Ranking 🇨🇦 Banking

Ranking Banking

I was curious. I've been thinking about the banks recently and wondering how the performance of the Canadian banks would rank as well as how big is the difference?

So today, I'll try not to ramble too much (unbelievable I know... don't worry I'll probably fail) and focus on the results I got when trying to figure this out. As always, past performance isn't necessarily indicative of future results.

Best Banks

The first rather important lens to decide on is over what timeframe? I decided to pick 5, 10 and 20 years to get different perspectives.

Over 5 years the rankings go

1: National Bank 15.8

2: Royal Bank 15.16

3: EQB 14.9

4: Toronto Dominion 13.8

5: Bank of Montreal 12.6

6: Canadian Imperial Bank of Commerce 12.4

7: Scotiabank 12.3

8: Canadian Western Bank 9.65

9: Laurentian Bank 5.8

Over 10 years the rankings go

1: Royal Bank 15.7

2: EQB 15.5

3: National Bank 15.2

4: Canadian Imperial Bank of Commerce 15

5: Toronto Dominion 13.7

6: Scotiabank 13.3

7: Bank of Montreal 12.4

8: Canadian Western Bank 10.2

9: Laurentian Bank 7.3

Over 20 years the rankings go

1: Royal Bank 16.1

2: EQB 16

5: Scotiabank 15.5

3: National Bank 15.1

5: Canadian Imperial Bank of Commerce 15.1

6: Toronto Dominion 14.0

7: Bank of Montreal 13.4

8: Canadian Western Bank 12.1

9: Laurentian Bank 8.1

Some in the middle probably surprised people...  I think most would have guessed Royal would be where it is. 

Expected earnings yield

The next problem is that the market has assumptions. So I looked at what I'll call expected earnings yield. Essentially long run return on equity decided by price to book. This will be my basic cheapness factor.

I think this one was more interesting as it questions 'how much better does the market think'

It's still imperfect because of various payout ratios, and rates of growth on retained earnings but it's close.

Normalized Payout Ratios

On the topic of payout ratios... here's my 'normalized payout ratio' (today's payout vs the expected earnings)

Over 10 years the rankings go

1: EQB 14.5%

2: CWB 33.6%

3: LB 41.4%

4: NA 42.5%

5: CIBC 44.1%

6: RY 45.6%

7: TD 47.5%

8: BMO 48%

9: BNS 50.1%

Most are very similar.

Upside to 10X Earnings

On a similar 'judgmental' metric, I looked at what the upside in valuation would have to be to get the company to a 10% earning yield. I picked 10x with the thought that at 10x earnings all companies would have 'the ability' to payout all earnings for a 10% expected return which is in the range of reasonable.

Over 10 years the rankings go

1: LB 64%

2: CIBC 55%

3: CWB 43%

4: EQB 42%

5: BNS 40%

6: BMO 11%

7: NA 8%

8: RY 3%

9: TD 2%

*** as of the time of writing this, this will fluctuate by the day and the quarter***

Keep in mind, retained earnings would ideally increase these numbers over time. The scale of the increase could be 3%-10% per year depending on the results and the case.

It should be noted that the higher ROE banks would have increased benefits on retained earnings in the very long term... if they retain them at least. Given the difference between the main banks is so small, I didn't go too far into the attempt to sort out the minutia there as it would take many years to see a noticeable difference. 

Can't really look at banks without some capitalization comparison. On a global scale, Canadian banks are all very well capitalized but here you go:

Best Bank Awards

I'm making this up now... but this is how many of the last 20 years each bank was the best performing (based on my data)

CIBC 9 (I know right... the same guys who have no share appreciation since 2007?)

BNS 2

RY 2

BMO 2

NA 2

EQB 2

TD 1

CWB No

LB Lol

Commentary

To the surprise of no one, Royal is probably the best bank. Unfortunately "Canada's Worst Bank" aka Canadian Western Bank (CWB) isn't the worst bank. That title probably belongs with Laurentian.

I wasn't particularly surprised about LB and CWB being the bottom two by a decent length. I was surprised that the data matched my "eyeball test" for BNS, CM, BMO and TD being almost interchangeable over many timeframes. I also admittedly didn't expect CIBC to have scored so well over 10 years or Scoita over 20.

