Wednesday, January 04, 2006

Cdn Bank Stocks are Losing their Allure

Although profitability has improved, the stocks of all the Big Six banks are dropping in value

Investment Executive, Carlyle Dunbar, 4 January 2006

Just about every investor owns a bank stock, and most investors regard them as close to bulletproof.

That’s why banks and other financial stocks dominate North American markets, especially in Canada. In this country, financial stocks account for almost $1 of every $3 of total market value; in the U.S., they account for $1 of every $5 of total market value.

So popular are these bank stocks, in fact, that banks alone account for 7% of the Standard & Poor’s 500 composite index and a hefty 19% of the S&P.

TSX 300 composite index. This is because banks have flourished in the past 20 years in the benign environment of a secular drop in interest rates and ample money supply.

If there is one thing the stock market does, it gives — and then it takes away. Any industry group that has had fair sailing for several decades is positioned to be overtaken by storms, if not disaster.

You have only to think of the U.S. automobile industry or the U.S. supermarket chains as examples. This systemic or cyclical risk has become a risk for bank stocks.

But valuations have also become a major risk. You clearly get less for each dollar invested in a bank stock today than you did even five years ago. Average profitability, however, has not changed much in recent years — and profitability is as variable as it ever was.

Over the long term, then, basic valuations have changed greatly. Today, banks trade between two and a half and three times their book value. Two decades ago, you could, at times, buy a bank stock for less than book value — a true bargain. At today’s multiples, there is no margin of safety, meaning that three times book value enters the high-risk zone for bank stocks.

Although book value is a theoretical measure for most businesses, it is real for banks because their only asset is money (although, increasingly, goodwill has been swelling their balance sheets).

Another way of looking at bank values is to see how much you get for your investment dollar. Each dollar that is invested in Royal Bank of Canada, for example, buys $8.20 of total assets. Five åyears ago, $1 invested in Royal Bank bought $10.54 of assets; and five years before that, a dollar bought $21.33.

The pattern of dropping value is the same for all Big Six banks. Bank profitability has improved since the 1980s, but not sufficiently to justify such a large swing in valuations.

Risk is increasing for more than just valuations. Monetary conditions are clouding over and rising short-term interest rates have flattened the yield curve, which is always a harbinger of a slowing business climate. A greater threat is the possibility of yield-curve inversion, with short-term rates higher than long-bond yields — an invariable precursor to an economic recession.

Return on equity

As the Canadian banks make their initial reports for the fiscal year ended Oct. 31, 2005, it is clear that their profitability is bumping along a ceiling. Over the past decade, return on equity has ranged as high as 20% for most banks. In the occasional exceptional year, ROE has been as high as 27% for an individual bank.

The contrast with their performance 20 years ago is not that large. Average ROEs were generally lower in the five years ended 1984 compared with the five years ended 2004. ROE also peaked around 20% in the first half of the 1980s, but there were no one-year spikes above that.

In the past decade, return on average assets has generally gone as high as 0.8% — again, with occasional exceptional years for a single bank going as high as 1.3%. Two decades ago, returns on average assets were definitely lower, however, hovering around 0.5% for most banks in the early 1980s.

In terms of volatility of profitability, there is little difference between the two periods. If anything, there was less variance or volatility in ROE and return on average assets 20 years ago.

Nevertheless, a comparison of bank returns in this decade and those of 20 years ago shows another thing: industry leaders and laggards change. Two decades ago, the TD Bank Financial Group produced the best average returns. Now, Royal Bank and Bank of Nova Scotia are the leaders.

High relative dividend yields, as well as frequent dividend increases, are the foundation of banks’ appeal. Up to the late 1970s, the yield from bank stocks differed little from the average market yield. After that, bank yields climbed relative to the market.

In the late 1980s, the TSX bank index yield was double the TSX composite index yield. At the banks’ peak in 2000, they yielded 2.9 times more than the TSX composite. This has subsequently dropped to the point at which the bank index dividend yield is about 1.8 times the market yield.

One final consideration: although bank stocks recently stood at their highest level in relation to the broad market in their 86-year stock market history, they have not improved this position since the beginning of 2003. This is actually their “normal” behaviour.

Since 1919, Canadian bank stocks have generally performed in line with the overall market — sometimes a little better; sometimes a little worse. The period from the late 1980s until the early 2000s, when bank stocks rose faster than the market, has been an exception.