Canadian banks show resilience

Globally, financial service stocks have offered investors a rough ride — but if you are going to put your money in the sector, it appears Canadian banks are the place to be. Three of Canada’s “Big Five” banks have reported positive quarterly earnings in the last couple of days, highlighting their resilience in an extraordinarily difficult market.

TD Financial Group, RBC and CIBC all posted modest gains for the first quarter. While the earnings were down from this time last year, the earnings beat most analyst forecasts and were positive during a period when many of the world’s banks were posting record losses. TD posted a $712-million gain, RBC earned $1.05 billion and CIBC had a $147-million gain.

During the same period, U.K banking giant Royal Bank of Scotland announced it had suffered the largest corporate loss in the country’s history, at £24.1 billion. It’s estimated that the debts it will owe from dealing in risky or “toxic” assets are in the vicinity of £325 billion. Similarly, U.S. banking giants like Citigroup and Bank of America continue to tap U.S. bailout money and some form of quasi-nationalization looms over the industry.

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What this means for investors is that Canadian banks remain an appealing dividend investment, points out Chris Lowe, senior vice-president of AIC. Lowe says even if growth is slow for the Canadian banks, as it’s anticipated to be, the high yield on the dividends make them an attractive buy-and-hold investment. AIC has a number of funds that hold TD and RBC.

“One of the things people are focusing on at the moment is the ability of the banks to pay the dividend and how they will handle the crisis that has befallen many other large global banks around the world. It appears that Canadian banks are doing well, relatively,” Lowe says. “Obviously relative performance is matched to a low benchmark right now.”

Lowe emphasizes that investors can’t expect much growth performance from the banks. The global financial crisis has forced them to move away from asset management and brokerage business and focus on more conservative core businesses such as consumer lending. For this reason, he doesn’t expect Canadian banks to cut their dividends, but he doesn’t expect there to be an increase, either.

He points out that many investors opt for dividend reinvestment, which helps the banks by shoring up demand for their stock.

“In this market, when you get more investors to buy through the use of share capital, it’s a strong looking endorsement of those businesses,” he says. “I think we’re looking at a flat dividend for quite some time, if for no other reason than the dividend yield is way over the yield of a treasury. A flat dividend for a few years will still provide a good rate of return.”

The Canadian banks have avoided the pitfalls of being too heavily exposed to the U.S. subprime crisis. There are still risks outlined in their earnings reports related to a potential slowdown in consumer assets as the Canadian economy contracts.

“Securities losses may be beginning to ebb. The next shoe to drop will be credit deterioration. Credit is a lagging indicator. This is going to create headwinds to earnings. Credit typically doesn’t cause holes in the balance sheet like losses do. It is really a headwind against momentum as opposed to erosion of capital,” says John Aiken, vice-president and senior analyst of financial services for Dundee Capital Markets.

“There is the risk that earnings become reduced and payout ratios become unsustainably high. When you’re looking at the dividend of the Canadian banks, as far as we’re seeing they look quite safe for 2009. Realistically, the only bank at risk is Bank of Montreal.”

Aiken points out that BMO is currently offering a dividend yield at about 10%, which means the market is pricing in the probability of a dividend cut.

Should the Canadian banks continue to tread water long enough to see the other side of the global banking crisis — as all signs suggest they will — investors should prepare to lower their expectations, Aiken says.

“Growth and overall profitability once we come out of this mess will likely be lower. Banks are refocusing their business not just on consumer businesses, but capital is being pulled out of riskier areas which had given you higher returns,” he says. “With that capital pulled back, you’re not going to see the same levels we’ve seen historically. I think that 20%-plus return on equity (ROE) over the last few years will be exceedingly difficult for the banks to achieve over the next five years, given the fact that we’re likely to see higher government intervention and lower demand for high-profitability products from their clients.”

Determining what their growth rate or earnings will be is also difficult, because there is no historical precedent on which to base future expectations.

“The banks are a very different beast from what they were even ten years ago. This is the trouble that investors are having: How low can we go, and where is the bottom on this front? When we look at the 1980s, the banks were by and large deposit-taking lending machines that didn’t have capital markets presence,” Aiken says. “I think a new run rate ROE level over a cycle is probably going to be in the 15% range. The banks are going to be below that over the next year or two. When we come out of this, the height is not going to be nearly as large as 20%.”

(02/26/09)