but also due to other benefits – such as lower repatriation rates for cash held abroad – that won't provide a measurable boost to Canadian-owned banks.

The most significant change in the new bill drops the marginal corporate tax rate from 35 per cent to 21 per cent. But there are also accounting considerations in the fine print that could limit the short-term benefits of the tax breaks for some banks, including adjustments to the Base Erosion Anti-Abuse Tax (BEAT), which limits certain tax-deductible payments made to foreign affiliates.

In annual filings, BMO disclosed that the changes would require the bank to reduce its net deferred tax asset – an accounting measure tied to the timing between a bank booking a tax loss and realizing its benefit – by roughly $400-million (U.S.). And that "would result in a one-time corresponding tax charge in our net income," the bank said, which would then be offset over time by higher earnings.

Capital levels that regulators track closely could also temporarily inch lower. Using an estimated 20 per cent corporate tax rate – which is slightly lower than the actual 21-per-cent rate – BMO estimated its common equity tier 1 (CET1) ratio could fall by about 15 basis points (100 basis points equal one percentage point). But BMO has a more than ample buffer: As of Oct. 31, its CET1 ratio was a robust 11.4 per cent.

"There could be a hit to tangible book [value], and a much smaller one to regulatory capital, from the write-off of [deferred tax assets]," said the Citigroup analysts.

Of the four major Canadian banks that stand to benefit the most, TD reaps the largest share of its total profit from U.S. operations, at 29 per cent, according to the report.

Tuesday, December 05, 2017

A Tax Case for Early RRSP Drawdowns

The Globe and Mail, Jonathan Chevreau, 5 December 2017

While it's tempting to "bask" in the low tax rates that may prevail between the years of full employment and full-stop retirement, in the long run you may be better off paying a little more tax now in order to avoid a lot more tax later. The latter can happen once you're required to annuitize or convert your RRSP to a RRIF.

Because of Canada's graduated tax system, tax rates escalate the more you earn. This has left many would-be retirees with the impression their retirement income will be lower and they'll be paying taxes at a lower rate. That in turn has led to the strategy of deferring receipt of registered retirement savings plan (RRSP) or registered retirement income fund (RRIF) income as long as possible.

However, more than a quarter of retirees are in a tax bracket that's either the same or even higher than in their working years, says a BMO Wealth Institute report published in 2013.

The solution may be to accelerate the drawdown of RRSPs in the decade prior to the RRIF years, or even to set up a RRIF years before it's required (by the end of the calendar year when you turn 71), especially if you have fallen into a lower tax bracket during the transition between full employment and traditional retirement.

Counterintuitive though it may appear, there is a strategy for people who are temporarily in lower tax brackets, says Robert Armstrong, Bank of Montreal's vice-president of managed solutions. He calls the strategy "Topping up to Bracket," which involves ensuring you receive a yearly income in the range of $12,000 (zero tax) and $42,000 (the lowest tax bracket).

Matthew Ardrey, a wealth adviser and vice-president of Toronto-based Tridelta Financial, says "there is certainly a benefit to ensuring your income remains below $42,000 if you can."

If you're temporarily in a lower bracket – perhaps you're between full-time jobs – you should move heaven and earth to maximize the precious non-taxed dollars you take into your hands every year, and after that, at least the very low-taxed dollars.

For everybody, including high earners, the first $11,635 of income is tax-free: This is the federal "basic personal amount" (BPA) in 2017. So the first $11,635 is a no-brainer, but next best are the lower-taxed dollars, which is where Mr. Armstrong cites the key number of $42,000. Between the BPA and $42,000 the federal tax rate is 15 per cent. Add in provincial tax and the result in Ontario is that in 2017, the first $42,201 of income has a top marginal tax rate of 20.05 per cent. After $45,916 of income, the combined federal/provincial tax rate becomes 29.65 per cent, and gets higher still for larger incomes.

For couples, if one spouse is fully employed and paying a top marginal tax rate (in Ontario) of 53.53 per cent (taxable income of $220,001 or more) while the other spouse has minimal income, I'd argue this: Every non-taxed or low-taxed dollar that the latter brings into the family unit is more valuable than each (roughly) 50-cent dollar the higher-income spouse generates in any extra income.

For pensioners 65 or older, the tax-free zone can exceed $20,000: That's the BPA, plus federal $7,225 age amount (in 2017) plus (if applicable) the $2,000 pension credit. (The age credit can be clawed back at high enough levels of income.)

Topping up to bracket in low-earning years is a use-it-or-lose-it proposition. If you let a year go by and bring in none of that tax-free income at all, you don't get to carry forward the opportunity to another year.

What if you have no earned income? Then it may make sense to withdraw some RRSP funds, as you probably were in a higher tax bracket when you made the original contributions. Raiding your TFSA makes little sense here because they're tax-free dollars anyway, so there's no urgency to de-register TFSA money while you're in a low tax bracket; besides, you want to maximize precious TFSA room after the age of 71, when those forced RRIF withdrawals put you in a higher tax bracket again.

Once you're 65, there's a case for limiting annual intake to $74,788, beyond which Old Age Security benefits are subject to clawback. OAS is completely clawed back at $121,071.

This is why Mr. Ardrey proposes "melting down" RRSPs before OAS or CPP kick in. Assuming they are in a lower tax bracket, "when many people think of an RRSP drawdown they only think of doing it up until the basic personal amount." But for someone with a large RRSP, this could be a detrimental decision.

Warren MacKenzie, head of Financial Planning at Toronto-based Optimize Wealth Management, says if you expect future income, and thus tax, to be higher, as well as clawed-back OAS "then it makes sense to withdraw some money from a registered account if it can be taken into income at a lower tax rate." However, if income is projected to be lower in old age, it may not make sense to pay tax sooner than necessary, he adds.

For most couples, the biggest tax hit comes after the second partner dies, RRIFs are collapsed and capital gains realized. Since the RRIF of the partner who dies first passes tax-free to the survivor, he or she is often pushed into a higher tax bracket

Mr. MacKenzie says spousal loans may help one partner stay in lower tax brackets longer: "Overall, the lowest amount of income tax will be paid when each spouse has the same level of income."