Scotia Capital, 7 April 2008
Banking Siege - Nine Months and Counting - Buy Banks
• The Banking Siege is into its ninth month and counting. Canadian Bank stocks continue to be extremely volatile reacting to every gyration in the credit markets. Bank stocks have been under constant downward pressure since the credit crisis began in August 2007 re-coupling with U.S. Banks at a time when we believe decoupling would be in order.
• The bank index has rebounded 11% from the lows reached on March 17 (Bear Stearns Rescue). The Bear Stearns Failure/Rescue we believe is an important step for the market in grinding through the financial and credit crisis. In fact a financial failure is usually needed before any stability is achieved. Prior to the recent bounce the bank index was down 16% year-to-date. The bank index remains in underperformance territory down 7% year-to-date versus the market's decline of 1% with BMO a major outlier down 16%.
• The bank group's release of solid first quarter operating earnings with modest writedowns has done little to ease market fears about future asset writedowns, balance sheet risk and earnings levels in an economic downturn. Consequently, Canadian bank stocks are being impacted, not surprisingly, by the negative global sentiment towards the financial services sector. Investors have a heightened awareness of systemic risk and are pricing for it.
• What we underestimated was the global players' exposure and leverage contained within to the U.S. sub-prime market and how negatively it could impact credit markets and liquidity and the degree of investor panic towards the sector indiscriminately. We suspect that the volatility and panic has been enhanced by large pools of capital in hedge funds especially influential in periods of fearful and illiquid markets.
• We view Canadian banks' balance sheets as strong. We expect future asset writedowns to be modest and expect bank earnings to be resilient in a recession with ROE a conservative 15% plus. Dividends we believe are safe with dividend growth moderating in 2008 before returning to double digit growth levels as stability is restored in the credit markets.
• Bank first quarter operating earnings were solid with extremely high return on equity of 22%, although operating earnings did decline 2% YOY after five years of 15% growth.
• Bank cumulative writedowns as at January 31, 2008 have been relatively modest representing only one quarter of bank earnings with writedowns at RY, TD and BNS nominal.
• Despite relatively strong earnings, low exposure to high risk assets, modest writedowns and generally solid fundamentals, Canadian bank stocks have seen major declines in their market capitalizations by a magnitude not seen before. This may be the largest discount for systemic risk in history.
• The bank group market capitalization decline for Canadian Banks has been very sharp in contrast to its writedowns. (Bank Quarterly Review, First Quarter 2008). Bank market capitalization has declined by $62 billion against writedowns of $4.7 billion or 13x.
• Excluding CIBC, the market capitalization decline is 24x (writedown ratio) the writedowns for the bank group as at January 31, 2008. If we set a writedown ratio at an aggressive 6x the market would be discounting a further $9 billion in bank writedowns which does not seem feasible given their exposure to the high risk assets.
• The writedown ratio in the LDC crisis in early 1980s and in the Commercial Real Estate debacle in the early 1990s was 1.8x and 2.3x respectively. If we apply these types of ratios the market would be discounting future losses of $34 billion which we believe is not feasible.
• Future loan losses in a recession are a very valid concern. Loan loss provisions for the bank group in 2007 were $2.8 billion or a modest 27 bp of loans. We believe that 2006 was the trough and that loan losses will rise steadily over the next five years. However we believe that loan losses will peak at much lower levels than historical norms due to major loan mix shifts and the impact to earnings will be much lower than the past due to lower leverage, higher capital levels and larger earnings base. If loan loss provisions double to $5.6 billion in the next three to four years the earnings drag is 9%. The market in our view has already discounted extreme scenarios. If we were to triple LLPs in the next five to ten years to $8.4 billion or incremental drag of $5.6 billion pre-tax ($3.6 billion after-tax) this seems pale by comparison to the market capitalization decline over the past nine months.
• The market capitalization decline as of the date (March 10, 2008) of our first publication of the writedown ratio analysis was $76 billion with the decline being $82 billion as at March 17 (Bear Stearns Rescue). Sentiment, fear and short interests we believe are the major share price drivers.
• As highlighted in our Short Interest Report (February 12, 2008), short interest in Canadian Banks has increased to meaningful levels in the past year versus negligible short interest in the last credit scare of 2002 (Telco/Cable/Power/Power Generation).
