Saturday, April 15, 2006

Cdn Bank Index, Doubled Since 2002

The Globe and Mail, Derek DeCloet, 15 April 2006

Ed Clark has spent a career looking at the banking business from all sides. He's been a Finance Department mandarin, a deal maker at Merrill Lynch, head of a struggling lender and the top executive at Canada Trust. Now, at 58, the Toronto-Dominion Bank chief might be Bay Street's most popular CEO.

In all those years, have the Canadian banks ever had a streak of good fortune like this? “No. Absolutely not,” Mr. Clark says. “Maybe if you went back to the sixties.”

In the country's biggest financial district, there's a pervasive sense of calm, and why wouldn't there be? The banks have turned Murphy's Law on its head: Anything that can go right, will.

The economy is strong, inflation low. Unemployment? The lowest since Mr. Clark was a rookie bureaucrat in the Trudeau government. Interest rates? On the rise, but reasonably low. Stock market? Breaking records almost weekly.

The result is not only record bank profits — nothing's new about that — but surprising growth. In the past, senior bankers moaned that Ottawa's effective ban on mergers left them boxed into a stagnant market, but the financial results are making liars out of them. The Big Six banks' profit per share increased 11.1 per cent in the first quarter, calculates National Bank Financial, after a 15.2-per-cent gain last year. (The numbers exclude certain unusual items.)

The biggest surprise is the way corporate borrowers have stayed so healthy for so long. Moody's Investors Service Inc. says Canadian companies defaulted on just $86-million in bonds last year, the lowest since 1996. For the moment, at least, very few bank loans are going sour. Individual consumers are borrowing more, but paying their bills as reliably as ever.

“These are very unusual conditions, so it's hard to get yourself tossing and turning in the middle of the night,” Mr. Clark says. “So what you toss and turn on is, how long can this keep on going?”

That's the question investors are asking, too. The banks' outsized profit growth has brought huge stock gains, to the delight of the millions of Canadians who own bank shares directly or through their mutual funds.

But the S&P/TSX bank index has almost doubled since 2002, and valuations may be getting stretched. The Big Six banks haven't looked this expensive since they surged on merger mania in the spring of 1998. (That period ended when Russia defaulted on debt, Long-Term Capital Management collapsed, global financial markets convulsed and Canadian bank shares fell 33 per cent in three months.)

The banks, in fact, have done almost as much as the headline-hogging oil companies to lift the stock market to great heights. The S&P/TSX composite has gained about 5,630 points since Jan. 1, 2003. The six largest banks are responsible for nearly 1,000 points of that increase — more than EnCana Corp., Suncor Energy Inc., and Canadian Natural Resources Ltd. put together, despite the greatest bull market in energy stocks in a generation.

Three banks — TD, National Bank of Canada, and Canadian Imperial Bank of Commerce — have doubled their investors' money in that period. Even the worst performing, Bank of Montreal, gave its shareholders a total return of 71 per cent, including dividends.

It may seem churlish to cast a shadow over the banks in their moment of glory. But if things are as good as they've been in decades, as Mr. Clark says, doesn't that mean there's a lot of room for them to get worse? Few investors seem to think so, and even fewer are willing to bet that the market is wrong to be so wildly bullish.

Wade Burton is one of them. He manages about $4-billion in equities for Vancouver's Cundill Investment Research Ltd. His portfolio is an unusual one for a domestic money manager: It contains not a single share of any one of the Big Six, and has been that way for the past two years. Painfully so.

“You're going to say: ‘We missed the banks,' ” Mr. Burton says “And I'm going to say: ‘You can't say there's any margin of safety in these companies.' ” He thinks investors have underestimated the lending risks banks are taking in the amount of credit they are willing to give consumers, a belief that is partly based on experience — he used to be a commercial lender for Canadian Western Bank. “If you experience low loan losses, you become more aggressive in lending to that asset class.”

For most Canadian investors, though, a decision to avoid bank shares is highly unusual. Every one of the country's 10 largest domestic stock mutual funds has banks at or near the top of its largest holdings, and they continue to be among the most widely owned stocks in brokerage accounts.

“With these banks, I am on Mars and everyone else is on Venus,” Mr. Burton says.

But he is not alone in believing that Canadian banks have been so profitable and so popular for so long that they can't possibly reproduce the returns of the past three years. Price is the big reason. The Big Six now trade at nearly 2.8 times book value, to take one important industry measure. That's a sharp increase from two times book value three years ago. (Book value is a company's net worth — its assets minus its liabilities.)

