Thursday, December 28, 2017

New Manulife CEO Roy Gori Veers from Alternative Assets

  
The Globe and Mail, Tim Kiladze, 28 December 2017

Three months into his tenure as Manulife Financial Corp.'s chief executive officer, Roy Gori is taking on the role of insurgent.

As an outsider who joined the Canadian insurance company in 2015, he is largely free from internal politics or long-standing loyalties. Hardly anything in his path appears untouchable – not even a signature bet of his predecessor.

Late last Friday, the last business day before Christmas, Manulife Financial Corp. unveiled two charges worth $2.9-billion. The first, a $1.9-billion writeoff, was beyond the insurer's control, stemming from new tax laws in the United States. The second charge, worth $1-billion, is the product of a significant shift in investment strategy. Mr. Gori has decided to lessen Manulife's dependence on alternative assets, such as timberland, agricultural crops and oil and gas wells – a decision that reverses one of former CEO Don Guloien's expansion strategies.

In the past five years, Manulife's exposure to "alternative long duration assets" nearly doubled, to $35-billion from $18-billion. The company had also launched a business to emphasize them. Because interest rates remained so low for so long, alternative assets soared in popularity and Manulife hoped to persuade other institutions to invest alongside its own bets.

Alternative assets account for 11 per cent of Manulife's $325-billion investment portfolio and they have caused some headaches. In 2015, the oil and gas collection generated $875-million in writedowns after energy prices plummeted and the total portfolio's value is generally volatile, which can be a problem because Manulife must continually mark it to market prices.

Mr. Gori's plan is reduce the insurer's exposure to these assets over the next 12 to 18 months. Once the transition is complete, Manulife will have freed up $2-billion in capital that currently acts a safety cushion in case of losses. That money will be redeployed into other business lines.

We believe that alternatives are still, and will be, an important asset class for us," Mr. Gori said in an interview. "However, given the nature of the asset class, they can be more risky." His decision, then, is a trade-off: The repositioning will hurt long-term asset returns, but it will reduce volatility and improve capital efficiency – the latter being one of his five major strategies.

Mr. Gori appreciates that actions such as this one can cause internal dissent. But he is adamant that they are necessary. And more change is coming, both at Manulife and in the life insurance business.

"There is this sense of complacency in the industry," he said in an interview.

To get everyone on board, Mr. Gori said, "it is critical we clearly map out what we want to change." When he hits roadblocks, he must remember that outsiders, namely shareholders, are desperate for action. He believes Manulife trades at a discount and he said one message was repeated when meeting with all types of stakeholders over the past six months: "There was a real, strong readiness to embrace change."

Underlying that is the notion that shareholders seem ready to swallow a billion-dollar writedown so long as it is for the long-term good. Manulife's shares have barely fallen since the charges were announced after markets closed on Friday – albeit on lower holiday trading volumes. Over the past 10 years, Manulife's shares have delivered a total return, including dividends, of negative 6 per cent. Rival Sun Life Financial's equivalent return is 47 per cent.

Although Manulife's alternative asset exposure had been questioned for some time, Mr. Gori has other pressing issues. The insurer's U.S. long-term care business is widely seen as its biggest problem. People are living longer, healthier lives and claims for home care often aren't made until 20 to 40 years after a policy was first purchased. It is tough for any insurer to manage its risk and generate adequate returns to cover those costs in an era of low rates.

Manulife's John Hancock subsidiary is also stuffed with variable rate annuities that tend to guarantee policy-holders a fixed-return or payment. Mr. Gori has said the returns from that business aren't good enough. But the new CEO said the timing of his retreat on alternative assets was partly pegged to the U.S. tax changes. Manulife had already been studying what to do with the exposures, but wasn't sure just how far it wanted to go if it cut back. Getting a final answer on the U.S. corporate tax rate, which will boost future earnings, helped determine the "quantum" of the pullback.
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Friday, December 22, 2017

US Tax Overhaul is a Present for Big Canadian Banks

  
The Globe and Mail, James Bradshaw, 22 December 2017

By overhauling corporate taxes, American legislators have delivered a gift to some of Canada's largest banks that's potentially worth hundreds of millions of dollars a year in added profits.