Canadian/U.S. Banks - Re-coupling - Why?
• It is interesting that the Canadian and U.S. Bank Index correlation (R2) has been historically very high at 96% but significantly decoupled over the past five years with low correlation of 34% based on what we believe is significant differences in operating performance. However since the current credit crisis began in August 2007 the correlation has increased to 83% as the market has not differentiated between Canadian and U.S. Banks despite significant differences in balance sheet risk, earnings and banking environments.
Bank Valuation - Already Discounting a Recession
• In our view bank valuations are already discounting a recession. The banks trailing P/E multiple declined to a low of 9.4x on the Bear Stearns Rescue (March 17, 2008) slightly above the Asia Crisis bottom in 1998 of 8.9x. The bank current trailing P/E multiple is 10.6x similar to the bottom in Telco/Cable Credit crisis in 2002.
• Bank P/E multiples are extremely compelling at 10.4x and 9.3x on our 2008 and 2009 estimates. Our estimates have some modest vulnerability to continued grid lock in the credit markets and slowing economy.
• Bank P/E multiples are a 7% discount to U.S. banks despite higher return on equity, higher capital, lower exposure to high risk areas and a more favorable banking and economic environment. The bond market and the currency markets have revalued Canada favorably versus the U.S. over the past 15 years. But not the equity markets. Yet?
• Bank dividend yields relative to bonds continue to be near all time highs at 121% or 5.8 standard deviations above the mean. Bank dividend yield versus the TSX, Pipes and Utilities are also at all time highs.
Recommendations
• We continue to recommend aggressively buying bank stocks at these levels. As fear subsides, we expect share prices to move up sharply. We see strong fundamentals and compelling valuation.
• We would recommend moving to your maximum allowable weightings in bank stocks. We have only buys and strong buys in the bank group with no sells or holds on an absolute return basis.
• Maintain our 1-Sector Outperforms on RY and CWB. Maintain 2-Sector Performs on TD, CM and NA. Maintain 3-Sector Underperform on BMO and LB.
• Our stock picks in order of preference are RY, CWB, TD, CM, NA, BMO, LB.
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Banking Siege - Nine Months and Counting - Buy Banks
• The Banking Siege is into its ninth month and counting. Canadian Bank stocks continue to be extremely volatile reacting to every gyration in the credit markets. Bank stocks have been under constant downward pressure since the credit crisis began in August 2007 re-coupling with U.S. Banks at a time when we believe decoupling would be in order.
• The bank index has rebounded 11% from the lows reached on March 17 (Bear Stearns Rescue). The Bear Stearns Failure/Rescue we believe is an important step for the market in grinding through the financial and credit crisis. In fact a financial failure is usually needed before any stability is achieved. Prior to the recent bounce the bank index was down 16% year-to-date. The bank index remains in underperformance territory down 7% year-to-date versus the market's decline of 1% with BMO a major outlier down 16%.
• The bank group's release of solid first quarter operating earnings with modest writedowns has done little to ease market fears about future asset writedowns, balance sheet risk and earnings levels in an economic downturn. Consequently, Canadian bank stocks are being impacted, not surprisingly, by the negative global sentiment towards the financial services sector. Investors have a heightened awareness of systemic risk and are pricing for it.
• What we underestimated was the global players' exposure and leverage contained within to the U.S. sub-prime market and how negatively it could impact credit markets and liquidity and the degree of investor panic towards the sector indiscriminately. We suspect that the volatility and panic has been enhanced by large pools of capital in hedge funds especially influential in periods of fearful and illiquid markets.
• We view Canadian banks' balance sheets as strong. We expect future asset writedowns to be modest and expect bank earnings to be resilient in a recession with ROE a conservative 15% plus. Dividends we believe are safe with dividend growth moderating in 2008 before returning to double digit growth levels as stability is restored in the credit markets.
• Bank first quarter operating earnings were solid with extremely high return on equity of 22%, although operating earnings did decline 2% YOY after five years of 15% growth.
• Bank cumulative writedowns as at January 31, 2008 have been relatively modest representing only one quarter of bank earnings with writedowns at RY, TD and BNS nominal.
