I want to build on a March 6 article on bank valuations by David Berman. Canadian bank stocks have done exceptionally well over the last year and a half. Their businesses have been strong, but the biggest factor has been expanding valuations. As David pointed out, RBC is trading at 14.1 times earnings, well above the long-term average of 11.9.

To most investors, both these numbers seem low, especially compared to companies in other industries that don’t appear to be nearly as good. Indeed, if someone described the attributes of a Canadian bank to me in a blind test, I’d likely say the company should trade at either side of 20 times earnings. What’s not to like?

The Canadian banks have unassailable franchises. They provide a necessary service, have sticky customers and can raise prices with impunity. They’ve become high-octane marketing machines and operate in a government-supported oligopoly characterized more by co-opetition than competition. And for income-oriented investors, they provide healthy and growing dividends.

So why do these powerhouses trade at such low multiples?

Risk and leverage

First and foremost, banks are highly levered. The amount of money they lend out is many multiples of their common equity. Small errors, while unlikely, can turn into huge loses.

Unlikely, but it can happen, as Hugh Brown, one of Canada’s best bank analysts, pointed out in a 2011 exit interview. “In 1982, Third World debt collapsed. The Big Five Canadian banks had 2.5 times their equity invested in Third World loans, and those loans plunged to 50 cents on the dollar. On a mark-to-market basis, the banks were insolvent.”

Back then, banks weren’t required to market down distressed loans and were able to work their way out of the hole in the years that followed.

Citigroup, the global financial services giant, wasn’t so lucky. Shareholders were severely diluted during the 2008 financial crisis and two decades later, the stock trades 80-per-cent below its 2007 high.

Banks report their results in great detail but there’s little transparency around the most important risk, loan losses.

Structural mismatch

Customer deposits are a wonderful source of funding, but banks must manage a liquidity mismatch. The money coming in from individuals and companies (bank accounts; GICs) is plentiful and cheap (low or no interest cost) but can be withdrawn at any time. On the other hand, investments made with the deposits (loans and mortgages) aren’t so easily liquidated.

Because of the leverage and mismatch, banks must maintain depositor and investor confidence in their lending practices and financial management. A crisis of confidence like the one Silicon Valley Bank suffered three years ago can have a dramatic effect.

Economic and market sensitivity

Banks’ fortunes are closely linked to the strength of the Canadian economy. If borrowers are losing their jobs and can’t make their payments, and the collateral is not easily sold, as is the case with real estate today, banks will feel it.

The good news is they’re more diversified today than they were decades ago, but wealth management and capital markets have their own sensitivity to the stock market.

The next wave of growth

Canadian banks have done an amazing job of expanding into new business areas, including brokerage, wealth management and insurance, and increasing their share of Canadian wallets. The question is: Where will the growth come from?

On the asset side of customer balance sheets, banks already have a huge share of savings and investments. On the liability side, they’ve been so successful that borrowers are running out of room to add more debt.

The Canadian banks could find themselves in the same box as the multinational consumer product companies that have run into a growth wall. After squeezing every bit of revenue and profit out of their customers, leading companies like Nestlé, Unilever, Procter and Gamble, Pepsi and Coca-Cola have little room to raise prices and are struggling to grow.

Foreign expansion is a potential growth area although the historical record is mixed. There have been plenty of missteps (and write-offs), and the successes are far less profitable than the home market.

A core holding

Canadian banks are great businesses and should be core holdings in your portfolio. Like any investment, paying a reasonable price is important so you want to add when you can’t believe how cheap they are (and yields are high) and hold off when analysts are rationalizing why they should trade at a market multiple. Remember, there are structural reasons why banks trade at low valuations.