The sweeping tax cuts hastily passed by the U.S. House of Representatives and Senate and signed into law by U.S. President Donald Trump on Friday are expected to boost earnings per share at four of Canada's largest lenders by 1 per cent to 3 per cent, according to a report by analysts at Citigroup Global Markets Inc.

Bank of Montreal stands to benefit the most: With its extensive banking network in the American Midwest, it is estimated to receive a 2.6-per-cent lift to earnings per share. At Toronto-Dominion Bank, with its network of more than 1,200 branches stretching the length of the U.S. East Coast, EPS is projected to rise by 2.3 per cent. Royal Bank of Canada and Canadian Imperial Bank of Commerce, which have both acquired banks focused in private banking and commercial lending to build out their U.S. presence in recent years, can expect increases of 1.6 per cent and 0.9 per cent respectively, according to Citigroup.

Spokespeople for BMO, CIBC, RBC and TD declined to comment for this story.

That's a welcome tailwind, but also a far cry from the boon expected for the largest U.S. banks, which will see EPS climb by anywhere from 8 per cent to 17 per cent. That's largely because they do the lion's share of their business in the United States, but also due to other benefits – such as lower repatriation rates for cash held abroad – that won't provide a measurable boost to Canadian-owned banks.

The most significant change in the new bill drops the marginal corporate tax rate from 35 per cent to 21 per cent. But there are also accounting considerations in the fine print that could limit the short-term benefits of the tax breaks for some banks, including adjustments to the Base Erosion Anti-Abuse Tax (BEAT), which limits certain tax-deductible payments made to foreign affiliates.

In annual filings, BMO disclosed that the changes would require the bank to reduce its net deferred tax asset – an accounting measure tied to the timing between a bank booking a tax loss and realizing its benefit – by roughly $400-million (U.S.). And that "would result in a one-time corresponding tax charge in our net income," the bank said, which would then be offset over time by higher earnings.

Capital levels that regulators track closely could also temporarily inch lower. Using an estimated 20 per cent corporate tax rate – which is slightly lower than the actual 21-per-cent rate – BMO estimated its common equity tier 1 (CET1) ratio could fall by about 15 basis points (100 basis points equal one percentage point). But BMO has a more than ample buffer: As of Oct. 31, its CET1 ratio was a robust 11.4 per cent.

"There could be a hit to tangible book [value], and a much smaller one to regulatory capital, from the write-off of [deferred tax assets]," said the Citigroup analysts.

Of the four major Canadian banks that stand to benefit the most, TD reaps the largest share of its total profit from U.S. operations, at 29 per cent, according to the report.
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Tuesday, December 05, 2017

A Tax Case for Early RRSP Drawdowns

  
The Globe and Mail, Jonathan Chevreau, 5 December 2017

While it's tempting to "bask" in the low tax rates that may prevail between the years of full employment and full-stop retirement, in the long run you may be better off paying a little more tax now in order to avoid a lot more tax later. The latter can happen once you're required to annuitize or convert your RRSP to a RRIF.

Because of Canada's graduated tax system, tax rates escalate the more you earn. This has left many would-be retirees with the impression their retirement income will be lower and they'll be paying taxes at a lower rate. That in turn has led to the strategy of deferring receipt of registered retirement savings plan (RRSP) or registered retirement income fund (RRIF) income as long as possible.

However, more than a quarter of retirees are in a tax bracket that's either the same or even higher than in their working years, says a BMO Wealth Institute report published in 2013.

The solution may be to accelerate the drawdown of RRSPs in the decade prior to the RRIF years, or even to set up a RRIF years before it's required (by the end of the calendar year when you turn 71), especially if you have fallen into a lower tax bracket during the transition between full employment and traditional retirement.

