The list of Canada’s largest companies is dominated by banks:
The Toronto Dominion Bank (NYSE:TD) and the Royal Bank of Canada (NYSE:RY) rake in huge profits from consumers Debt up to their eyeballs. The problem is that this looks all too similar to the US in 2007. Let’s examine the risks to see why we are bearish on Canadian banks.
The real estate bubble
Canadians have literally skyrocketed home prices in recent years. Over the past year, many new listings, particularly in urban centers, have received multiple bids above list price. Bidding wars literally broke out. The economies of British Columbia and Ontario have been particularly hot. Vancouver, British Columbia’s largest city, is at the peak of the bubble. Vancouver is the third cheapest city in the world. The average Vancouver home costs 13.3 times the household income and the median price of a detached single family home is CAD$1,870,000. Yes, almost $2 million.
Sailing on a sea of debt
If you own stock in a bank, this isn’t the kind of headline you’re hoping for:
Debt has been growing faster than income in Canada for some time. Household debt to disposable income recently reached a record high of 180%. For a country to be able to get into debt in this way, there usually has to be unwise lending by the banks. Canadians often have a 5-year fixed-rate mortgage and will soon be forced to refinance at higher interest rates. When that happens, the debt crunch will be severe. Note that Canadian consumers are now in significantly worse shape than American consumers, even if you compare them to the 2008 global financial crisis:
Canada’s companies are also in terrible financial shape. Just look at the balance sheets of companies like Bell Canada (BCE), Enbridge (ENB) and Air Canada (OTCQX:ACDVF). It’s not uncommon for Canadian companies to have net debt to income ratios of 10x or more. These companies compete to see who can pay the highest dividends, and their competitiveness and financial position often deteriorate as a result.
Why is this all happening? Basically, the United States deleveraged completely in 2009 and Canada did not. Canadian consumers and businesses have been on thin ice with huge debt and near-zero interest rates for years, but that’s about to change as interest rates rise.
Could Canada’s Biggest Banks Go Bust? Probably not without bailouts from the Bank of Canada. The last round of bankruptcies in Canada’s banking sector occurred in the late 1980s and early 1990s. Government bailouts failed in 1985. But had the banks been the size of TD and Royal Bank, the government would probably have launched a second round of funding.
TD and Royal Bank are trading at a significant premium to book value. This leaves no margin of safety should recession losses hit. Just look at what happened to the P/B ratios of Bank of America and Citigroup in 2009:
Here’s how the banks stack up against each other and their U.S. peers:
|Toronto Dominion Bank (TD)||Royal Bank of Canada (RY)||Bank of America (BAC)||JPMorgan Chase (JPM)|
|balance sheet ratios||TD||RY||BAK||JPM|
|Equity to Assets (%)||5.4%||5.2%||8.2%||7.2%|
|Cash and Asset Equivalents (%)||0%||6.1%||8.3%||18.3%|
Our key takeaway here is that US banks are both better capitalized and cheaper than their Canadian counterparts.
Over the past 10 years, TD Bank (TD) and Royal Bank (RY) have grown equity by 5.5% and 6.7% per year, respectively. Going forward, Canadian consumers should start saving more and borrowing less. We believe these banks will see their book value growth slower going forward and estimate growth at 5% per year. This gives us equity of $117 billion and $122 billion for TD and RY in 2032.
We expect multiple contraction after Canada’s next severe recession. Events like this tend to change sentiment and risk premia, driving the banks themselves to lend more conservatively and even earn less on equity. Currently, many Canadians see banks as blue chip companies rather than cyclical investment vehicles. We have set a P/B of 1.3 for RY and 1.2 for TD for 2032. Royal Bank currently has the best brand in the business and is known for their customer service. TD is weaker in this regard, but that may change over time.
Overall, our price targets for 2032 are $78 and $113 per share for TD and RY, respectively. This means returns of 6% and 5% per year with dividends reinvested.
Risks for the thesis
The risk with this conclusion is that the banks will manage to sail smoothly through the next recession, perhaps with pre-emptive support from the Canadian government. If banks can maintain their market premiums and continue to grow as they have in the past, they could earn higher returns. Banks could benefit from moderately higher interest rates in 10 years.
The worst-case scenario is Citigroup, which still hasn’t recovered from the Great Recession:
At TD and Royal Bank, we believe that risk and reward do not favor the common shareholder. We have a sell rating on both stocks. Canadian banks are often viewed as blue chip companies, but the global financial crisis is a sobering reminder of the downside. There is far too much debt and financial stupidity in Canada right now. There may be better buying opportunities after the credit losses have materialized. If investors want to maintain their positions in financials, we recommend US banks, which appear to be both cheaper and better capitalized.
You can find more about this in my articles:
- JPMorgan Chase – Buy the fear
- Bank of America – A bear market buy