04 May 2009

RBC CM Turns Positive on Bank Shares After Missing the Huge Price Run-up

On 9 March 2009, RBC Capital Markets analyst Andre-Philippe Hardy reiterated his call that it was too early to buy Canadian banks. At that time, RBC Capital Markets analyst Andre-Philippe Hardy also stated that Canadian banks should consider suspending their dividends. Today, less than 2 months later (and after a huge run-up in Canadian bank shares since 9 March 2009), in a report, RBC Capital Markets analyst Andre-Philippe Hardy states that he is "turning more positive on Canadian bank shares as indicators of future profitability have improved, and the banks have enough capital in our view to handle the negative impact of challenging economic conditions on loan losses over the next 6 to 12 months."

Andre-Philippe Hardy should seriously consider a new line of work that does not involve analyzing or forecasting.
RBC Capital Markets, Andre-Philippe Hardy, 4 May 2009

• Our upgrade of the bank sector is not reflective of a positive outlook for bank earnings over the near term. We have thought and continue to think that loan losses will negatively exceed expectations.

• We do believe, however, that the key to investing in bank shares is not to look at the immediate future for earnings but rather at whether the outlook for future earnings is improving (which we believe it is as leading economic indicators, credit spreads, funding costs have all improved) and whether bank capital positions are adequate to face challenges until earnings actually turn.

• Said differently, we are comfortable that 12 months from now, investors will be talking about an economic recovery/earnings potential under a recovery scenario/how much earnings estimates might rise. In that context, we believe that it is reasonable to anticipate higher share prices 12 months from now.

• Negative news flow on the economy and credit is likely to continue, and consensus earnings expectations still need to decline in our view. As a result, a pull back in bank shares is quite possible (20% is not unimaginable) so our change of view is not a trading call, but we believe that fundamentally a pullback should be viewed as a buying opportunity, so long as key indicators of future profitability trend in the right direction.

• We believe that upside in share prices over the next two years if leading indicators continue improving could be in the 40%-80% range, which is on top of the annual dividend yield of 5– 7% at current share prices.

• We are upgrading our ratings on most banks and our favourite banks to own near term remain National Bank and Royal Bank. Investors looking to establish positions in the banks with the best franchises outside of Canada should look to Royal Bank, TD Bank and Scotiabank. However we do not believe that TD Bank and Scotiabank's stocks will be the best to own over the next six to 12 months because (1) in a recovery scenario, we believe that investors would be best positioned in names that suffered more in the downturn and are viewed as higher beta names; and (2) we believe that there is a greater chance of disappointment relative to expectations in the near term for those two names, particularly TD Bank.