Counterintuitive though it may appear, there is a strategy for people who are temporarily in lower tax brackets, says Robert Armstrong, Bank of Montreal's vice-president of managed solutions. He calls the strategy "Topping up to Bracket," which involves ensuring you receive a yearly income in the range of $12,000 (zero tax) and $42,000 (the lowest tax bracket).

Matthew Ardrey, a wealth adviser and vice-president of Toronto-based Tridelta Financial, says "there is certainly a benefit to ensuring your income remains below $42,000 if you can."

If you're temporarily in a lower bracket – perhaps you're between full-time jobs – you should move heaven and earth to maximize the precious non-taxed dollars you take into your hands every year, and after that, at least the very low-taxed dollars.

For everybody, including high earners, the first $11,635 of income is tax-free: This is the federal "basic personal amount" (BPA) in 2017. So the first $11,635 is a no-brainer, but next best are the lower-taxed dollars, which is where Mr. Armstrong cites the key number of $42,000. Between the BPA and $42,000 the federal tax rate is 15 per cent. Add in provincial tax and the result in Ontario is that in 2017, the first $42,201 of income has a top marginal tax rate of 20.05 per cent. After $45,916 of income, the combined federal/provincial tax rate becomes 29.65 per cent, and gets higher still for larger incomes.

For couples, if one spouse is fully employed and paying a top marginal tax rate (in Ontario) of 53.53 per cent (taxable income of $220,001 or more) while the other spouse has minimal income, I'd argue this: Every non-taxed or low-taxed dollar that the latter brings into the family unit is more valuable than each (roughly) 50-cent dollar the higher-income spouse generates in any extra income.

For pensioners 65 or older, the tax-free zone can exceed $20,000: That's the BPA, plus federal $7,225 age amount (in 2017) plus (if applicable) the $2,000 pension credit. (The age credit can be clawed back at high enough levels of income.)

Topping up to bracket in low-earning years is a use-it-or-lose-it proposition. If you let a year go by and bring in none of that tax-free income at all, you don't get to carry forward the opportunity to another year.

What if you have no earned income? Then it may make sense to withdraw some RRSP funds, as you probably were in a higher tax bracket when you made the original contributions. Raiding your TFSA makes little sense here because they're tax-free dollars anyway, so there's no urgency to de-register TFSA money while you're in a low tax bracket; besides, you want to maximize precious TFSA room after the age of 71, when those forced RRIF withdrawals put you in a higher tax bracket again.

Once you're 65, there's a case for limiting annual intake to $74,788, beyond which Old Age Security benefits are subject to clawback. OAS is completely clawed back at $121,071.

This is why Mr. Ardrey proposes "melting down" RRSPs before OAS or CPP kick in. Assuming they are in a lower tax bracket, "when many people think of an RRSP drawdown they only think of doing it up until the basic personal amount." But for someone with a large RRSP, this could be a detrimental decision.

Warren MacKenzie, head of Financial Planning at Toronto-based Optimize Wealth Management, says if you expect future income, and thus tax, to be higher, as well as clawed-back OAS "then it makes sense to withdraw some money from a registered account if it can be taken into income at a lower tax rate." However, if income is projected to be lower in old age, it may not make sense to pay tax sooner than necessary, he adds.

For most couples, the biggest tax hit comes after the second partner dies, RRIFs are collapsed and capital gains realized. Since the RRIF of the partner who dies first passes tax-free to the survivor, he or she is often pushed into a higher tax bracket

Mr. MacKenzie says spousal loans may help one partner stay in lower tax brackets longer: "Overall, the lowest amount of income tax will be paid when each spouse has the same level of income."
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Wednesday, November 01, 2017

Darryl White — New BMO CEO

  
The Globe and Mail, James Bradshaw, 1 November 2017

Darryl White is not sure what is ailing his beloved but slumping Montreal Canadiens. "It's confidence, right? It's got to be confidence," he ventures.

