Too much of a good thing
My philosophy on markets is that when everyone thinks something is definitely going to happen, it's time to think again.
I'm not biased against Canadian financials. In fact, until last week my largest position was in TD Bank (NYSE:TD). It was the first stock I owned after graduating in 2012, and it's done well for me over the last four and half years, earning a compounded annual return of 19%.
So what's changed the long-term investment picture? Well, a lot. For one thing, Canadian credit market debt just hit 2 trillion dollars, and the ratio of household debt to after-tax income now sits at a whopping 168%.
Credit risk aside, even the most ardent dividend investor will admit that the Canadian market is oversaturated. The thesis has now shifted to foreign markets. Yet, in these jurisdictions, Canadian banks have no competitive advantage to speak of against larger incumbents with home court/regulatory advantage.
I think we're approaching a type of "blue sky" mentality that's dangerous for value investors. Now more than ever, it's important to check our biases. Particularly the endowment effect, which leads people to ascribe more value to things just because they own them.
In this article, I'll try to make the case that the Big Five (TD, Scotiabank (NYSE:BNS), Royal Bank of Canada (NYSE:RY), CIBC (NYSE:CM) and Bank of Montreal (NYSE:BMO)) have, at the very least, begun to trade outside of Warren Buffett's "zone of reasonableness."
1. Overvaluation Relative to Larger and More Profitable Peers
Wrong. That bank is TD.
Meanwhile, Wells Fargo and JPMorgan Chase trade at 1.5x and 1.4x book respectively, and represent the best of the breed. Both are billion dollar cash flow compounding, mid-double digit ROE machines. Wells is also the cost leader in the industry and has basically cornered the residential mortgage and commercial real estate markets.
I think that on relative terms, Canadian banks are trading at an unjustifiable premium to their U.S. counterparts.
2. Overoptimistic assumptions on the impact of rising interest rates
All else being constant, rising interest rates means improved earnings for financials. But here's the thing: the world is not constant. The market is dynamic, not static.
Having consulted for back offices of four major banks, I agree with SA contributor Marc Radow's excellent article that as interest rates rise, the rate paid to depositors (i.e., an expense) tends to go up at a faster rate than a bank's ability to increase returns on its loan portfolio. Two reasons for this: one is bureaucratic inertia; the second is increased competition among lenders right as borrowing begins to slow down.
At current prices, the market has baked in far too simplistic assumptions about the relationship between rising rates and net interest margins.
3. Dividend yields are becoming less attractive (not more)
Finally, there's the classic dividend argument. But when it comes to evaluating whether a dividend is attractive, we need to ask ourselves this question: attractive relative to what?
Four years ago, when the 10-Year U.S. Treasury yield (i.e., the risk-free return) was 1.50%, TD Bank's 4% dividend yield was extremely attractive. That's why I bought the shares.
Now the U.S. 10-Year is at 2.38% and TD's dividend yield sits at 3.28%. With at least two interest rate hikes penciled in for 2017, that dividend is looking less attractive by the day.
When you factor in increased deficit spending in Canada and the U.S., an inflation rate of 3% could wipe out a dividend investor's real returns. And with Canadian credit markets already overtapped, why are Canadian banks still being valued at a premium to their U.S. counterparts?
For the reasons listed above, I've completely exited from my position in TD and taken profits. I might have kept a small stake had it not been for the recent fire sale of Wells Fargo, a bank I believe is far better equipped to underwrite loans as credit markets dry up.
Disclosure: I am/we are long WFC.
I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.