BMO Capital Markets, 7 July 2006
Highlights
• After an extended period of annual outperformance, Canadian banks have so far in 2006 lagged their U.S. peers. We believe that the relative correction between the two groups should be largely complete given the current relative valuation.
• Canadian banks deserve to trade at better relative metrics than they have in the past—their ROEs have trended higher and their Tier 1 ratios have also improved dramatically. These changes have not only occurred in absolute terms, but also on a relative basis when compared to U.S. banks. Today, compared to their U.S. peers, Canadian banks are producing higher ROEs on better balance sheets. We believe that this justifies some relative revaluation premium for Canadian banks.
• The conventional wisdom is that Canadian banks are currently more expensive than their U.S. peers. This is certainly a debatable point, given the recent relative correction. From a P/E perspective, Canadian banks are trading on par with U.S. banks—roughly in line with the longer-term averages. On P/BV, Canadian banks have certainly moved to large premium valuations, but this simply reflects the better balance sheets and ROE. When one considers price to tangible book value, the Canadian relative valuations are higher than in the past, but appear essentially in line with their U.S. peers.
• We believe that Canadian banks are likely to have better earnings performance going forward than their U.S. counterparts. Canadian loan growth is accelerating, as business demand for credit is increasing and as consumer demand for credit remains strong. Over the past year, earnings revisions for U.S. banks have been flat or negative while the trend for Canadian bank earnings estimates has been positive.
Canadian Bank Relative Valuation Has Changed Somewhat
After trading for most of the 1990s at material discounts to their U.S. peers, Canadian banks stocks have clearly moved to more expensive relative valuation metrics. Charts 1 and 2 show this to be the case, particularly in the case of P/BV.
We should note that it is impossible to look at U.S. bank valuations over long time periods without appreciating that there is a heavy “survivorship” bias to any U.S. bank series: the smaller banks are acquired, while the bigger ones do the acquiring. In the Canadian situation, there is little, if any, such bias—Canadian banks have been, and will likely for the foreseeable future continue to be, restricted from further consolidation.
We believe that outside of this issue, the changes in Canadian bank fundamentals continue to warrant some revaluation. Specifically, we point to two variables: better balance sheets and improved ROEs, both driven by shifting business mix. We address these points later in this report.
One metric that receives less attention (largely because it is difficult to track) is price to tangible book value (P/TBV). This subtracts goodwill and intangibles from book value, and therefore is more consistent with the regulators’ definition of Tier 1. On this basis (see Chart 3), Canadian banks appear to be similarly priced at a 5% discount to their U.S. peers, but more expensive than they have been in the past. Again, we believe that the improved ROEs and Tier 1 ratios of the Canadian banks actually argue for even higher P/TBV multiples.
Canadian Banks Have Been Building Balance Sheet Strength
Canadian bank balance sheets have become meaningfully better than their U.S. peers’ (see Chart 4). Canadian bank Tier 1, the most useful metric in establishing balance sheet strength, has improved materially because of a fundamental shift toward lower risk businesses. Specifically, Canadian banks have moved away from high-risk corporate loans (100% risk weighted) to lower risk residential mortgages (50% risk weighted, or 0% risk weighted if insured). This has allowed Canadian banks to limit risk-weighted asset growth and to retain excess capital, which bolsters Tier 1 ratios.
On the U.S. side, banks have generally been less successful in shifting loan mix away from business lending. Furthermore, the extensive amount of M&A activity in the U.S. has resulted in dramatic increases in the amount of goodwill on bank balance sheets. As this is subtracted from common equity in the calculation of Tier 1 capital, it has had a materially negative impact on U.S. balance sheet strength.
Whatever the cause, the reality is that Canadian bank balance sheets have improved versus their U.S. peers’. This is one reason why Canadian bank stocks should trade at better valuations than U.S. banks.
We note that some analysts who attempt to consider leverage continue to focus on assets to equity rather than a risk-based metric such as Tier 1. We find this extremely simplistic. While the risk-weighting approach of Basel I is clearly very primitive, the approach of ignoring the riskiness associated with assets borders on pre-historic. The only benefit of focusing on assets to equity is expediency—it requires less work.
Canadian ROEs Have Improved While U.S. ROE Have Been Stagnant
A second fundamental change that warrants better valuations for Canadian banks is the relative change in ROE. As we show in Chart 5, Canadian bank ROE have risen significantly over the past few years, while the U.S. peers’ have remained relatively stable.
This trend has occurred because Canadian banks have been shifting their business mix toward higher ROE operations such as wealth management. In addition, banks continue to grow their mortgage book as a percentage of overall loans. Given the 0–50% risk weighting of these assets, the ROE can remain solid despite tight margins—especially if mortgages are used as “anchors” to cross-sell other products.