Mr. White officially starts as Bank of Montreal's new chief executive officer on Wednesday, and also happens to serve as a director of the storied hockey club. At 46, with close-cropped brown hair, he is youthful, trim and small in stature. But he radiates confidence.

Striding past the polished marble columns and century-old teller windows in BMO's historic Montreal main branch to sit for an interview days before taking over as CEO, Mr. White seems to embody a new generation of bankers tasked with leading Canada's oldest bank into its third century in business – and determined to push ahead at a faster pace.

His ambition at the outset is not to change the bank's fundamental course. Board chairman Robert Prichard said Mr. White's priority will be keeping "continuity of strategy and continuing acceleration of performance." That means driving faster growth – particularly in BMO's U.S. operations – by boosting spending on technology and "actually thinking like a customer," Mr. White said.

"I think we've been doing a pretty good job of it," he said. "I think we can do a better job as we go forward."

Yet, squeezing more performance out of an established bank that ranks as Canada's fourth-largest will be no simple task. BMO's share price has hovered around the $100 mark of late, but has gained only 2.3 per cent year-to-date – which trails all of its Canadian peers. The bank's return on equity, watched closely by shareholders, stood at a healthy but unspectacular 13.4 per cent at the end of its most recent fiscal quarter.

And red flags are on the horizon.

Uncertainty about the fraught renegotiation of the North American free-trade agreement (NAFTA) could spell particular trouble for BMO, which calls itself Canada's largest trade bank. At the same time, there are continuing concerns about Canadians' high consumer-debt load and soaring urban-housing prices, as interest rates begin to rise from historical lows. And new technologies are threatening to upend banking conventions, forcing financial institutions everywhere to adapt quickly.

Unlike departing CEO Bill Downe, who stepped into the job in early 2007 and quickly faced a global financial meltdown, Mr. White inherits BMO on a stronger footing, with a more optimistic economic outlook. On Mr. Downe's watch, total assets roughly doubled to $709-billion, while its U.S. footprint through the BMO Harris Bank subsidiary, which will be crucial to its growth prospects, expanded to serve more than two million personal and commercial customers with 600 branches across the U.S. Midwest.

BMO has similarly lofty expectations for Mr. White, a father of three who has worked at the bank for half his life. For the lion's share of that tenure, he was an investment banker in its capital-markets arms, known for giving sharp strategic advice to blue-chip companies and for his deep devotion to his roster of clients.

But last year, as his name rose to the top of the bank's succession chart, Mr. White took on much broader duties as chief operating officer. That gave him global responsibilities spanning retail and commercial banking, wealth management, marketing and even technology. As he delved deeper into corridors of BMO that were less familiar to him, he discovered a willingness to adapt embedded in the bank's culture that fuels his confidence in its prospects.

"I don't want the culture to change," he said. "And if there's a change, it's perhaps at a pace that's taking advantage of the foundation that we've built – so a pivot from foundational investments to acceleration."

Made in Montreal

As he prepared to lead BMO into the future, Mr. White took a step back into the bank's past on Sunday, revisiting the city that raised him.

More than 100 current and former executives, board members and their families assembled in Montreal. It was a rare gathering of multiple generations of the bank's most senior leaders: Mr. White and Mr. Downe, as well as previous CEOs Tony Comper and Matthew Barrett; Mr. Prichard, the current chairman; and past chairman David Galloway; plus an array of financial-sector heavy hitters, including Bank of Canada governor Stephen Poloz.

They came together for a ceremony unveiling a stone tablet in the foyer of the bank's historic and opulent Montreal main branch, first built in 1847 and expanded in the early 1900s. The setting and timing were carefully chosen for their symbolism, as a culmination of a year-long celebration of the bank's 200th anniversary, which arrives on Friday.

