The Globe and Mail, Report on Business
Published December 8, 2007

What price-earnings multiple would you put on a company that is growing at 10 per cent, is highly profitable and pays a healthy dividend? A company that has steadily increased its return on equity (from an average of 11 per cent in the 1980s to 18 per cent in the current decade), strengthened its balance sheet and successfully expanded into new business areas. With this profile, you might reasonably expect the stock to trade at a premium to the overall market, perhaps at a multiple of 18 to 20 times earnings.

Well, you would be wrong. This mystery company fits the description of Canada's Big Five banks, and their stocks trade at multiples of 10 to 12 times earnings, well below the average stock on the S&P/TSX Composite Index.

So why are the banks barely into double digits, while companies with less robust business models trade at higher multiples?

More than once in my investment career I've stopped to ask that question. As I usually do when something doesn't make sense to me, I take an industry veteran out to lunch. Over the course of a clubhouse sandwich and fries, I get my answer.

I'm told that because the banks are highly levered - $24 of assets for every dollar of equity - when something goes wrong, the losses get really big really fast. To illustrate the point, I'm subjected to the gory details of 1987, a year when the industry as a whole lost money and banks were virtually insolvent due to problems with their loans to less developed countries (LDC).

My friend also points out that the banks are vulnerable to changes in liquidity. As was the case with Northern Rock in Britain, when there's more money going out the front door than coming in the back, things get dicey.

By the time I reluctantly pay the bill, the history lesson is over. The banks are cheap because every once in a while something comes along to sideswipe them - LDC loans, Dome Petroleum, Canary Wharf. Because they are levered and dependent on others for liquidity, there is a chance - albeit a remote chance - that something bad happens.

Applying this historical perspective to the current environment, it's not clear whether or not the banks are deserving of a higher multiple.

On the positive side, the Canadian banks have skated through the credit crisis very well so far. That was clearly illustrated the week before last when Citigroup Inc., the largest bank in the United States, was raising $7-billion (U.S.) in emergency capital while Royal Bank of Canada, our largest, was reporting record earnings. Royal Bank had a return on equity of 24.6 per cent and increased its dividend by 26 per cent during the year, despite some writeoffs in its capital markets division and a tougher environment for its retail bank in the United States.

The reality is that the Canadian banks are well-diversified and less exposed to big blowups than they were in previous years. They have better balance sheets and make a ton of money at everything they do. Canadian banking is an oligopoly that really works.

And it is an oligopoly that has governments and central bankers watching over it. As we've seen in the United States, if there is any sign of trouble, the Federal Reserve Board is quick to step in and lend a hand.

Finance Minister Jim Flaherty has been seen politicking about high bank charges, but in his heart of hearts, what he really wants are strong, profitable banks to facilitate economic growth. The alternative is not an option.

But there are offsets to the positives, in addition to the historical factors, that will serve to hold the price-earnings multiples down.

For one thing, we're not out of this crisis yet. Bankers are putting on a brave face, but they're still white knuckling it.

Second, the Canadian banks are already trading at a 10- to 20-per-cent premium to U.S. and European banks.

And third, markets put higher valuations on growth stories, and the banks may go through a period of little or no growth. The turbo-charged Canadian economy will slow down at some point, which means less business to go around and higher loan losses.

In addition, growth will slow if the credit squeeze results in a de-levering of the financial markets, which appears likely. The last few years were the exact opposite. They represented a super cycle for the banks - lots of leverage, rising real estate and equity prices, more leverage, fees from CDOs, LBOs and other exotic acronyms, still more leverage.

Adding it all up, I suspect the banks will continue to trade at conservative valuations. It's not the kind of environment that suggests a break from the historical trend. Even if the Big Five make it through the current crisis with minimal damage, investors have had a peek at what could happen, and it's not pretty. Citigroup, Northern Rock and numerous hedge fund blowups haven't helped the cause.

In the meantime, we can continue to buy these venerable Canadian institutions at 10 to 12 times earnings, collect our dividends and pray for good management.