The thing I enjoy the most about my “new life” is the flexibility that comes with it. I can now combine my passions together and I have plenty of time to stay in shape. On Thursday morning, I went for my 6km run around 10am (so it’s not freezing! Ah!) and then a news caught me by surprise.
Steven Eisman, AKA the BIG SHORT, was calling out Canadian banks!
While I was getting ready to get back to my home office, I took 20 minutes to watch his interview on BNN Bloomberg (video here). The guy who is famous for having shorted the market in 2007-2008 and calling the US housing bubble is back stronger than ever and now hits “my” Canadian banks. According to the interview, he shorted 3 banks: Royal Bank (RY), CIBC (CM) and Laurentian Bank (OTCPK:LRCDF). He expects a 20%+ drop for these.
I’ll share with you an excerpt of what was sent to my Dividend Growth Rocks members on Friday morning:
His thesis in less than 275 words
Eisman’s thesis for shorting the bank is founded on two points. First, banks are making a “favorable” adjustment to their books to make their earnings look better. Banks must consider a provision for losses on their loan book. Each quarter, they basically tell the market how much they put in “reserve” in the case some of their customers go default and they have to write off loans (lose the money). This provision negatively affects their profit for each quarter.
Banks divide their loan book in three stages according to “IFRS 9 Expected Credit Loss”:
Stage #1 includes good standing loans.
Stage #2 includes loans with a slight delinquency.
Stage #3 includes delinquent loans (about to be written off).
Eisman blames banks for issuing a provision only for bucket #2 and #3 and issuing negative provision (banks think they will have more loans than what they will have to write-off) for bucket #1. This accounting procedure helps earnings to look better. Because I’m sometimes a financial nerd, I went and dug out a provision for credit losses on bucket #1 and #2 (called stage) for Royal Bank last quarter:
Source: RY Financial Supplement page 29
You will notice each negative number (circled in red) will help earnings grow by that much.
Second, Eisman calls for a credit normalization in the upcoming quarters. In other words, he expects the Canadian economy to slow down and have more loans going south. He doesn’t call for an apocalypse, but simply a contraction as consumers finally run out of breath after a 10-year credit marathon.
My take on his short thesis
Eisman has definitely made more money than me on the market so far (I don’t intend to beat him anytime soon!). But I have to respectfully disagree with his decision on shorting banks. However, what he says about provision for credit losses helping earnings is pretty much true. I’ve worked in the banking industry for 13 years and I noticed the same thing. From time to time, banks would revise their credit losses expectancy model and improve their earnings for a few quarters in a row. Some other times, banks would increase their provision and hurt their earnings.
What is important to understand here is that the three stages are determined by the bank’s model. Therefore, depending on the bank’s perception of their loan book, it could look very safe or a bit shakier. What usually happens is all models tend to fail when consumers can’t keep-up with their credit anymore and start missing payments. This is what we call “the end of the credit cycle.” Once there is more default than what was expected by the model, the bank revises its book, applies new restricting rules and then, disappoint the market with lower earnings.
But is this enough to short banks? Let’s take a deeper look at the three names that were mentioned during his interview.
A short sentiment toward Laurentian Bank
I know there are many investors who would be tempted to invest in Laurentian Bank. For many, all Canadians banks are equal. Therefore, if you pick one with a higher yield, you just get the most out of your investment without taking additional risk. After all, when you look at Laurentian Bank’s dividend profile, you can’t really argue with this thesis. Who would turn a blind eye to a solid institution offering a 6%+ yield and consistent dividend increase for the past decade?
When you dig further, you realize why the stock has recently plummeted and is pushing the yield over 6% for the first time of the past 10 years. First, let me compare revenue and earnings per share growth in the past 5 years with the largest Canadian bank:
When I mentioned that some investors think all Canadian banks are created equal, I forgot to tell you that this isn’t true. Laurentian bank can’t play in the big league anymore.