Under the branch's ceilings adorned with gold leaf, the tablet now bears brass lettering spelling out 66 names – Mr. White's among them – of the bank's foremost leaders through its most recent century, steps from a similar memorial erected in 1917. "Our chief financial officer is quite happy to know we don't build [branches] this way any more," Mr. Downe joked in a speech at the ceremony, before guests decamped upstairs to toast the retiring CEO's career over a dinner of mustard-crusted rack of lamb and caramelized black cod.

Mr. White's own roots in Montreal are more modest. He grew up in a middle class, West Island home five minutes from the city's largest airport, before studying business at the University of Western Ontario and Harvard Business School.

Beginning at the bank with a gruelling apprenticeship with Nesbitt Thomson (now BMO Nesbitt Burns Inc.), he charged through BMO's ranks. And eventually, in 2006, he returned to Montreal for a five-year homecoming that proved an important testing ground, where he caught the attention of senior executives.

Jacques Ménard, the current president of BMO in Quebec, was one of Mr. White's mentors during his time in Montreal. "He made me look good every day," Mr. Ménard said, but he eventually advised BMO's leadership "to get him out of here" and see what he was capable of.

Mr. White moved to Toronto in 2011, but has kept close ties in Montreal. He keeps a summer home in Quebec, and pledged to maintain a regular presence in Montreal, which "will continue to be the heartbeat of the company."

Day one and beyond

Mr. White's first day as CEO, Nov. 1, will begin with client meetings and end with parent-teacher interviews at his children's school.

In the intervening hours, he will fit in visits to two Toronto branches, to the bank's computing centre in Scarborough to see its chief technology officer and to an off-site gathering on inclusion and diversity at the BMO Institute for Learning – which he calls "BMO University."

The day marks a milestone for the bank, but Mr. White's agenda is fairly typical of his own education over the past year. As COO, he has spent much of his time getting an immersion course in BMO's diverse business lines, making countless branch visits, joining the phone lines at call centres and meeting an array of customers.

"For me, that's been an extraordinarily valuable experience to cut across all of our businesses," he said, and it has also made him more attuned to what's happening outside the bank.

One of Mr. White's early plans to hedge against uncertainty is to boost BMO's spending on technology. He declined to attach dollar figures to the existing budget or the increase he has in mind, but pledged that the bank will stay disciplined about digital investments. "A strategy whereby one splashes capital at technology because it's a trendy thing to talk about falls short," he said.
In the United States, Mr. White expects to quicken the rise of BMO Harris as a share of the bank's overall earnings. Like many of its Canadian peers, BMO has looked to the hard-fought U.S. banking market for an opportunity to grow faster than the mature Canadian market will allow.

Over the past six years, the bank's U.S. arm has grown at a compound annual rate of 24 per cent and now contributes about a quarter of the bank's income, with 70 per cent of that coming from personal and commercial banking, nearly 25 per cent from capital markets and the remainder from wealth management.

"That's the earnings growth story in the U.S., and that'll continue to be the case," he said.

He is bullish on the prospects for U.S. tax reform, and sees room to grab market share. Within five years, he predicts the U.S. arm's overall contribution to earnings may be "approaching a third" on the strength of its existing assets. "In order for it to be much greater than that, you'd have to look at growing by acquisition," he said.

But Mr. White concedes that the prospect of a breakdown in NAFTA talks as Canada, the United States and Mexico struggle to make headway in negotiations could put the brakes on trade flows that are vital to BMO's cross-border business.

"NAFTA's important. If NAFTA goes away, would we see a slowdown in economic trade? Yes. How much? I don't know," he says, noting that 32 U.S. states count Canada as their biggest export market. "Is it an impact that we're going to worry about unduly from the perspective of our delivery to our customers and our shareholders? No. We're going to continue to serve those customers in the markets that we have under the regimes that will exist."

The bank has also been adapting to a new reality for credit in Canada, as federal measures have been rolled out to tax foreign home buyers and require tougher stress testing on mortgages, just as interest rates have begun to climb. Mr. White reiterated that "we've been supportive of those" new regulations.