I also had in my head that there was a bigger gap between the top banks like Royal and the rest. In reality, it's 2-3% over most timeframes. In fairness, that adds up over time. I guess my misconception came from... stock performance. I think a big factor is everyone knows Royal is the best, but fewer think about how good some others were many years ago. Some have seen expectations collapse in slow motion over time. If unjustified, that certainly makes them more interesting.

CIBC

CIBC was the bank with the most chaotic results. They were the best bank 9 times but if you exclude CWB and LB from the worst bank calculations, CIBC was the worst bank 5 time too. That's 14 of the 20 years that they were either 1/7 or 7/7 CIBC: Consistency Isn't Bank's Code.

Scotiabank

Scotia was the best bank over the first 10 years I looked at... which is surprising because over the second decade it was the worst of the big 6. I didn't know this going in.

Bank of Montreal

BMO has lagged the other big 6 members over most timeframes. Only recently did CIBC and BNS catch down as BMO improved.

Toronto Dominion

TD has been very medium among the banks. That's not to say a medium bank as all the Canadian banks have done pretty well globally.

National Bank

National has actually been pretty good for longer than many might think. While most has a hiccup in the GFC, National really had 3 bad years. Recently it has been the best of the banks but it's also been fine over longer periods.

Royal Bank

Nobody sits higher than the king... that's the rule of Canada. Royal has long been one of the greats, stocks, companies and banks. National has been slightly batter in recent years but the consistency of Royal for a long time has been what stuck out. They've only been the best in 2 of the last 20 years but still wind up on top.

EQB

EQB scores pretty well across most perspectives, near the top across many timeframes in operating and cheapness. It really only would stand out to the negative because of the low dividend. Others would look at that same fact as a significant positive due to the significant growth.

Laurentian

There has been a concerning decline in the last few years. Perhaps that's why we're seeing the executive exodus. They're surprisingly cheap on assets that they can't seem to get much out of. Most upside if they can turn recent results around but there's little to suggest they are.

Canadian Western Bank

Not Canada's worst bank... But far from Canada's best. CWB is clearly not on the same level as the rest but it's unclear if their "western" exposure would make them less vulnerable going forward. They certainly are not as proficient as they once were (like many)... So there's certainly potential for upside surprise if they can recover.

Fading Earnings

The last 5 years haven't been straightforward. There was an economic slowdown in 2019, Covid in 2020, a bit of a bounce in 2021 before rapid enough rate hikes to send shockwaves through the banking system in 2022 & 2023. It's always difficult to pin down what's going on in a single year with provisions/provision releases etc. That said, most of the banks have put out lower to noticeably lower numbers in the last 5 years. When that persists, it's hard to tell if they're deteriorating or if it's a temporarily uncooperative market.

I think the idea of 'broken banks' bleeds into the fear of a bursting housing bubble in Canada... Negative amortization of mortgages and so on. I couldn't tell you what next year will look like let alone the next 10. I can say that if you remove the word "bank," and look at the history and the price that today's market is giving the performance data suggests some above average returns even using the lower end of historic results. The risk to that statement is a continued prolonged trend in lower earnings or a severe crisis.

Conclusion

They say past performance isn't indicative of future results... Then they go out and pretend to have a good idea of what's going to happen in the future. We've seen multiple rate hiking cycles and crises over the last 20 years. We've seen periods with strong growth and periods of weak growth. Some banks have stayed strong, others have weakened. We can only wait to see what the next 20 years brings.

Disclosure: At the time of this article I own shares in multiple banks as well as indirect stakes in other entities mentioned in this article.
Not investment advice, please see (Can Do Investing: Ground Rules) page for more information.

"Dead Money" a Brief Look at CIBC

"Dead Money" a Brief Look at CIBC

"Dead Money." The term for a stock that has gone nowhere or will go nowhere for an extended period. CIBC, Canada's 5th largest bank has now provided no share price appreciation since 2007. You could basically have invented a product and turned it into a multi-trillion dollar company in the time that it has taken CIBC to go... nowhere.

Now for sure, there have been relevant dividends paid over time but how could a large, profitable staple of the Canadian economy go over 15 years without adding any value?

