A Look at EQB Inc
EQB Inc or EQ bank or Equitable group is a small 'challenger' bank in Canada. Ok... so I've now lost 100% of my non-Canadian readers... and 50% of my Canadian ones.
The simplicity of the pitch is that this looks like a company that generates high teens returns on equity trading near book value. For reference a 16% ROE for a company at 1x book would amount to a 16% CAGR. Excluding impact of share issuances/repurchases, whether it trades at a large discount or a large premium to book, the long term expected returns should be tied to book. ROE is effectively, how quickly book value increases.
To me, this kind of results would suggest that I was looking at a good company. The next question would be, what am I paying for it?
That looks like a reasonable amount, relatively average vs it's recent history. It looks like you'd be paying what amounts to, in normal times, a premium of a few months to asset value. This compares to 2015 where you'd be paying a premium of 4 years to book value at the high end or 2021 where it would be a premium of 3 years. Both of those points weren't points where you needed to exit as much as points where patience was required to let the company work off the premium. That takes us to now where although near the middle of the range, a 50% appreciation would be needed to return to the 'wait' point.
My father would be quick to point out that the on the low end the valuation has hit 0.8x book multiple times which could represent 25% downside to where you may be able to get a better entry. That is of course, possible, as is any number of 'worse' scenarios. One could also suggest that, now in a higher rate environment, that lower valuations are in order. At 0.8X book someone would say that book is about to decrease due to losses... at 1.6x book someone would say it might be cheap at 8 time earnings. All of these theoretical opinions can be right... The point is, Nobody knows what's going to happen next... ever. Still let's examine the would-be point of my father... if this is valuation range bound would it not be a better risk/reward to wait for the bottom of the range? Yes and No. It depends when. If it's going to be 0.8X book tomorrow, then that's obviously a better price. Assuming normal course of business (or thereabouts) the value will increase by roughly 15%-17% per year (excluding dividends). So in 2 years, the company might be worth 1.3 times what it is now and 0.8x book then is more than 1x today's book.
In fact if you thought that on average a company were to generate 15% ROE for the next 10 years, then you could even pay 1.5 times book (10 times earnings) and still generate 10% CAGR returns even assuming that you'd lose 1/3 of the valuation and end at 1.0 times book. Valuation risk is mostly a shorter term phenomenon for better companies. Of course, valuation risk is far from the only risk.
Base Case Math
My base case goes something like book today: ~$70
As stated above, 1.5x book would be roughly right to target 10% returns... except, because of current market conditions... or some difficult future year, I want to assume that in one year the earnings may be $0 (offsetting losses in difficult market etc)... So (70*1.15^9)/(1.1^10) = $95
So $95 is probably what I'd call fair value TODAY... or roughly 10x trailing earnings.
That could be $110 next year and $125 the year after that... If they keep proving themselves to be the same caliber of company.
This is effectively a budget discounted cash flow. The reality is I have no idea how to predict any single year of the next 10. I'm making a guess that on balance the future will be similar to the past. Obviously the market believes the future will be different from the last 20 years. I could pretend I know the probability that the average of the next 10 years is 12% ROE or that 8 of the 10 will have 17% ROE, one 12% and one 15% but I don't have any idea.
For me, by this point it seems like there may be something here as it checks the boxes of
Above average company
Below average price
Growth runway
Next of course is to hunt down the details.
Basics
The average age across +$1B Canadian banks is probably something like 100 years old. Our banking system is smaller and funded effectively quite differently from the US. The funding and lending is much shorter term. That reduces the SVB style term risk. There are also far fewer options from deposit flight. Historically, despite the millions of charts that you see our there about how impossible it is to afford housing in Canada, defaults and delinquency are frequently much lower in Canada than the US... like 1/8th. Additionally, there are many more stress tests and a requirement to insure low equity loans.
Last Quarter Some peer banks reported that 90+ day delinquent loans
Mortgages 0.14%
Personal Loans 0.63%
Credit Cards 0.61%
Secured Lines of Credit 0.22%
International & U.S. is regularly much higher
That's not to say there's no risk, of course there is, mostly in credit. My point is that the Canadian banking system is usually a lot less volatile than many places... even if it's ridiculously unaffordable.
Comps
It's interesting to sometimes try to compare the companies I'm interested in with popular ones. I'm not going to go into great detail here but I did have a few relevant thoughts. You could probably find companies with lower returns on equity and growth rates for closer to 25 times earnings (in other industries) BUT I wouldn't expect bank stocks to attain those valuations. Maybe it's the leverage, maybe the business type, maybe they're just not worth that much. I don't know. That's not really an issue for Canadian owners of banking peers.
The current closest ROEs among CAD banks are probably Royal & National. Someone once said of EQB, "It'd be weird to own a financial with such a low dividend yield." I think that's half the reason for the discount (the half I hope they don't change yet). The other half is that they're 1/10 the size of National... which is 1/5th the size of Royal. They're small and less established. I do think that from a valuation agnostic perspective all are interesting companies.