First, Laurentian bank is a small firm in a small market (mostly province of Quebec). We are talking about a bank showing $45.9B in assets under administration and management and $1B in annual revenue (2018 numbers). In comparison, National Bank (OTCPK:NTIOF), the largest bank in Quebec, shows $485B in assets and $7.17B in revenue. Royal Bank (RY), the largest bank in term of market cap, shows $1,397B in assets and $42.55B in revenue. You can imagine how small Laurentian is. Therefore, it doesn’t benefit from much brand recognition, size, scale, network presence or financial strength to compete against “The Big 5.”
Second, Laurentian bank’s growth strategy has been at best blurry for the past decade. It has been forced to close branches, merged some, cut jobs in the past few years (2017, 2018 and 2019). Due to its small size and lack of strategic vision, Laurentian is in damage control mode most of the time. The bank is evolving mostly in Quebec and Ontario, two provinces known for a strong economy in the past 5 years. If the bank can’t surf on economic tailwinds, what will happen if we hit the end of the credit cycle?
Not impressed by CIBC
Among The Big 5, my least favorite bank is definitely CIBC. The reason why I don’t like CIBC too much is mostly because of its lack of growth vectors. While Scotiabank (BNS) developed Latin America, TD Bank (TD) now shows 1/3 of its business coming from the U.S. and while BMO (BMO) targets wealth management and ETFs market, CIBC remains a classic “savings and loans” bank.
Source: 2018 annual report
Since the bulk of its business is related to Canadian savings and loans, it is one of the banks that has the most exposure to Eisman's thesis. He also noted CM was the first bank to declare its model showed credit deterioration in their latest quarter.
Is this enough to short CIBC? I don’t think so. CM is already trading at a low PE ratio and the market seems to have priced those risks. While CIBC lags behind other banks on the stock market, it gives investors the opportunity to pick a 4-5% yielder without much risk. I like its idea to growth through its wealth management division (finally) with the acquisition of PrivateBank Corp. for $5B in 2017. If you are looking for additional income, CM is probably one of the best picks on the Canadian stock market, but don’t expect the stock to soar.
Finally, Eisman is shorting my favorite bank!
What surprised me the most about that interview was to learn that my favorite bank, Royal Bank, was on the short-seller’s list. Royal Bank is a lot more diversified than the other two banks. The firm counts 48% of its income coming from “classic banking activities” while the other half of the business represents strong growth vectors:
Source: 2018 annual report
First, RY counts on a strong presence in Capital Markets. The company has recently confirmed an alliance with the world's largest asset manager, BlackRock (BLK) to create a $60 billion RBC iShares ETF suite. Mutual funds with high fees are legions in Canada at this point. Such partnership will definitely take some assets away from Investors Group (OTCPK:IGIFF) mutual funds at 2%+ MER’s.
Second, after acquiring City National, a U.S. private and commercial bank, in 2015, the firm has posted strong growth in its wealth management segment. Despite highly volatile market conditions, the Wealth Management division posted net income growth of 8% during their latest quarter (source). As the market has been bouncing back since the beginning of the year, you can expect Q1 2019 to be even better.
Final thought: I’m keeping my banks in my portfolio!
While I was watching Eisman's interview, I had some flashback from ShowTime TV show Billions. It reminded me that sometimes, short sellers will sell you panic to make money. You surely remember Citron Research's “bomb” on Shopify (SHOP) a couple years ago?
I think Eisman is right about banks being a little overconfident with their provision for credit losses. But I certainly don’t see how most banks will fall by more than 20% in 2019. I will keep my shares of Royal Bank and National Bank and enjoy their dividend payments.
Many investors focus on dividend yield or dividend history. I respectfully think they’re making a mistake. While both metrics are important, aiming at companies that have and show the ability to continue raising their dividend by high single-digit to double-digit numbers will make your portfolio outperform others. When a company pushes its dividend so fast, it’s because it is also growing their revenues and earnings. Isn’t this the fundamental of investing – finding strong companies that will grow? If you are looking for a great combination of dividend and growth, check out Dividend Growth Rocks.
Disclosure: I am/we are long RY, NTIOF, BLK. 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.
Additional disclosure: The opinions and the strategies of the author are not intended to ever be a recommendation to buy or sell a security. The strategy the author uses has worked for him and it is for you to decide if it could benefit your financial future. Please remember to do your own research and know your risk tolerance.