This article was first published in the National Post on March 18, 2023. It is being republished with permission.
by Tom Bradley
If I told you about a company that is highly profitable, has a strong balance sheet, has grown steadily by expanding into new business areas, pays a healthy dividend and dominates its market with a few other firms, what would you think its price-to-earnings multiple (P/E) should be? I suspect you’d say it should trade at a premium to the overall market, perhaps a P/E in the high teens or low 20s.
Well, not even close. The description above is that of our Big Five banks, all of which trade in the range of 10 to 12 times earnings. How is it that these world-leading institutions, which investors are so fond of, barely crack double digits while other companies with less impressive track records garner higher multiples?
Last week’s banking scare in the United States goes a long way to explaining why. Two banks were bailed out after depositors rushed to pull their money out. The demise of Silicon Valley Bank (SVB) and Signature Bank illustrates how quickly the tide can turn.
Let’s go back to basics. There are two key factors to consider in valuing a lending institution. First, the banks are highly levered. The amount of money they lend out is many multiples of their common equity. If a chunk of its loan book goes bad, a bank’s equity can be wiped out in a heartbeat. Banks’ valuations reflect this leverage even though such a circumstance is highly unlikely.
Unlikely, but it has happened during my investment career. Hugh Brown, Canada’s all-time great bank analyst, described it best 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. Canada was also in the worst recession in 40 years. But it was another testimony to the banks’ core franchise — give them time and they can earn their way out of trouble. It took seven years to absorb the Third World writedowns.”
Since that loan debacle, Canadian banks have skated through credit cycles well. They’re well-diversified and less exposed to big blow-ups. They have better balance sheets and make healthy profits at everything they do (I remind my wife that while she can grumble about obscene bank profits, it beats the alternative).
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On the other hand, they wouldn’t be given seven years to dig themselves out from another 1982-like situation. They’d be rescued in weeks and, like SVB, shareholders and unsecured creditors would take the hit.
The second issue to keep in mind is that banks have a natural liquidity mismatch. The people and companies funding the loans, namely the depositors, can show up at a branch, or on their app, and ask to take their money out any time they want. The loans and investments funded by the deposits aren’t nearly as liquid. In other words, the banks’ liabilities are liquid while their assets are illiquid.
Because of these two dynamics, banks must engender depositors’ and investors’ trust and confidence in their lending practices and financial management. As we saw last week, a crisis of confidence can have a dramatic effect and spread quickly through guilt by association.
Getting back to valuations, I suspect the banks will continue to trade at conservative multiples. As recent events attest, the environment isn’t conducive to a breakout from their historical range. The U.S. Federal Reserve’s dramatic action to protect depositors speaks to the fragility of the banking system, or at least the fragility of customer confidence.
And, just as important, it would appear the Canadian banks’ supercycle is coming to an end. They’ve had everything go their way for decades now. They’ve been allowed to expand and, in most cases, dominate in new business areas such as brokerage, asset management and insurance.
Their primary customers, Canadian families, have significantly expanded their debt levels via mortgages, home equity lines of credit (HELOCs), lines of credit, car loans and leases, and credit cards. Rising real estate prices have improved their collateral and higher stock prices have increased their wealth-management assets. And with the benefit of time, the industry’s comfortable oligopoly has been entrenched.
If the banks couldn’t break out of their modest valuation range with a howling wind at their back, investors shouldn’t expect it to happen any time soon. Then again, stability and a good dividend sound pretty good about now.