What We Learned from Canadian Banks Q1 2019 Earnings

Canadian banks are important…not just to Goodreid’s clients (although they are very important to us, comprising nearly 20% of our Canadian portfolio), but to the overall direction of the S&P TSX Composite Index which is 23% comprised of banks and more broadly to the overall Canadian economy as conduits for investment and lending and as some of the largest employers in the country. As such, we study their financial results closely, reviewing their press releases, reading their financial statements, as well as joining their conference calls to hear directly from management teams. Broadly speaking, this latest set of quarterly results was underwhelming, with profits at best flat, and in most cases down in the current quarter vs. the prior quarter, and with profits up just 1% as compared with the same quarter last year for the median bank. Investors were somewhat surprised by this moderation in growth, as four of the six big banks earned notably lower profits than analysts had been expecting, and two of the banks reported their most disappointing results relative to analysts’ forecasts in a decade. Beyond the headline growth rates and the over/under tallies vs. analyst forecasts though, there are some important takeaways:

• mortgage demand is slowing…by official statistics Canada is experiencing the slowest growth in mortgage balances since 1983, as the dual effect of higher interest rates and the B-20 stress test rules hinder borrowers from qualifying for mortgages, such that mortgage balances are growing at roughly 3-4% vs. double that rate a few years ago
• the benign credit cycle has turned…provisions for credit losses are at historically low levels (approx. 0.25 to 0.3% of loans for personal loans), but rose sequentially and year over year across the entire bank group; this dovetails with StatsCan data showing that consumer bankruptcies rose 7% year over year in January and business bankruptcies rose 10%...high debt levels and the inevitably of interest rates moving away from zero are coming home to roost
• business loan growth has been very strong, with most banks enjoying business loan growth of 8-12% year-over-year
• international diversification is working very well for banks who have expanded in the United States, Latin America, South America and elsewhere, with those business units outperforming the domestic businesses 
• the capital markets businesses went into the abyss, with profits disappearing altogether at one bank and declining between 3 and 38% at the other banks
• bank balance sheets are very strong, with a median common equity tier 1 ratio of 11.5%, such that the banks collectively have tens of billions of dollars of surplus capital above the regulatory thresholds
• dividend growth is a powerful and unstoppable force in this group, with four banks announcing dividend increases, including one double digit % dividend increase, despite the tepid sequential and year over year growth in earnings
• organic growth is sluggish, especially in the domestic banking units, and capital strength at the overall bank level is high, so accordingly we expect mergers and acquisitions to be in sharp focus…both integrating recently completed transactions and identifying attractive opportunities to deploy capital in high growth strategic focus areas

We take this all in stride, realizing that the banks have outperformed the S&P TSX Composite Index in a staggering 20 of the last 25 yearsand further realizing that the temptation on the part of investors to “just do something” can be overwhelming sometimes. But there is nothing to be done. The banks always have and always will rotate through periods of relative “glory”, basking in the sunlight of a strong quarter, as BMO did this quarter and “shame”, deflecting criticism of a relatively weak quarter as TD did this quarter. This is the cycle of life in Canadian banking and savvy investors construct portfolios with this in mind, knowing that over a cycle each bank will show its strength, reflecting differences in lines of business and in geographic focus and further understanding that a portfolio firing on all cylinders at any point in time is undoubtedly an under-diversified portfolio. The very long view on the Canadian banks and the simple math behind it is this: bank dividends yield about 4%, and most banks have a medium term goal of growing earnings 7-9% annually, affording investors very good visibility towards a double digit return over a sustained period of time. Remarkably, a very long term owner of bank shares will see the annual dividend exceed their cost base on the stock, as buyers of Royal Bank for under $4 in late 1988 can attest, with the annual dividend of $4.08 now comfortably above that level. So, sit tight and enjoy the multi-decade benefits of compounding in these secular growth and income stalwarts.