Thinking Long Term? Try Canadian Banks.

Snapshot

Despite high interest rates and mixed results in their recently reported earnings, Canadian banks’ fundamentals signal that they represent attractive valuations for long-term investors. While increases in loan loss provisions may prompt some concern from investors, Canada’s “Big Six” remain well-capitalized, are diversified businesses, and have a history of strong performance.

Why Canadian banks continue to look attractive

The “Big Six” Canadian banks recently reported earnings, and while the results may have been mixed, the fundamentals on the group continue to look attractive, particularly for longer-term investors. After fast paced rate hikes by the Bank of Canada (BoC) over the last year, the overnight lending rate remains at levels last seen in 2007. With household debt at record levels in Canada, higher interest rates are expected to be a drag on households, potentially leading to a greater number of non-performing loans for Canadian banks. As a result, a recurring theme this quarter has been Canadian banks increasing their loan loss provisions as a precaution in the event that some consumers fail to pay back loans. Below we give a quick recap on the Canadian bank earnings, their increases in loan loss provisions, and their loan portfolios and valuations.

Bank of Montreal (BMO)

• Lower second quarter profit, but results were due to costs associated with the recent successful acquisition of Bank of the West, which were included in financials for the first time
• Set aside $1.02 billion for loan loss provisions, which also includes provisions for Bank of the West
• Raised its quarterly dividend to $1.47/share

Bank of Nova Scotia (BNS)

• Softer Global Banking and Markets was offset by better International Banking
• Set aside $709 million for loan loss provisions
• Raised its quarterly dividend to $1.06/share

CIBC (CM)

• Domestic personal and business banking provided a boost as higher interest rates helped offset higher loan loss provisions and softening in other units
• Set aside $438 million in loan loss provisions
• Raised its quarterly dividend to $0.87/share

National Bank (NA)

• Personal and Consumption (P&C), its biggest division, had higher than expected earnings
• Set aside $85 million for loan loss provisions
• Raised its quarterly dividend to $1.02/share

Royal Bank of Canada (RY)

• Higher than forecasted expenses, with plans to reduce expenses by managing headcount growth through attrition and slower hiring
• Set aside $600 million for loan loss provisions

TD Bank (TD)

• Called off $13.4B acquisition of U.S. regional bank First Horizon
• Will buy back 30 million common shares and reassess further buybacks in the summer
• Set aside $599 million for loan loss provisions

A closer look at non-performing loans

It should be noted that loan loss provisions are essentially expenses that are set aside to account for loans that don’t perform, including delinquencies and defaults. While the recent increase in loan loss provisions have weighed on the stocks of Canadian banks, it should be noted that these are part of the banks’ risk mitigation strategies and are precautionary rather than actual defaults. While banks increasing their loan loss provisions isn’t necessarily a good sign, actual non-performing loans can potentially come in lower than expectations.

Below, we use Bloomberg data to outline the Non-Performing Loans as a percentage of Total Loans for each of the Big Six Banks and compare it to their peak levels in the wake of the Great Financial Crisis. A combination of higher interest rates and a softening economic backdrop will undoubtedly result in a higher amount of non-performing loans. Furthermore, as loan loss provisions have recently weighed on stock prices, it would imply that at least some of the bad news has been baked into the share prices. Actual losses coming in less than the accounted provisions would likely be a positive for share prices. At this point, it’s too early to tell the impact of a pending recession on bank loans, however the strength of the labour market may be one of key reasons why non-performing loans may come in less than the provisions.

Additionally, Canadian banks maintain strong Tier 1 Capital Ratios, which is a core measure of a bank’s financial strength. This measure is the bank’s core equity capital and disclosed reserves relative to its total risk-weighted assets. Canadian banks tend to be more conservative, as they are better capitalized than the Basel 3 and OSFI requirements.

Source: Based on Bloomberg data as of May 31, 2023.

Valuations are extremely attractive

Using the S&P/TSX Composite Banks Industry Group (STBANKX) as a reference, the forward-looking price-to-earnings (P/E) ratio currently sits at 9.5x. While the data only goes back to 2003, it does capture two market troughs. On only two other occasions has the forward P/E ratio on the STBANKX been lower: 2009 (the Great Financial Crisis) and 2020 (the COVID-19 pandemic). Both of these turned out to be opportune entry points into Canadian bank stocks.

Source: Bloomberg, January 1, 2003— May 31, 2023.

Comparing the valuation of the Big Six Canadian banks relative to the market also gives us further insight into why banks represent an attractive opportunity for long-term investors. Based on the chart below, the average current and forward-looking P/E ratios of the Big Six banks represent a -22.7% and -31.3% discount, respectively, to the S&P/TSX Composite. Furthermore, on a price basis, the banks on average are trading at a -17.5% discount to their 52-week highs, while the TSX is only at a -7.0% discount.

Source: Bloomberg, BMO Asset Management Inc.

Canadian banks: A history of strong performance

Canadian banks have historically been strong performers. Using the STBANKX index and examining data back to its inception date of December 31, 1987, they have outperformed not only the broader S&P/TSX Composite, but also the MSCI World Index (in Canadian dollar terms). This outperformance has been due to the Canadian banking sector having much higher barriers to entry compared to that of the U.S. While the historical performance also accounts for periods in which we saw consolidation in the industry, banks have now become much more diversified compared to decades prior. The greater diversification in the banks allows them to have various sources of revenue, and many Canadian banks have made key acquisitions of non-domestic banks in order to grow their footprint. Banks being independently regulated by OSFI has also helped create a sound banking system in Canada.

Source: Bloomberg, BMO Asset Management Inc., December 31, 1987–May 31, 2023.

Mutual Funds can provide an efficient way to gain exposure to the banks

The BMO Canadian Banks ETF Fund – F Series provides exposure to the Big Six Canadian banks on an equal weight basis. The Fund is rebalanced twice a year, it allows profits from winners to be redistributed in those banks that have underperformed—essentially a buy low, sell high strategy. The F series² of the Fund currently has a net distribution yield of 5.4%.²

Investors that want to generate additional yield may consider BMO Covered Call Canadian Banks ETF Fund – F Series, which provides exposure to the same base portfolio as ZEB with the addition of call options on the individual banks being sold in order to generate option premiums to enhance the yield of the portfolio. Currently this ETF has a net distribution yield of 8.1%.²

Fund Codes

*Front End = Sales Charge. MER as of September 30, 2022.

¹ Series F units are only available to investors who participate in eligible wrap programs or flat fee accounts with their registered dealers that have entered into a Series F Agreement with BMO Investment Inc.

² Annualized Distribution Yield as of May 31, 2023: The most recent regular distribution, or expected distribution, (excluding additional year-end distributions) annualized for frequency, divided by current NAV. Source: BMO Global Asset Management.