Friday, April 17, 2009

canadian banks look frothy

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 (RY) as an example for the group:
How quickly things can change. Royal Bank was trading at $26 in late February and is now changing hands at $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 a $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.

7 comments:

BIGINTOBONDAGE said...

As I wade into the online community of personal investing, it's difficult to find young canadians taking a proactive step in handling their finances. I'm glad to have the opportunity to exchange ideas on investments.

I've commented with some of my general theorizing and enjoy gaining knowledge of your choices and the context within which you make them.

fair to say, i don't quite see eye-to-eye with this post. i keep it simple and highly conservative. i have my savings accounts spread across the big five banks and i keep it below the insurable limit. We all keep our money in the hands of one of the big 6 banks. Is there really a stable market of people who would have confidence to take all their money (if there was a real Canadian financial meltdown)out of the big 5/6 and put it somewhere else? In essence where would we go without them? Whatever the share price is, the ability of these companies to still remain capitalized and profitable during the global financial crisis will likely allow them to exist in their current form for a long time coming.

though, i admit, i would have agreed with your position in nov-march, when we didn't know if the world was going to collapse or not (it's not). the fact the banks generate consistent revenue from fixed-income sales (both retail and institutional investors)and hidden credit card fees. Personally, i know senior bank employees who would attest to the same thing, i know virtually all experts and experienced investors and traders will tell you bank stocks are the investment choice of 'widows and orphans'. and i say then it's difficult to lose in the short-, medium- or long-term in this scenario.
I'm not predicting anything, and it's possible the share prices could continue to rise or fall back to the lows of early march. If it did, we should be happy we can purchase more at this discounted rate. The unfortunate truth for the Canadian Bank Bears is that they are sleeping through the best time in a century to buy shares in the bank they keep their money in.

as an anecdote: I have a friend whose grandmother inherited a farm in the early 1920s. She didn't want the land, didn't need the money and decided she would purchase common shares in the canadian banks rather than put it in her savings account. Today, even through two economic depressions, thanks to the power of reinvestment, her great-grandchildren are millionaires.

BIGINTOBONDAGE said...

you've inspired me to share more about my beliefs. and i wish you all the best of luck.
http://canadianbondmarket.blogspot.com/

Scott said...

MG wrote:
"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."

Have you sold or do you intend to sell?

Nurseb911 said...

Frothy? I would almost argue that they were hit irrationally by the market and their lows indicated substantial value when you consider the fear & turmoil in equity markets and financial services companies.

I don't intend to sell, but having loaded up I'll be in a position shortly to trim positions to rebalance my individual holdings in BNS, RY & TD.

MG (moneygardener) said...

Scott, No, I haven't sold and I don't intend to sell. I'm just not interested in adding at these levels whatsoever.

Brad, I agree that their lows offered substantial value, I just think they've run up too much now, given the environment and short term outlook.

BIGINTOBONDAGE said...

from the globe and mail:
However, Royal Bank's writedown is being seen as a sign of realism, not something that investors should worry about. Mr. de Verteuil said: "We believe that this will be a minor issue and is unlikely to affect the share price meaningfully.”

But the top-ranked analyst did warn: “Canadian banks are now 50 per cent above their panic lows of February 2009 so a pullback for the group is possible.”

i see where you have an argument, but again:
short-term pain (3 months to a year?) vs. long-term gain....

MG (moneygardener) said...

If an investor needed more exposure in this area, I would wait for a significant pullback from these levels to buy. There are far better opportunities elsewhere IMO.