The improved performances on both an ROE and Tier 1 basis are clearly correlated. Shifting to lower risk-weighted assets results in higher ROE, but also drives up Tier 1. The higher ROE (allowing banks to generate and retain more capital), in the face of stable RWAs, have bolstered the balance sheets.
We Believe the Relative Performance Gap Will Continue
The past is history. Improved fundamentals warranted a revaluation of Canadian banks. The issue for investors is how the difference plays out in the future. As we look at it, there are several reasons suggesting that the better relative performance of Canadian banks should continue in the coming years.
1) Earnings revisions are still to the upside in Canada
As we show below, over the past year, Canadian bank earnings revisions have, broadly speaking, been positive, on the back of better than expected loan loss experiences and excellent core loan growth. In addition, spreads have essentially stabilized. In the U.S., however, spreads (particularly on the deposit front) remain under pressure, offsetting strong loan growth. This has led to minor or negative earnings revisions.
2) Canadian banks are less vulnerable to an Inverted Yield Curve
Canadian banks typically do not “play” the yield curve—the core retail book in Canada is profitable enough that Canadian banks have shied away from taking the inherent interest rate risk that can arise from customer preference for shorter-duration deposits and longer-duration loans. For perspective, we note that Canadian spreads have been declining for five years—even during a period of a relatively steep yield curve. The driving factor behind spread compression is largely mix: higher levels of thin-margin secured lending. We believe much of this mix shift is now complete and that, even if the flat yield curve continues, Canadian bank spreads will be stable to rising.
3) Canadian banks are less vulnerable to a broad-based North American economic slowdown
Canadian banks have shifted meaningfully from business lending to personal lending and from unsecured to secured lending. While Canadian banks have largely felt the impact of this shift through tighter spreads, we believe the benefit—structurally lower loan losses—will become more apparent in the next slowdown. Essentially, we believe that Canadian bank loan losses will be less sensitive to a broad based economic slowdown.
4) Further U.S. dollar weakness would mitigate any relative performance for U.S. Banks
Over the past several years, Canadian dollar strength has benefitted Canadian bank investors. It is noteworthy that even so far in 2006, half of the relative move in U.S. banks versus Canadian banks has been erased by currency revaluation. While we don’t expect material additional weakness in the U.S. dollar against the “loonie,” we believe the bias is still in favour of the Canadian dollar.
Which U.S. Banks Are the Right Comparison?
Canadian banks are essentially a hybrid of their U.S. bank peers. They are more like US Money Centers than U.S. regional banks, but they are more like regional banks than are the U.S. Money Centers. In addition, they have large wealth management and fee based components – which is quite different from most U.S. banks.
As such, any comparison of U.S. and Canadian banks must first establish valid benchmarks. Our approach was to establish a core group of U.S. banks that are, in aggregate, similar to Canadian bank business models. This list (shown in Table 2) includes the Money Center Banks (Citigroup and JP Morgan Chase), numerous regional banks (such as BB&T, Key, Regions, etc.), several super-regionals (Bank of America, Wells Fargo, etc.) and a handful of private banking/custody banks (Northern Trust, Bank of New York, State Street, Mellon, etc.). We have also included some broker-dealers. For our analysis, these were equally weighted so as to limit the exposure to mega-cap banks such as Citigroup and Bank of America.
Consistent with this approach, we have also equally weighted the six Canadian banks. While this provides National Bank with more importance than a cap-weighted average would, it is probably a reasonable approach, as it reduces the volatility created by any one of the five larger banks. Furthermore, the approach is used over the entire time period.
One concern we have with our U.S. database is the reality that it has an ongoing survivorship bias. As we have indicated previously, the extensive amount of consolidation in the U.S. means that any long-term data series is skewed toward the companies that are bigger and are acquirers, rather than ones that are smaller and are acquired. In Canada, the lack of consolidation activity means that this is not an issue.
A further point of note is that our Canadian data are a simple average of six names. The small number means that a meaningful jump in valuation in a single bank could distort the averages. The good news is that there have not been meaningful variations across the six other than National has typically traded at a discount, while TD has typically traded at a premium.
To ensure that a specific event at a specific bank doesn’t skew the P/Es, we have analyzed the data and removed any individual bank for a time period where it dramatically distorts the data. Specifically, we removed Royal during its commercial real estate debacle, TD during its “sectoral phase” and CIBC after the Enron fiasco. Including these periods would argue that Canadian banks are even cheaper today than historically (i.e., we removed periods when earnings were low and P/Es were elevated).
A similar situation occurs within the U.S. data when considering Tier 1 ratios. Some of the U.S. group—mainly the brokers Merrill and Morgan—can occassionally skew the data and were therefore removed from our list for analysis purposes.
Finally, we have tried to use identical time frame and data series for all our analysis. This was not always possible but when using different data sources, we back tested (and, where appropriate, extended the data ourselves) to ensure consistency.