“Shorter-term valuations, I think, are a little ahead of themselves,” says Suzann Pennington, a veteran portfolio manager who follows financial stocks for Toronto's Saxon Financial Inc. “When that happens, I get a little less comfortable because my [potential] downside is a little bit greater than I'd like to see.”

A large gap has opened up between them and some highly regarded foreign banks. Royal Bank of Canada, whose stock price is up 49 per cent in two years, now trades at 14 times this year's projected earnings. Even mighty Citigroup Inc. doesn't get the Royal treatment: It's valued at a little more than 11 times earnings.

“I'm of the view that Canadian banks should trade at a premium to many other countries' banks,” says Rob Wessel, a bank analyst at National Bank Financial. “But do they deserve a premium of this magnitude to the large U.S. banks? I would say no.”

That's especially the case if the Bay Street earnings machine is about to shift into a lower gear. The commodities boom and the hot stock market has boosted bank profits in numerous ways — through commissions, mutual funds and investment banking fees, but also increasingly from investing and trading their own money for profit. The Big Six earned $1.7-billion in trading revenue in the first quarter, a 12-per-cent gain from the previous year. In the long run, Mr. Wessel says, this is not sustainable.

Yet, some banks continue to expand their bets on buoyant markets, and may be taking more risk. While a few banks, such as TD, have been shedding some of their higher-risk business lines, others are taking bigger gambles, the results of which won't be apparent until there's something to shock the financial system or the market, as happened in 1998 (Long-Term Capital) and again in 2002 (the Enron and WorldCom bankruptcies).

In banking circles, one of the more talked-about developments is RBC's apparent decision to find growth by plowing more money into new areas, such as derivatives trading. Two years ago, the bank reported $9.1-billion in assets that were exposed to market fluctuations — such as foreign exchange contracts. Today, the total is $14.6-billion. The bank's disclosure on this is skimpy, but it appears the biggest part of the increase comes from trading in commodities, precious metals and other derivatives. (“I don't want us to overplay the significance of the market risk,” says Nabanita Merchant, the bank's senior vice-president of media relations, who points out that RBC's safer businesses, such as mortgages, have grown briskly, too.)

For all the alleged hatred the public has for banks, Canadian consumers are remarkably loyal to them. Remember the famous quote of Matthew Barrett, explaining why BMO needed to merge with RBC in 1998? “What we don't plan to be is the corner hardware store, waiting for Home Depot to put it out of business.” Throughout the industry there were dire predictions of American and European financial giants coming to Canada to cherry-pick the banks' best customers.

The foreigners showed up, but they've failed to crack open the oligopoly. Nearly a decade after its launch, ING Bank of Canada is profitable, but only modestly and it fell last year. MNBA Bank Canada, the credit card issuer that stuffs envelopes into your mailbox, also showed a decline in profit last year.

How did this happen? The Big Six have learned how to keep market share and elbow the foreign guys out — by matching ING's cheap mortgages, for example, or starting their own high-interest savings accounts. Their market share of consumer lending is higher now than it was when ING and MBNA got their bank licences in the late nineties, according to BMO Nesbitt Burns research.

That should mean less volatile earnings than in the last downturn, when both TD and CIBC were whacked with big corporate loan losses. In 2000, the Big Six earned 63 per cent of their profits from individual and small-business customers. This year, the number will rise to 77 per cent, BMO Nesbitt says, which is why so many people think you can throw away the old models for how to value bank stocks.

“When I look at these companies, they are more expensive than they've ever been historically,” says a top bank analyst. “But they're also more profitable than they've ever been. Their balance sheets are better than they've ever been. And their business mix is more stable that it's been in the past.”

Some day, of course, the economy will stumble, or there will be a big bankruptcy, and the banks' streak will end. No sign of it yet, though. “If General Motors collapsed, would that ripple through the auto sector? It's hard to believe that it wouldn't,” TD's Mr. Clark says. “But as a general statement, is the credit cycle moving? There's just no evidence at this stage that the credit cycle's moving.”

And when it does, banks' devotion to paying dividends will give shareholders some shelter, Ms. Pennington of Saxon says. RBC, for example, has not yielded less than 4 per cent since the early 1990s (with a couple of brief exceptions). That suggests that in a 1998-type financial shock, the share price probably wouldn't fall below $36, based on the current dividend — and that's in an extreme case.

“A 10 per cent correction [in bank stocks] would be healthy and normal,” Ms. Pennington says. “But longer term, I think they're still okay.” So, sure, maybe it's easy to hate the banks, but do you really want to bet against them? It's usually a bad idea — no matter what planet you're from.