Monday, July 10, 2006

Cdn Bank Earnings Expected to Slow

Neil Murray, 10 July 2006

Few would argue that the past 10 years have been great for investors who held Canadian banking stocks. The question now is what can investors expect over the next five or ten years? Moreover, is it possible that the easy money has already been made in the Canadian banking sector?

Bank stocks sold off along with most other stocks in the TSX Composite's latest retreat that began on April 19. The TSX is enjoying a reflex rally from oversold conditions and as of July 5 was hovering around the 11,600 mark.

The high for the TSX on April 19 was 12,494. The TSX reached a low on June 16, 2006 of 10,860, before rallying back to the 11,733 level on July 4. The TSX's initial initial downward move to the downside from high to low amounted to a decline of 13 per cent. I say initial move to the downside, because I believe that the TSX could lose another 1000 points or more before a new, more sustainable, uptrend can emerge.

Canadian bank stocks are not immune to market volatility or corrections, especially in a rising interest rate environment. Bank stocks declined fell seven per cent from the market's April highs, compared to a decline of 10 percent for the TSX when measured off its closing price.

Among the big five banks in Canada, CIBC and TD Bank have declined the most. In fact, when you compare the performance of these two banks to the TSX from April 19 until July 4, they are off more than the index. CIBC and TD are down 11 per cent compared to the TSX which is off six per cent. Bank of Montreal, Royal Bank and Bank of Nova Scotia are down 5.5 per cent, 3.6 per cent and 2.7 per cent respectively.

Profitability amongst the banking sector in Canada has been stellar over the past five years. After-tax earnings have grown from $4.6 billion in 2000 to $6.5 billion at the end of 2004.

According to BMO Nesbitt Burns' banking analyst, Ian de Verteuil, "the strong Canadian economy has been good for the banks. Asset growth has been excellent and loan losses have been well controlled."

Going forward the concerns are higher loan losses, slowing asset growth and weaker capital markets. De Verteuil expects loan losses to increase over the next two years but acknowledges the losses will be low by historical standards.

In a note to clients in June, de Verteuil says, "five per cent asset growth can produce ten percent bottom line growth as long as spreads remain stable."

The biggest fear for bank analysts is the health of capital markets. After several record years, the environment seems ripe for some form of correction that would impact bank profitability.

de Verteuil expects to see more moderation in performance from bank stocks as the year progresses.

Many of the banks have raised their dividend payout ratios, which mean shareholders will get a bigger slice of the earnings pie. Bank of Montreal currently pays a dividend of 4.1 per cent -- the interest equivalent of 5.3 per cent for a bond or GIC investor in the top tax bracket.

Many investors are willing to accept moderate growth from their bank shares, as long as they continue to receive a tax-advantaged dividend that compares favourably on an after-tax basis with interest yielding investments.

de Verteuil has outperform ratings on TD Bank, National Bank, CIBC, Bank of Nova Scotia, and Canadian Western Bank. The Royal Bank, Laurentian Bank and Bank of Montreal are currently rated Market Perform.

Over the years, bank stocks have been terrific investments for Canadian investors. Despite the potential for a slowdown in bank earnings growth, there are fewer better equity investments out there for low to medium risk portfolios.