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Highlights
• After an extended period of annual outperformance, Canadian banks have so far in 2006 lagged their U.S. peers. We believe that the relative correction between the two groups should be largely complete given the current relative valuation.
• Canadian banks deserve to trade at better relative metrics than they have in the past—their ROEs have trended higher and their Tier 1 ratios have also improved dramatically. These changes have not only occurred in absolute terms, but also on a relative basis when compared to U.S. banks. Today, compared to their U.S. peers, Canadian banks are producing higher ROEs on better balance sheets. We believe that this justifies some relative revaluation premium for Canadian banks.
• The conventional wisdom is that Canadian banks are currently more expensive than their U.S. peers. This is certainly a debatable point, given the recent relative correction. From a P/E perspective, Canadian banks are trading on par with U.S. banks—roughly in line with the longer-term averages. On P/BV, Canadian banks have certainly moved to large premium valuations, but this simply reflects the better balance sheets and ROE. When one considers price to tangible book value, the Canadian relative valuations are higher than in the past, but appear essentially in line with their U.S. peers.
• We believe that Canadian banks are likely to have better earnings performance going forward than their U.S. counterparts. Canadian loan growth is accelerating, as business demand for credit is increasing and as consumer demand for credit remains strong. Over the past year, earnings revisions for U.S. banks have been flat or negative while the trend for Canadian bank earnings estimates has been positive.
Canadian Bank Relative Valuation Has Changed Somewhat
After trading for most of the 1990s at material discounts to their U.S. peers, Canadian banks stocks have clearly moved to more expensive relative valuation metrics. Charts 1 and 2 show this to be the case, particularly in the case of P/BV.
We should note that it is impossible to look at U.S. bank valuations over long time periods without appreciating that there is a heavy “survivorship” bias to any U.S. bank series: the smaller banks are acquired, while the bigger ones do the acquiring. In the Canadian situation, there is little, if any, such bias—Canadian banks have been, and will likely for the foreseeable future continue to be, restricted from further consolidation.
We believe that outside of this issue, the changes in Canadian bank fundamentals continue to warrant some revaluation. Specifically, we point to two variables: better balance sheets and improved ROEs, both driven by shifting business mix. We address these points later in this report.
One metric that receives less attention (largely because it is difficult to track) is price to tangible book value (P/TBV). This subtracts goodwill and intangibles from book value, and therefore is more consistent with the regulators’ definition of Tier 1. On this basis (see Chart 3), Canadian banks appear to be similarly priced at a 5% discount to their U.S. peers, but more expensive than they have been in the past. Again, we believe that the improved ROEs and Tier 1 ratios of the Canadian banks actually argue for even higher P/TBV multiples.
Canadian Banks Have Been Building Balance Sheet Strength
Canadian bank balance sheets have become meaningfully better than their U.S. peers’ (see Chart 4). Canadian bank Tier 1, the most useful metric in establishing balance sheet strength, has improved materially because of a fundamental shift toward lower risk businesses. Specifically, Canadian banks have moved away from high-risk corporate loans (100% risk weighted) to lower risk residential mortgages (50% risk weighted, or 0% risk weighted if insured). This has allowed Canadian banks to limit risk-weighted asset growth and to retain excess capital, which bolsters Tier 1 ratios.
On the U.S. side, banks have generally been less successful in shifting loan mix away from business lending. Furthermore, the extensive amount of M&A activity in the U.S. has resulted in dramatic increases in the amount of goodwill on bank balance sheets. As this is subtracted from common equity in the calculation of Tier 1 capital, it has had a materially negative impact on U.S. balance sheet strength.
Whatever the cause, the reality is that Canadian bank balance sheets have improved versus their U.S. peers’. This is one reason why Canadian bank stocks should trade at better valuations than U.S. banks.
We note that some analysts who attempt to consider leverage continue to focus on assets to equity rather than a risk-based metric such as Tier 1. We find this extremely simplistic. While the risk-weighting approach of Basel I is clearly very primitive, the approach of ignoring the riskiness associated with assets borders on pre-historic. The only benefit of focusing on assets to equity is expediency—it requires less work.
Canadian ROEs Have Improved While U.S. ROE Have Been Stagnant
A second fundamental change that warrants better valuations for Canadian banks is the relative change in ROE. As we show in Chart 5, Canadian bank ROE have risen significantly over the past few years, while the U.S. peers’ have remained relatively stable.
This trend has occurred because Canadian banks have been shifting their business mix toward higher ROE operations such as wealth management. In addition, banks continue to grow their mortgage book as a percentage of overall loans. Given the 0–50% risk weighting of these assets, the ROE can remain solid despite tight margins—especially if mortgages are used as “anchors” to cross-sell other products.
