This week’s e-mail will review the Big 6 banks and their reported earnings. First things first, make sure you have images enabled for this e-mail, there are a multitude of them.
Canada’s Big Six banks are largely considered to be bellwethers of the Canadian economy, and how these companies perform can give us insight into the impacts of the recent rate hikes and high inflation on the economy. With that in mind, let’s look at how Canada’s banks fared this quarter.
Of note, here is our commentary on our 3 bank stocks on the Bull List or Foundational Stock List:
Royal Bank – Click here to read our Foundational Stock page and commentary on Royal Bank
Bank of Montreal – Read our full report here
Toronto Dominion Bank – Read our full report here
Overall, it really wasn’t pretty. It has been a while since Canadian banks performed so poorly against estimates and just poorly overall. There is no question that macroeconomic headwinds are starting to impact the banks. As a result, valuations are coming down across the board.
Interestingly, when we look to a portfolio of Big 6 banks over the last half-decade, they are now underperforming the TSX Composite, even with dividends reinvested.
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Since the financial crisis, Canadian banks have gone on a significant run. So, it’s not surprising to see them settle down a bit in the last 5 years, particularly throughout 2022 and 2023, now that rate hikes are starting to take hold.
This is a lesson in the reality that past returns do not guarantee future performance. Many Canadians went overweight on Canada’s major banks in terms of allocations, and ultimately it has led to underperformance.
You can adopt your own rules, but both Mat and I really try to have no more than 20% exposure to a particular sector in the markets. At this point in time, four Canadian banks (EQB,RY,BMO,TD) and a single insurer in Intact Financial make up around 16% of my total portfolio. A 4% position in US Foundational Stock Blackrock (BLK) gets me to that 20% mark.
Remember, the banks have still returned 41%~ over the last half-decade. We’re not trying to say that the banks’ returns were poor or disastrous over the previous 5 years. Just a little underwhelming.
However, although buying the banks half a decade ago has yielded somewhat underwhelming results, discounted valuations right now are likely to lead to larger returns in the future. You just have to be able to withstand some potential volatility.
Remember, as stock prices get cheaper, expected future returns get higher.
Let’s get into the earnings
Last quarter, we talked about the many “warning signs” in Q1 earnings. In Q2, those signs came home to roost, so to speak.
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There was no sugar-coating this quarter – it was disappointing. While most banks saw strong revenue growth, profitability was eroded across the board, and only one bank (CM) topped expectations on both the top and bottom lines.
This type of large-scale earnings decline has not been something we’ve witnessed in quite some time.
Provision for Credit Losses
As we did last quarter, we will start with provision for credit losses (PCLs), which have been getting plenty of attention lately.
This is an important metric for the banks as it reflects credit quality. It is also a forward-looking number, as PCLs estimate future loan defaults.
Simply put, it is money set aside for loans the bank predicts could go unpaid. Provision for credit losses reflects bad debt, and despite it being an estimate, it is booked as a quarterly expense.
Because PCLs are booked as an expense, it impacts the company’s overall net income.
As a result, if a bank underestimates its PCLs, you will see it having higher earnings over the short term and lower earnings in the future because it has to claim more PCLs during that time to make up for underestimating them initially.
If a bank overestimates its PCLs, you’ll see a sharper decline in earnings over the short term, followed by better earnings in the future, as it can claim some of those prior PCLs back, increasing net income.
The pandemic led to significant swings in PCL losses and gains because of how quickly things changed.
If PCLs rise, it is a sign that credit quality is deteriorating and is likely a sign of challenging macroeconomic conditions.
With this in mind, it wasn’t surprising that some PCLs were materially revised upwards. As interest rates rise and inflation persists, certain banks foresee greater defaults on the horizon.
It is also important to note that while these are some big numbers, they still account for a small percentage of overall loans. Here is the breakdown of last quarter.
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It really was a mixed bag as far as PCLs are concerned. Notably, every bank except for TD Bank saw their Total PCL Ratio increase quarter-over-quarter (QoQ). Speaking of TD, despite PCLs coming in lower than expected, TD still expects to exit Fiscal 2023 in the 0.35-0.45% range, albeit at the lower end of guidance.
Also worth noting, last quarter, CIBC stood out with lower-than-expected PCLs, and the company’s outlook was much more positive, especially on the retail side of the business. We noted that this was “in stark contrast to some of the other banks.”
Likewise, we warned that such a big disconnect between one Big 6 bank and its peers may be a sign that the bank is either under or overestimating PCLs. That could lead to a situation where a bank must play catchup in subsequent quarters, as we mentioned above.
It looks like CIBC did exactly that, as it saw total PCLs jump by 48.5%, leading to a 0.1% jump in the company’s Total PCL ratio from 0.19% to 0.29%. While a 0.1% jump doesn’t seem like much, it is notable in the context of the Total PCL Ratio.