Dividend
They don't pay much of a dividend, and if they can keep growing at this rate, I hope they continue to not pay much of a dividend. I suspect that they'll raise their dividend to 0.40/share per quarter when they next report/declare.
Their dividend is roughly 2%-2.5% of their equity (so with 15% ROE they'd keep 12.5%-13% to grow and pay out the rest of the earnings). This means that there's been some decent growth and that will probably continue.
Provisions for credit losses.
Despite the bank's good results in recent quarters they have actually been increasing their PCLs. Obviously people are thinking that that will need to further increase as things deteriorate. Provisions have doubled in the last 18 months and are now more than 20% above COVID levels
Growth
EQB has been fairly consistently growing all the categories that an investor would want them to grow; Deposits, loans, EPS, book value per share, dividends, Revenue...
While impossible to grow things like Return on Equity and CET1 ratios, forever, even they have been trending in the right direction recently.
How to get to losses
Given the primary knock on Canadian banks is that they have lots of exposure to the Canadian "housing bubble," I want to look at what's needed for the bank to lose money.
1: Decline in property prices
Given that mortgages with less than 20% equity get insured by the CMHC, you'd first need a decline of more than 20% to be at risk...
Except: Over the first 5 years where rates are mostly locked in (at a supposedly stress tested affordable level) mortgage holders are scheduled to pay off ~10% of their principle. So you'd actually need closer to a 30% decline over a few years to risk getting to a power of sale situation.
Then you figure that most of the portfolio of 25 year mortgages weren't purchased at the perfectly wrong time. IE: some people were 25% + in the money by the time the price peak hit so a 25% drawdown takes them back to flat except that they've built 15% more equity over that time too etc.
Ok so if prices drop +30% and the mortgage-holder (who can't contribute more equity) bought at virtually the top and they weren't adequately stress tested...the bank can lose money.
Also remember that as time passes older loans have more equity and newer loans have fresh 'buffers'. Essentially, house prices meandering sideways or creeping slowly in a direction may be derisking the loans over time.
Then you approach the question of how much... because I mean in the end the banks are kinda at risk of having to buy a house 30% off...
I want to be clear, I'm not making light of this scenario. It can happen to some unlucky people. There's also plenty of possibility for loss of earnings from lower volume, affordability, or the busting of some insured mortgages. I'm saying that if we figure a small amount of mortgages reset each week/month, the stress from the rates is slow and incremental. If the pipe were to burst in a deflationary shock hopefully central bankers would perform their main useful (non sarcastic) function and loosen monetary conditions before we repeat the great depression... but in the end I suppose you never know. Can't imagine too many stocks would do well in that scenario.
Capitalization
EQB is pretty decently capitalized. The degree to which that equates to safety however is always more in question. As of last Q, EQB's CET1 was 14.1%.
For context (not comparing quality of lending only CET1)
TD 15.2
Royal Bank of Canada 14.1 (pre HSBC)
JP Morgan 13.2
Bank of Nova Scotia 12.7
Bank of America 11.4
Wells Fargo 10.8
*Canadian banks are generally well capitalized.
Negative Amortization
Of note in the recent fixation on the negative amortization-pocalypse... EQB doesn't offer products structured in that way. On their variable rate products when rates increase, payments increase. As such they don't have mortgages with over 30 year amortization schedules.
Fundamental Backdrop
Some of you have read some of my other stuff where I discussed this so I won't go into too much depth here.
Essentially I think that population growth is acting as a significant buffer against a negative economic environment and it means lots of demand for housing... meanwhile, I think supply is far closer to the cost of production than many proclaiming 'housing bubble' are willing to admit. Individuals suffering isn't the same as the economy suffering.
Most of the remaining inflation is rent and mortgage interest cost. Rent denotes very strong demand for housing. And Mortgage Interest Cost, aside from being artificial, denotes that a tremendous amount of stress is already being felt and it hasn't yet resulted in a violent decline.
Other Lending
EQ does lend more than residential mortgages. It does represent approximately half of their lending portfolio with the rest being commercial of various types.
Their deposit base is also diversified with:
Brokered Deposits 54% EQ Bank 26% Deposits Covered 8%
Bonds
Corporate and
Institution Deposits 1% Credit Union Deposits 5% Deposit Notes 6%
Risks
I'm not the biggest bull on the Canadian economy right now... so do I really want to own a less established bank stock? That's a fair question. Especially with the big banks trading at close to their lowest valuations in 30 years. I think the market is reflecting some of this in price. It may reflect more of it in prices again. Last time it did it turned out there wasn't a fundamental reason for it. It traded down to a price that turned out to be a very low multiple of forward earnings. I think it's less helpful to predict what the market may think and more helpful to look at fundamental risks...
Losses, bankruptcy, sustained loss in earnings capacity... that kind of thing. I don't know if we see outright losses in coming years. My base case as stated above is essentially "no but" as in not net annual losses but we do see a year's worth of profit go towards offsetting other losses. This could happen over 6 months or 5 years of reduced earnings... I expressed it as one missing year for simplicity. Last quarter they were quite far from that while (impressively) still growing provisions.
I obviously don't think something like bankruptcy is likely.
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