The improved performances on both an ROE and Tier 1 basis are clearly correlated. Shifting to lower risk-weighted assets results in higher ROE, but also drives up Tier 1. The higher ROE (allowing banks to generate and retain more capital), in the face of stable RWAs, have bolstered the balance sheets.
We Believe the Relative Performance Gap Will Continue
The past is history. Improved fundamentals warranted a revaluation of Canadian banks. The issue for investors is how the difference plays out in the future. As we look at it, there are several reasons suggesting that the better relative performance of Canadian banks should continue in the coming years.
1) Earnings revisions are still to the upside in Canada
As we show below, over the past year, Canadian bank earnings revisions have, broadly speaking, been positive, on the back of better than expected loan loss experiences and excellent core loan growth. In addition, spreads have essentially stabilized. In the U.S., however, spreads (particularly on the deposit front) remain under pressure, offsetting strong loan growth. This has led to minor or negative earnings revisions.
2) Canadian banks are less vulnerable to an Inverted Yield Curve
Canadian banks typically do not “play” the yield curve—the core retail book in Canada is profitable enough that Canadian banks have shied away from taking the inherent interest rate risk that can arise from customer preference for shorter-duration deposits and longer-duration loans. For perspective, we note that Canadian spreads have been declining for five years—even during a period of a relatively steep yield curve. The driving factor behind spread compression is largely mix: higher levels of thin-margin secured lending. We believe much of this mix shift is now complete and that, even if the flat yield curve continues, Canadian bank spreads will be stable to rising.
3) Canadian banks are less vulnerable to a broad-based North American economic slowdown
Canadian banks have shifted meaningfully from business lending to personal lending and from unsecured to secured lending. While Canadian banks have largely felt the impact of this shift through tighter spreads, we believe the benefit—structurally lower loan losses—will become more apparent in the next slowdown. Essentially, we believe that Canadian bank loan losses will be less sensitive to a broad based economic slowdown.
4) Further U.S. dollar weakness would mitigate any relative performance for U.S. Banks
Over the past several years, Canadian dollar strength has benefitted Canadian bank investors. It is noteworthy that even so far in 2006, half of the relative move in U.S. banks versus Canadian banks has been erased by currency revaluation. While we don’t expect material additional weakness in the U.S. dollar against the “loonie,” we believe the bias is still in favour of the Canadian dollar.
Which U.S. Banks Are the Right Comparison?
Canadian banks are essentially a hybrid of their U.S. bank peers. They are more like US Money Centers than U.S. regional banks, but they are more like regional banks than are the U.S. Money Centers. In addition, they have large wealth management and fee based components – which is quite different from most U.S. banks.
As such, any comparison of U.S. and Canadian banks must first establish valid benchmarks. Our approach was to establish a core group of U.S. banks that are, in aggregate, similar to Canadian bank business models. This list (shown in Table 2) includes the Money Center Banks (Citigroup and JP Morgan Chase), numerous regional banks (such as BB&T, Key, Regions, etc.), several super-regionals (Bank of America, Wells Fargo, etc.) and a handful of private banking/custody banks (Northern Trust, Bank of New York, State Street, Mellon, etc.). We have also included some broker-dealers. For our analysis, these were equally weighted so as to limit the exposure to mega-cap banks such as Citigroup and Bank of America.
Consistent with this approach, we have also equally weighted the six Canadian banks. While this provides National Bank with more importance than a cap-weighted average would, it is probably a reasonable approach, as it reduces the volatility created by any one of the five larger banks. Furthermore, the approach is used over the entire time period.
One concern we have with our U.S. database is the reality that it has an ongoing survivorship bias. As we have indicated previously, the extensive amount of consolidation in the U.S. means that any long-term data series is skewed toward the companies that are bigger and are acquirers, rather than ones that are smaller and are acquired. In Canada, the lack of consolidation activity means that this is not an issue.
A further point of note is that our Canadian data are a simple average of six names. The small number means that a meaningful jump in valuation in a single bank could distort the averages. The good news is that there have not been meaningful variations across the six other than National has typically traded at a discount, while TD has typically traded at a premium.
To ensure that a specific event at a specific bank doesn’t skew the P/Es, we have analyzed the data and removed any individual bank for a time period where it dramatically distorts the data. Specifically, we removed Royal during its commercial real estate debacle, TD during its “sectoral phase” and CIBC after the Enron fiasco. Including these periods would argue that Canadian banks are even cheaper today than historically (i.e., we removed periods when earnings were low and P/Es were elevated).
A similar situation occurs within the U.S. data when considering Tier 1 ratios. Some of the U.S. group—mainly the brokers Merrill and Morgan—can occassionally skew the data and were therefore removed from our list for analysis purposes.
Finally, we have tried to use identical time frame and data series for all our analysis. This was not always possible but when using different data sources, we back tested (and, where appropriate, extended the data ourselves) to ensure consistency.