Overall, PCLs remain pretty low but are expected to continue rising. Today, the average Total PCL Ratio is 0.28%, and the Fiscal 2024 average estimate for the Big Banks is 0.33%.
Notably, National Bank commented that this is “roughly half of what one would expect to see in a moderate recession.”
Considering this, it is likely that PCLs will continue to rise in the coming quarters, which will continue to pressure earnings estimates. In fact, consensus earnings Fiscal 2024 estimates have fallen by approximately 6% this year. Considering the average EPS miss in Q2 was ~7%, we’d expect further downward revisions.
CET 1 Ratios
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(Source: RBC Capital Markets)
The Common Equity Tier 1 (CET 1) Ratio is used to measure a bank’s capital adequacy. It was introduced in 2014 to help mitigate issues that preceded the 08 Financial Crisis.
It measures a bank’s core equity capital as a percentage of its risk-weighted assets. If you’re unsure of what either one of these is, you are certainly not alone. Just know that the higher the number, the better.
The ratio is important, as the higher the ratio, the better positioned to absorb losses caused by unforeseen events. In February, the minimum CET 1 ratio in Canada was raised to 11% (from 10.5%) as the Office of the Superintendent of Financial Institutions (OSFI) raised the Domestic Stability Buffer (DSB) that financial institutions must hold to 3% from 2.5%.
The OFSI cited “increased risked from high household indebtedness and the rapid rise in interest rates” as the reason for the raised buffer, a component of the CET 1 ratio.
With that in mind, QoQ saw marked improvement by the banks as they further strengthened their CET 1 ratios. This is a good sign, especially for Scotiabank, which exited the quarter with a 12.3% CET 1 ratio, up from 11.5% last quarter, which at the time was the lowest among the Big 6.
We also saw a material change for BMO as their CET 1 ratio dropped by 6% QoQ. However, this was to be expected as it closed on the Bank of the West acquisition, which it needed to raise shares for to meet thresholds, which temporarily bloated the CET 1 of the company.
Similarly, TD Bank saw a slight drop as it closed on the Cowen acquisition. However, their ratio remains artificially high as the bank decided to walk away from the First Horizon deal.
That said, TD turned off the Dividend Reinvestment Plan and announced its intentions to repurchase 30M shares (~2%), which is expected to be completed by the end of summer.
While it has not ruled out future acquisitions, TD is taking a more cautious approach given the regional banking situation in the U.S. With that in mind, it looks like the company will focus on using excess capital to reduce its own share count and still views 12% as an appropriate CET 1 target based on current macro-economic environment.
All in all, the CET 1 ratios of the banks are still relatively healthy, and there is nothing here to really draw any concern. Let’s move on to dividends.
Dividend Patterns
It turns out that our theory around a shift in dividend patterns was right. As expected, we saw dividend raises by the following banks this quarter:
• RY: +2% to $1.35 per share
• BMO: +3% to $1.37 per share
• CM: +2% to $0.87 per share
• NA: +5.2% to $1.02 per share
• BNS: +3% to $1.06 per share * Annual Raise
In our newsletter on banks the last time, we incorrectly stated that the Bank of Nova Scotia was not expected to raise the dividend until the fall.
Pre-pandemic, the Bank of Nova Scotia had announced its intentions to move to an annual raise pattern, which was to occur with Q4 and year-end results. However, they have moved to an annual raise pattern in Q2 of each year. For its part, TD Bank remains on track to raise in the fall.
It is highly unlikely we will see the mid to high single-digit dividend growth we’ve witnessed from the banks over the last few years. There is likely to be a more prudent approach regarding the banks and the possible upcoming recession.
A cautious approach is one we agree with at this point, particularly after this weak quarter.
Closing thoughts
The markets are beginning to sour on the banks, which has proven to be one of the best opportunities to accumulate shares.
A tough environment is leading to significant headwinds, and the impacts are also reflected in lower-than-average dividend raises.
As mentioned, this isn’t necessarily bad as it shows the banks are being cautious and will likely want to ensure they are well capitalized given any unforeseen events. Those banks with exposure to the U.S. are likely to be even more cautious given the current regional banking situation that still lingers south of the border.
This is why a company like National Bank, which is as close to a pureplay Canadian bank among the Big 6 as you will get, continues to outperform its peers, which are far more exposed to the uncertainty down south.
All that said, banks are trading at valuations not seen since the pandemic crash and the financial crisis before that. While a cautious approach is warranted, it can also be a great time to slowly accumulate Canada’s banks.
While lump sum investing has proven to outperform, given the continued uncertainty about inflation, rising rates, recession, etc., averaging in at these levels may better align with one’s overall risk profile. It is what I (Dan) will be doing over the next few years.
