It’s becoming clear why Canadian bank stocks are trading at low valuations: With the fiscal second-quarter earnings season nearly over, investors have seen uneven profit growth and rising loan losses. Are bank stocks going nowhere this year?
The financial reporting season for the Big Six banks began last week with Royal Bank of Canada and will conclude on Thursday with results from National Bank of Canada. Based on results from the biggest five banks – RBC, Toronto-Dominion Bank, Bank of Nova Scotia, Bank of Montreal and Canadian Imperial Bank of Commerce – there is little reason to cheer.
Adjusted earnings (profits that exclude unusual gains and losses, and used by analysts to gauge operating performance) have increased by an average of just 4.4 per cent over last year, underscoring the difficult lending environment in Canada and lacklustre economic activity.
Even worse for investors: Three of the five banks – Scotiabank, CIBC and BMO – reported adjusted earnings that were slightly shy of analysts’ expectations. These are “misses” in the parlance of the Street, and add to the uncertainty hanging over the banking sector.
Concerns about the Canadian housing market, driven by tighter regulations, higher borrowing costs and sky-high levels of personal debt, only added to the gloom heading into the reporting season. The banks’ results failed to lift the mood: Provisions for credit losses (PCL) – or money set aside to cover bad loans – increased by an average of 27.6 per cent, year over year.
Though the Big Six bank stocks are up by an average of 9 per cent in 2019, after recovering from a sharp sell-off in late 2018, the rally has fizzled: The stocks have fallen 5 per cent in May and are now back to price levels seen more than two years ago.
Some analysts have been trimming their target prices, after earnings results. Robert Sedran, an analyst at CIBC World Markets, lowered his target on Scotiabank to $77 from $81 previously. Gabriel Dechaine, an analyst at National Bank Financial, expects that the shares of Scotiabank will trade at $74 within 12 months, which is down from his previous target of $78. The analyst also lowered his price target for CIBC shares to $115 from $120 previously.
“Although slower consumer loan growth is a sector-wide trend, it is most apparent in CIBC’s numbers,” Mr. Dechaine said in a note.
But investors who rely upon banks for steady dividend growth and strong long-term returns have a few key reasons to look beyond the hiccups this earnings season.
For one, the collective wisdom of the market could see trouble brewing for the banks prior to the release of their second-quarter numbers. Valuations were low, suggesting the market already had a dismal view of bank profits.
According to RBC Dominion Securities, the Big Six stocks traded at a price-to-earnings ratio (based on expected earnings) of 10.5, on average, heading into the earnings season. That’s cheap relative to the average P/E of 11.4 since 2000. If valuations are low, the downside may be limited.
CIBC is a standout here, trading at just 8.8 times estimated earnings – reflecting the bank’s higher exposure to the Canadian economy than the more diversified RBC, TD, BMO and Scotiabank.
A second reason to stick with bank stocks: dividends. To be sure, the fiscal second quarter isn’t a standout period for dividend hikes. Analysts weren’t expecting RBC, TD, CIBC or Scotiabank to raise their quarterly distributions, and none of the four banks did.
But on Wednesday, BMO announced an increase to its dividend, lifting the quarterly payout by 3 cents to $1.03 per share (as expected). That brings the year-over-year increase to 7.3 per cent. Analysts expect that National Bank will raise its dividend when the bank announces its financial results on Thursday.
Given the fact that bank stocks have been drifting sideways for more than two years amid rising dividends, yields are very attractive: On average, the Big Six yield more than 4.4 per cent.
And the third reason to keep your bank stocks close is that rising loan losses, while worrisome, aren’t yet flashing warning signs. That’s because losses have been exceptionally low in recent years, so an uptick now merely brings them in line with historical averages.
Darko Mihelic, an analyst at RBC Dominion Securities, estimates that CIBC’s provisions for credit losses will rise to about 0.3 per cent of total loans this year and in 2020, up from a PCL ratio of 0.23 per cent in 2018 and 0.27 per cent in the fiscal second-quarter.
The average historical loss ratio for the Big Six, going back to 1990? About 0.49 per cent, which suggests that the current gains are nothing to worry about – yet.