• Despite relatively strong earnings, low exposure to high risk assets, modest writedowns and generally solid fundamentals, Canadian bank stocks have seen major declines in their market capitalizations by a magnitude not seen before. This may be the largest discount for systemic risk in history.
• The bank group market capitalization decline for Canadian Banks has been very sharp in contrast to its writedowns. (Bank Quarterly Review, First Quarter 2008). Bank market capitalization has declined by $62 billion against writedowns of $4.7 billion or 13x.
• Excluding CIBC, the market capitalization decline is 24x (writedown ratio) the writedowns for the bank group as at January 31, 2008. If we set a writedown ratio at an aggressive 6x the market would be discounting a further $9 billion in bank writedowns which does not seem feasible given their exposure to the high risk assets.
• The writedown ratio in the LDC crisis in early 1980s and in the Commercial Real Estate debacle in the early 1990s was 1.8x and 2.3x respectively. If we apply these types of ratios the market would be discounting future losses of $34 billion which we believe is not feasible.
• Future loan losses in a recession are a very valid concern. Loan loss provisions for the bank group in 2007 were $2.8 billion or a modest 27 bp of loans. We believe that 2006 was the trough and that loan losses will rise steadily over the next five years. However we believe that loan losses will peak at much lower levels than historical norms due to major loan mix shifts and the impact to earnings will be much lower than the past due to lower leverage, higher capital levels and larger earnings base. If loan loss provisions double to $5.6 billion in the next three to four years the earnings drag is 9%. The market in our view has already discounted extreme scenarios. If we were to triple LLPs in the next five to ten years to $8.4 billion or incremental drag of $5.6 billion pre-tax ($3.6 billion after-tax) this seems pale by comparison to the market capitalization decline over the past nine months.
• The market capitalization decline as of the date (March 10, 2008) of our first publication of the writedown ratio analysis was $76 billion with the decline being $82 billion as at March 17 (Bear Stearns Rescue). Sentiment, fear and short interests we believe are the major share price drivers.
• As highlighted in our Short Interest Report (February 12, 2008), short interest in Canadian Banks has increased to meaningful levels in the past year versus negligible short interest in the last credit scare of 2002 (Telco/Cable/Power/Power Generation).
Canadian/U.S. Banks - Re-coupling - Why?
• It is interesting that the Canadian and U.S. Bank Index correlation (R2) has been historically very high at 96% but significantly decoupled over the past five years with low correlation of 34% based on what we believe is significant differences in operating performance. However since the current credit crisis began in August 2007 the correlation has increased to 83% as the market has not differentiated between Canadian and U.S. Banks despite significant differences in balance sheet risk, earnings and banking environments.
Bank Valuation - Already Discounting a Recession
• In our view bank valuations are already discounting a recession. The banks trailing P/E multiple declined to a low of 9.4x on the Bear Stearns Rescue (March 17, 2008) slightly above the Asia Crisis bottom in 1998 of 8.9x. The bank current trailing P/E multiple is 10.6x similar to the bottom in Telco/Cable Credit crisis in 2002.
• Bank P/E multiples are extremely compelling at 10.4x and 9.3x on our 2008 and 2009 estimates. Our estimates have some modest vulnerability to continued grid lock in the credit markets and slowing economy.
• Bank P/E multiples are a 7% discount to U.S. banks despite higher return on equity, higher capital, lower exposure to high risk areas and a more favorable banking and economic environment. The bond market and the currency markets have revalued Canada favorably versus the U.S. over the past 15 years. But not the equity markets. Yet?
• Bank dividend yields relative to bonds continue to be near all time highs at 121% or 5.8 standard deviations above the mean. Bank dividend yield versus the TSX, Pipes and Utilities are also at all time highs.
Recommendations
• We continue to recommend aggressively buying bank stocks at these levels. As fear subsides, we expect share prices to move up sharply. We see strong fundamentals and compelling valuation.
• We would recommend moving to your maximum allowable weightings in bank stocks. We have only buys and strong buys in the bank group with no sells or holds on an absolute return basis.
• Maintain our 1-Sector Outperforms on RY and CWB. Maintain 2-Sector Performs on TD, CM and NA. Maintain 3-Sector Underperform on BMO and LB.
• Our stock picks in order of preference are RY, CWB, TD, CM, NA, BMO, LB.
