03 November 2006

Bank Valuations Still Attractive

Scotia Capital, 3 November 2006

• Bank share prices have appreciated strongly in the past two days with the catalyst being the proposed taxation of Income Trust distributions.

• The bank index hit a new all-time high yesterday. The bank index is now up 11% year-to-date versus the S&P/TSX increase of 8%. Bank relative share price performance in the calendar fourth quarter is also off to a positive start with banks increasing 4% thus far versus the market gain of 3%. If banks manage to hold on to their performance this year, it would represent outperformance in 12 out of the past 13 years and 23 of the past 27 years in the calendar fourth quarter.

• We believe bank valuation remains compelling on a yield basis and attractive on a P/E multiple basis.

• The bank index has increased 177% since the beginning of 2000 with dividends growing at a similar rate of 176%; thus bank share prices have essentially kept pace with dividends. However, the 10-year government bond yield has declined significantly from 6.5% to the 4% range with no corresponding valuation increase in bank stocks on a relative dividend yield basis. Banks remain in the strong Buy range with the dividend yield relative to 10-year bond yields at 2.8 standard deviations above the historical mean.

• We expect four out of the six banks to announce dividend increases in the upcoming fourth quarter (BMO, BNS, CM, and NA) with RY and TD possible but less likely given that they increased their dividends last quarter.

• Bank dividend yields relative to Income Trusts have corrected significantly in the past few days with the Income Trust announcement. Banks were 38% undervalued relative to Income Trusts (reversion to mean) prior to the announcement; this has now fallen to 12% with the recent sharp share price moves. This ratio is based on the historical relationship of a number of Income Trusts since 1995 and does not factor in any change in the tax treatment. Bank stocks we believe would be considered more undervalued versus Income Trusts if Income Trust distributions were to be taxed as proposed and dividend tax credits enhanced.

• Bank dividend yields relative to Pipes & Utilities remain near their 10-year high at 1.8 standard deviations above the mean. Banks are undervalued by 27% relative to Pipes & Utilities if we assume a reversion to the mean. Banks are also 31% undervalued versus the S&P/TSX on a relative yield basis assuming reversion to the mean.

• On a price to earnings multiple basis, banks are now trading at 14.6x trailing earnings, below the February 2006 recent high of 15.1x but above the bottom of 13.8x in June 2006. Banks are trading at 13.0x our 2007 earnings estimates.

• We continue to forecast bank P/E multiple expansion to 16x trailing based on fundamentals. Banks traded at these types of multiples in the late 1960's, a period of low interest rates and relatively solid bank fundamentals. Graham & Dodd's P/E Matrix derives a 16.3x multiple using a 5% bond yield and 5% growth rate. If we were to see bond yields stay in the 4.5% range and the market was to actually discount this, at some point P/E multiples could expand higher than 16x but not likely on a long-term sustained basis.

• We continue to recommend an overweight position in bank stocks. Maintain 1-Sector Outperform rating on RY and BNS, 2-Sector Perform on CWB, TD, NA and LB and 3-Sector Underperform on BMO and CM. We have no sells in the bank group on an absolute return basis. In the Diversified Financials we continue to recommend Power Financial and AGF as 1-Sector Outperform.