High Expectations for Canadian Banks Is Unrealistic

Canada has recently been lavished with praise because of the strength of their financial institutions amid all of the global financial turmoil. Despite this halo effect, these banks have had their challenges. Royal Bank of Canada (RY) just took a large write down on their US assets. That may be a bell weather for other institutions such as Toronto Dominion (TD) and Bank of Montreal (BMO), who also have large assets in the US.

I can’t help but thinking that Canadian banks are not looking attractive right now as investments whatsoever. With headwinds of further write-downs, low consumer confidence, increasing unemployment, increasing loan losses, and Canadian real estate value declines, the big 5 Canadian lenders share prices look downright frothy. This is quite a change from a few months ago when you could have bought some of the banks at decade lows and towering yields.

Let’s look at Royal Bank of Canada as an example for the group:
How quickly things can change. Royal Bank was trading at C$26 in late February and is now changing hands at C$43. That means that the stock was yielding 7.7% back in February and is now paying out more like 4.7% of their share price in dividends. That is dramatic rise in share price of 65%!

The P/E ratio is now 13.4x for a company that just took an C$850M write-down and is facing multitude of pressure brought about by a recession. There is very little probability of any dividend growth in the short term so investors don’t have much to look forward to in the next two years in that arena. When Royal yields north of 7%, I would argue that as long as they don’t cut their dividend, buying might be wise; however 4.7% does not carry the same appeal.

You could look at all five banks and probably see a similar pattern. The rally in these banks recently looks overdone to me and I believe the expectation currently built up in their share prices is not realistic. The risk return on these investments is not attractive at the current level because the potential short to mid term return has probably evaporated and the risk still exists.

Comments

[Chezfrederick:]

I could have agreed with your assessment, had you been alluding to banks other than Canadian Banks. First, you fail to mention that Canadian Banks are down an average 35% from their peaks. Second, they were not engages into any of the sub prime and other exotic orgies which undermined their asset values. Third, they did not require any bailouts or taxpayer funding. Fourth, they continue to be very profitable and are rewarding shareholders for their loyalty. Fifth, the regulatory and oversight environment in Canada, combined with the banks' conservatism, kept their fundamentals solid and their capital whole. In other words, This is a model for any banking system.

The substantial drop in their prices from their peaks, was driven mostly by a herd mentality, punishing Canadian Banks along with the others. Mediocre analysts who paint the world with the same brush are often wrong as they showcase their weak analysis and poor judgement.

Another point, is that the Canadian economy has not suffered to the extent of the global downturn in most of the advanced world. It is true that real estate values have dropped in Canada, but to a fraction of the drop in the US and Europe. The Governemnt Balance sheet is very sound with accummulated budget surpluses for more than a decade. All this bodes well for the banks and their future performance. Here is a comment I wrote on a recent post on RY's write down of goodwill:

" Canadian Banks have always had a very conservative and at times boring posture, and this is just another confirmation that they prefer to keep clean books.

Further, investors understand that the economic downturn along with the presently reduced stock prices, provides Canadian Banks the opportunity to mop up their balance sheets as much as possible, such that when the economy turns around, they can shine with outsized and stellar performance, as only then will their stocks rise significantly.

Another comforting point, is that the write down of goodwill would not have been effected in this quarter, if RBC had other higher priority write downs of any substance or other skeletons in the closet either on balance sheet or off balance sheet."

My final comment; it is amazing that you find the 4.7 yield insufficent and unsustainable, while at 7-9% analysts we predicting, if not calling for the slashing of the dividend... in lockstep with the insolvant US Banks. Please find another excuse to write more reasoned and well researched articles.

Apr 19 07:55 AM

[moneygardener:]

First off to Seeking Alpha, the title of the article is not proper grammar; please revise.

To Chez,
Just as the sell off was overdone, the rally is overdone in Canadian banks. I would have alluded to all banks if I actually felt that way. I feel US banks offer better long term value still.

All your points are common knowledge and I was not disputing any of them except for the fact that I did not say that a 4.7% yield is unsustainable; just not as attractive as 7-9%. The point is, what has changed since the yields were 7%+, not much. I had as much confidence in the dividend then as I do now. These should be bought when fear is commonplace not when euphoria overshoots on the upside. Any return on investment in these slow growth entities has been diminished significantly since Feb-March.

Apr 20 08:19 AM

[Currency_Tr...:]

OMG

I can't believe you even put Canadian banks in the same category as US banks... Canadian banks are regulated friend and sternly so. Furthermore, Canadian banks traditionally return a good majority of their profits to their shareholders in the form of dividends, often resulting in a yield higher than govt bonds or similarly stable commercial paper. Look at the biggest US banks and see what they pay out to their shareholders as a yield, fact is they gamble with their profits - which is exactly why they are in their current predicament. I'll take my gambling funds to the casino, thank you very much.

Apr 20 02:23 PM

[KIT:]

>Another point, is that the Canadian economy has not suffered to the extent of the global downturn in most of the advanced world. It is true that real estate values have dropped in Canada, but to a fraction of the drop in the US and Europe. The Governemnt Balance sheet is very sound with accummulated budget surpluses for more than a decade. All this bodes well for the banks and their future performance. Here is a comment I wrote on a recent post on RY's write down of goodwill:

" Canadian Banks have always had a very conservative and at times boring posture, and this is just another confirmation that they prefer to keep clean books.

Canada is not that great............

Canada just injected (stimulated ) the total amount we taxed over the last ten years.We no longer have a surplus. Interest rates near zero and the govt is about it print money at the first down slide. We sold to other counties most of our commodies companies. We are now a one trick pony with oilsands that cant afford to expand and cant make money in recession based oil prices

Canadian banks dropped the 20% down on mortgages long ago and replaced it with 5%. Young people left rentals and bought as they found out their friends could get equity loans ( got to keep up with the Jones ! I watched salemen signing up 25 - 30 year olds on $200,000 homes in Calgary in 2005 6 and 7. Average wage no more than 40K for skilled workers ( truck drivers ect ) 32% gross for mortgage is far exceeded 50 to 70 % of total income is comon

Canada is showing growing unemployed but we do not show the huge number of part time worker who are Employed with zero hours per week.

The place I work and I am sure other companies right sized and piled on the overtime 15 to 20 percent. Since the crash huge cuts in OT have workers screaming. They on mass layed off all contractors.

Disposable dollars are gone and those homes in Calgary cant withstand the losses... Canadian banks are the envy of the world is just so many parrots repeating OLD NEWS

Reality is putting your head in the sand wont save the house. Or the banks BAD investment

May 06 12:06 AM