16 February 2011

Bank Index Poised to Hit New All Time High

Scotia Capital, 16 February 2011

• The Canadian Bank index is poised to hit a new all time high surpassing the previous high reached in May 2007. The bank index hit another 52-week high yesterday and is only 3% below the all time high.

• TD, BNS, NA, and LB recently reached new all-time highs. Individual bank share price performance versus their highs seems to be correlated with earnings performance except forLB, CWB, and NA whose share price performance has lagged their earnings performance.

• Bank earnings level in 2010 was 9% below the bank group earnings peak of 2007. Bank earnings in 2011 are expected to surpass the 2007 peak by a modest 2%. Return on equity in 2011 is expected to be 16.7%, down from the record level of 23% in 2007. ROE in 2007 was driven by trough loan loss provisions, strong capital markets, high consumer and mortgage loan growth, and lower equity levels. Common equity in 2010 was $45 billion or 50% higher than 2007 levels. Consequently, Return on Risk Weighted Assets (RRWA) in 2010 was 2.12%, only slightly below 2007 level of 2.28%.

• Earnings growth for the bank group peaked in 2007 (see Exhibits 7, 8), with 2008 and 2009 representing the bottom of the cycle. Earnings recovery in 2010 was anaemic due to the countercyclical high wholesale earnings in 2009. We expect the earnings cycle recovery to gain momentum throughout 2011 (see Exhibit 8). Although earnings growth in this recovery cycle is expected to be solid but lower than most past cycles due to lower GDP growth, lower earnings leverage to the credit cycle, and countercyclical slowing of consumer and mortgage credit growth. Earnings growth is expected to remain at or above long-term rates over the next five years. RRWA for the bank group is expected to reach new highs in 2011 and 2012 of 2.32% and 2.31%, respectively (see Exhibit 20).

• The themes for 2011 are a "Return to Operating Normalcy for the Banking Industry," "Dividend Increases," "Improved Clarity on Capital Levels," and "Moderation of Fears about Consumer Debt and House Prices." Thus, the beginning of a great decade for bank share price performance, in our opinion. The theme for the decade is expected to be "Generation of Surplus Capital, Capital Deployment, and Share Repurchases." Share repurchases have never occurred of any consequence in Canadian banking.

• Canadian banks did not repurchase shares between 1967 and 1994. Share repurchases from 1995 to 2010 were insignificant averaging only 1.0% of shares outstanding with the highest year being 2.3% of shares outstanding. Bank share repurchases hype over the past 10 years was not matched by actual activity. Thus, the market did not differentiate much between individual bank capital levels or capital generation ability (RRWA). Capital deployment with a focus on share repurchases and RRWA (new profitability paradigm) are expected to be the themes of the next decade, supporting the expected continuation of the bank group's long-term outperformance.

• Bank stocks have substantially outperformed the market since 1967 (see Exhibits 4 and 12), we believe, because the market underestimates the sustainable earnings power and growth of the sector (barriers to entry and strategic industry) and is slow to attribute an appropriate multiple to reflect the fundamentals, profitability, and structural changes that have occurred in the industry. We expect long-term outperformance to continue and this could be one of the banks' best decades for absolute and relative share price performance.

• Basel III goal is to lower systemic risk, which we believe will ultimately result in a lower risk premium (see Exhibit 27) or higher P/E multiples as the quality of the ROE has improved considerably as reflected in the RRWA trend (see Exhibit 20). We also believe the market will focus more on bank dividend yields, especially given renewed expectations of dividend growth returning to the long-term rate of 10%.

• Bank dividend yields are extremely attractive relative to Government Bonds, Equities (TSX), Pipes & Utilities, and REITs (see Exhibits 23, 24, 25, and 26).

• We expect that TD and BNS will be the first major banks to increase their dividends in 2011, which should be a positive catalyst for bank stocks. NA, LB, and CWB are also likely to increase in 2011 following up on their modest increases in 2010.

• Banks are currently trading at a P/E multiple of 14.1x trailing earnings, below the 15.1x level reached in February and November of 2006 or 14.5x in February 2007.

• We are increasing our share price targets for the bank group (see Exhibit 1) with our target P/E multiple on 2011 earnings estimates increasing to 15.2x from 13.9x, which brings our target up to the 2006 peak levels. The P/E multiple in 2006 was late cycle where we believe 2011 is early cycle (see Exhibit 8).

• We are increasing our 12-month share price targets on TD and CM to $100, NA to $90, BNS to $72, BMO to $68, RY and LB to $65, and CWB to $38. Stock splits may soon be on the horizon.

• We reiterate our Overweight recommendation and we would have no sells in the group on an absolute return basis. TD Bank is our top pick in the sector. We have 1-Sector Outperforms on TD, CM, NA, and CWB with 2-Sector Performs on LB, BNS, RY, and BMO.