Wednesday, September 27, 2006

Bank Dividend Yields - Compelling Versus Bonds & Equities

Scotia Capital, 27 September 2006

• Bank dividend yields are near or at all time highs versus bonds, overall equity markets, Pipes/Utilities and Income Trusts; at the same time the bank group's one year beta has declined to the extremely low level of 0.39.

• In our view, although bank share prices have done exceptionally well, they still do not fully reflect the magnitude of dividend increases and the significant decline in bond yields. In fact reversion to the mean against bond yields (currently 3.3 standard deviations above the mean) would result in the bank index increasing by 56% or bond yields rising to 6.1%. If we assumed the bank dividend payout ratio increased to 50%, reversion to the mean would result in bank index gains of 74% or 10-year bond yield of 6.8% (Exhibit 2).

• Bank dividend yield reversion to the mean versus equity markets, Pipes/Utilities and Income Trusts would result in relative bank share gains of 32% - 39% (Exhibit 3). The potential gains for the bank index does not include the impact of future dividend increases.

• Banks have grown their dividends in the past five years at unprecedented rates and consistency as highlighted in Exhibit 10. Bank dividends have increased 176% since the beginning of 2000 with the bank share price increase of 161% over the same period. Banks have led all equities in dividend growth in the past four decades with a CAGR of 9.6% since 1967, more than double the market's growth of 4.6%.

• Despite the significant growth in dividends particularly since the beginning of 2000 the bank dividend payout ratio (Exhibit 11) remains low in our view at 45% trailing, although slightly above the historical payout ratio of 41% since 1967. Given the dramatic revenue mix shift to less capital intensive businesses and the record level of capital and profitability as well as level of free cash flow generation we believe the payout ratio will expand to 50% (see report titled Four Decades of Dividend Growth March 2002). Our long term growth rates and long term profitability estimates would theoretically equate to a 65% payout ratio however other intangible factors will likely result in the payout ratio being checked in the 50% range at least in a five to ten year horizon.

• The 10-year Canadian bond yield has recently declined to 3.97% from a high of 4.58% in June 2006. Canadian bond yields have declined from 6.54% in 2000 while the bank dividend yield has remained relatively constant in the 3% range as bank share price increased 161%, keeping pace with bank dividend growth but not reflecting lower bond yields (Exhibit 12). As a consequence bank dividend yields relative to 10-year bond yields have increased to 82% versus the historical mean of 53% or 3.3 standard deviations above the mean which is near a historical high (Exhibit 4). Thus bank valuations are very compelling versus bonds.

• The bank dividend yield relative to the S&P/TSX is near the highest in history at 1.9x, except for a brief period in 2000 with the Tech Bubble (Exhibit 5). The bank dividend yield relative to the S&P/TSX is almost double the level recorded from 1956 - 1978, a period of very sound bank fundamentals and low interest rates. Our view remains that longer term this relationship will trend back towards these levels.

• Bank dividend yields versus the Pipes/Utilities (Exhibit 6) and Income Trusts (Exhibit 7) are at or near their highest level in the past six years. In fact reversion to the mean would result in the bank index increasing on a relative basis by 32% and 39% versus pipes/utilities and income trusts respectively. The bank group's attractive dividend yields are supported by an extremely low one year beta of 0.39 (Exhibit 1).

• We reiterate our Overweight Bank recommendation based on compelling valuation and strong fundamentals and extremely low betas. Valuations are compelling on a yield basis and attractive on a P/E multiple basis. Strong fundamentals include low credit risk, record profitability, low financial leverage, low earnings volatility, reasonable earnings growth outlook and ability to increase dividends.

• Maintain 1-Sector Outperforms on RY, 2-Sector performs on TD, NA, CWB and LB and 3-Sector underperforms on BMO and CM. On an absolute return basis we would have no sells in the bank group.

• Our bank index 12 month target is unchanged at 27,000 based on 15.1 P/E our 2007 earnings estimates for total expected return of 25%. Individual banks' share price momentums relative to the bank index are highlighted in Exhibits 13 to 18.