Friday, December 08, 2006

UBS Analyst's Global Bank Recommendations

The Globe and Mail, David Parkinson, 8 December 2006

Owning a piece of a Canadian bank has become an expensive proposition. In fact, so expensive that analysts suggest investors should look outside the country if they want to add banks to their portfolios.

Analysts say bank stocks in other parts of the world, particularly Europe and emerging markets, are trading at considerably cheaper price-to-earnings valuations than Canadian banks, which have surged 20 per cent since June. Not only are these foreign bank stocks cheaper, but they also have a stronger earnings growth outlook heading into 2007. Even in terms of dividend yield, Canadian banks lag the global average.

"When you look globally, it's hard to make an argument to buy these [Canadian banks]," said Cameron Webster, head of research at investment management firm Sandstone Asset Management Inc. in Calgary.

Indeed, many global bank analysts are looking increasingly to emerging markets, where earnings growth potential looks particularly strong, or to Europe, where P/E valuations look particularly cheap. North America, where P/Es are relatively high, the economy is slowing, interest rates look poised to fall and earnings growth is slowing, has fallen out of favour.

In a new report from UBS Ltd., global banking analyst Philip Finch has assigned an "underweight" recommendation to both Canada and the United States -- the only regions receiving the investment bank's lowest rating.

The key issue with the Canadian banks is their valuation, which is running at almost 14 times their forecast 2007 earnings, compared with about 12 times for global banks as a whole. Banking stocks in Britain (10.3 times), Europe (11 times), emerging markets (11.8 times) and the United States (11.8 times) all offer better bargains.

"The valuations [in Canada] are getting pretty stretched," said Mr. Webster, noting that the typical P/E range for Canadian banks has historically been about 10 to 12 times.

A sector rotation away from cyclical stocks and into traditional safe havens has contributed to the strong performance of Canadian bank stocks in the second half of this year. But what pushed Canada's banks over the top was the exodus from the Canadian income trust sector, triggered by the federal government's Oct. 31 announcement that it planned to start taxing trusts' cash distributions. With investors looking for income-generating investments to replace the income from their trust holdings, they turned to other high-dividend sectors, and the banks were prime beneficiaries. The banking group is up more than 5 per cent since the trust tax announcement.

"We have a tough time justifying the relative valuation [compared with foreign banks]," said Martin Roberge, portfolio strategist at Montreal-based investment bank Versant Partners Inc.

Mr. Roberge said the relative valuations of Canadian versus foreign banks are at odds with their growth profiles. Profits at the Canadian banks are only expected to grow about 7 per cent next year -- "probably the first time in a decade that earnings growth will be single-digit" -- below the global average of about 8.5 per cent. In Britain and Europe, where bank stocks are trading at the cheapest multiples of any major global region, earnings are expected to grow about 9 per cent; in emerging markets, they are forecast to grow more than 20 per cent.

Sandstone's Mr. Webster points out that the cheapest PEG ratios -- a measure of stock value that takes growth into account by dividing the P/E to the annual percentage earnings growth -- are in Latin America and Europe, while Canadian banks carry some of the highest PEGs.

Those sorts of numbers explain why UBS's Mr. Finch doesn't have any Canadian banks on his global recommended list, which is dominated by European names, with a smattering of representation from emerging markets.

The list includes just one U.S. bank, Goldman Sachs.

"Within the global context, we continue to prefer Europe over the U.S.," he wrote. "In Europe, our overweight recommendation reflects the region's more favourable macro[economic] outlook, upside risk to bank earnings and attractive sector valuations."

UBS's top picks in Europe include BNP Paribas SA of France and Barclays Bank PLC of Britain, both of which have bargain-basement P/Es of 9.4 times. The list also includes Italy's UniCredit and Germany's Commerzbank AG.

Mr. Finch has an overweight rating on Japan -- where things can only get better, after a dismal 2006 in which lending margins slumped and profits shrank. His top Japanese pick is Sumitomo Mitsui Financial Group.

He has a neutral rating on Australia, where he believes valuations "to be full." He's also neutral on emerging markets, although within the emerging group he likes countries where the use of credit is poised to grow from low levels, such as Russia and Brazil.

Sandstone's Mr. Webster said Brazil looks particularly attractive as an emerging-markets bank play, noting that the country has a solid underlying economy and its consumer banking opportunities are still relatively untapped.

He also likes Standard Chartered Bank of Hong Kong, which has a P/E of about 12 times and forecast earnings growth "in the mid-teens."

Mr. Finch includes one Brazilian bank, Unibanco, on his recommended list, thanks to its cheap P/E of 9.3 times. His other emerging-market pick is Russia's Sberbank.