Well, the short answer is they did add value. The significantly longer answer is: What is value? Yes that's a question but realistically what's the right way to measure value? For me, it isn't exclusively stock price. So in an exploration about what's different between now and then (cause it sure isn't the stock price) let's explore what the books say the company should be worth. Don't worry I won't be going line by line through a bank's financials. I would however distill it to one thing, Book value per share.

Rewinding to 2007, CIBC was trading at just over 3 times book. Today we may look at that and wonder what possessed people to want to pay 3 times book for a bank stock but we did back then. I think, what possessed people was the fact that the banks were doing great. Those book values were growing by ~23% per year, making that 3x book something like 15x earnings. If you were to extrapolate what you saw back then (excluding dividends) it would look like paying a reasonable multiple for a company growing 20% CAGR. After all, why should a bank with nearly 20% earnings growth only have a 10PE/ 'bank' multiple? In that light, it seems a little less stupid.

Now CIBC trades at ~1.0 times book. Which today makes sense because returns on that book value have fallen and the market seems to think may be at further risk.

This also happens to be nearly the lowest valuation for them (and many banks) since the 90s. The other similar periods were when the economy shut down (COVID and GFC).

I'm sure some bears would point out the declining trend in Returns on Equity in addition to the dubious macro. It's possible that the trend will continue lower but my thinking is that much like 99, 02, 05, 09 & 2020, the earnings power will eventually spring back to the mid to high teens. Ideally for shareholders, perhaps even spend more time there.

CIBC also holds the distinction of being the only major Canadian Bank to record a YoY negative return on equity (a loss on a year over year basis) in the last 20 years. And as a matter of fact... they did so twice. 

I'll be honest, when I look at the 7 Canadian banks that I follow closest, I have 2 classifications. Good (3) & ok (4). CIBC fits the OK category. This doesn't mean that I don't want to own it (I actually do own a small amount) it just means it's one that I believe deserves a lower P/B multiple. I actually think the OK's are basically indistinguishable from each other, so if I'm interested in buying banks, I add to the cheaper end. The ok ones present an interesting conundrum (half explained above)... what if they're actually good? 

All the major banks were earnings high ROEs in 2007 and all had 'deservedly high' P/B multiples. There's not a good reason why they can't get their efficiency metrics back to the 'good' levels. Will they? No idea. I do think there's room between here and 3x here for reasonable appreciation. Even if not an 'appreciated appreciation' perhaps the stock might be even cheaper than it currently appears (able to add more value quicker). Remember also that back then we weren't just extrapolating nothing... the companies were adding value very quickly. That require a better valuation to be good.

Certainly things can get worse from here too or at least stay challenging for a while. Looking at 2007 however gives us a great analog of the ironic part of markets. Things were great for CIBC, roughly 'never better' so naturally, it was a terrible time to buy the stock. You don't want to buy high expectations. I think current expectations are beatable. Could they lose money next year? Yes. But they also could... and literally did then too.

The big banks don't cut their dividends very often. It's probably happened but I can't think of a case off hand. So I really look at the bank stocks similarly to how I might look at a cap rate. A base case for yield and probably eventually some growth and appreciation. I appreciate the yield which provides something that much of my portfolio is lacking. I think the market is pretty negative on the banks and eventually without any warning we'll find ourselves through the worst of 'it.' For now I don't mind sitting on the dividends even if the stock remains... well... dead money.

Disclosure: At the time of this article I own shares in $CM.TO as well as direct and indirect stakes in other entities mentioned in this article.

Not investment advice, please see (Can Do Investing: Ground Rules) page for more information.

EQB Inc

A Look at EQB Inc

I'm starting this unsure about how much I'm truly going to be able to say. Long ago, someone once mentioned that I have a knack for simplicity. When I look at this company, it's a case of well, that looks interesting but if you don't see it I'm not sure what I can say. Even still, let's discuss and see where we get.

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

Source: (1) Statistics Canada, Federal Reserve Board, RBC Economics. (3) Canadian Bankers Association, Mortgage Bankers Association, RBC Economics.

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.

Disclosure: At the time of this article I own shares in $EQB.TO as well as direct and indirect stakes in other entities mentioned in this article.
Not investment advice, please see (Can Do Investing: Ground Rules) page for more information.