But he also believes "credit, writ large, is well managed," and that the banking system, both in Canada and globally, is more sturdy than it was a decade ago.

"There's always going to be risk in a system," he said. "We've taken that risk throughout history, we have it today. But I think it's in a reasonable place on the curve."
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Monday, October 16, 2017

Scotiabank is Most Attractive on P/E Valuation, Adjusting for Excess Capital

  
Canaccord Genuity, 16 October 2017

In this report, we focus on Canadian banks P/E valuation analysis relative to the S&P/TSX Composite, bank stock 1-year return analysis under different P/E (NTM) multiple ranges, and looking at implied P/E taking into consideration each bank’s excess capital. Our main findings below are as follows: (1) group bank P/E (NTM) of 11.7x (vs. historical avg. of 10.9x) represents a 32% discount to the TSX Composite (vs. 30% historical avg.); (2) banks trade at P/E (NTM) between 11-13x over 50% of the time (since 2002) with price return over NTM lowest at 6% on average; (3) banks perform well historically when the group is trading above 13x; and (4) BNS’ relative P/E valuation is most attractive (vs. historical) taking into account their excess capital position (see Fig. 6). At Q3/F17, Scotiabank reported the highest CET 1 ratio at 11.3%.

Investment highlights

• Canadian banks trading slightly above historical average. YTD, banks stocks have outperformed the broad index with NA total returns leading at >15% (Fig. 7). The Canadian bank group (Big-6) average now trades a slight premium to its historical average (see Fig. 1). Currently, the group trades at a P/E (NTM) of 11.7x vs. its historical average of 10.9x (since 2002). During this time frame, group bank P/E’s have ranged from a low of 6.6x (during financial crisis) and high of 13.5x (prior to crisis). We believe the market is likely factoring in excess capital build, continued strong quarterly results (FQ4 upcoming), and potential future 2018 EPS upward revisions concurrent with year end results (i.e. stronger NIM and credit trends). Currently, market consensus calls for Big-6 bank EPS growth of 5% (similar to CG) in 2018E, below the S&P/TSX Composite EPS growth expectations of <10%.

• Relative group P/E valuation still trading at discount vs. broad index. In Fig. 1, we compare group bank P/E (NTM) multiples relative to the TSX Composite Index (NTM). On this basis, we find that bank stocks still look quite attractive. Currently, the forward group bank P/E of 11.7x compares to the TSX Composite of 17.3x. This represents a 32% discount, slightly favourable compared to the historical average of 30%. Based on historical trends, we note that investors should be underweight Bank stocks during crisis. Referring to Fig. 1, the three main periods during which Canadian banks traded at larger-than-average discounts related to the Tech bubble (2001-2002), financial crisis (2008-2009), and Oil price collapse (2015, 2016; WTI oil reached $26 in Feb/16).

• Canadian banks trade at P/E (NTM) between 11-13x more than half the time. Dating back to 2002, we looked at S&P/TSX Bank Index P/E (NTM) multiples that traded within four buckets or ranges. We found that the Index valuations traded within a P/E (NTM) range of 11-13x (see Fig. 3) for 54% of the time. Currently, the banks sit at the lower end of this range (11.7x). The group P/E between 9-11x, and 13-16x occurred 22%, and 21%, respectively. At the low-end (P/E of 6-9x) happened just 3% of the time, which was during the financial crisis.

• Looking at Bank performance during certain P/E trading ranges. After that, we took weekly P/E valuation data points and ran stock price returns over the next twelve months using the TSX Bank Index. Not surprisingly, we found that largest stock gains followed the financial crisis with average 1-year returns of 64%. The second highest return periods have come from when banks trade between 9-11x, compiling an average return of 13%. Using historical data, this suggests that it is best to overweight banks when the group trades below P/E (NTM) of 11x. From the group’s trading sweet spot of 11-13x; 54% of time), stock returns over the next year were lowest, averaging 6%. Interestingly, when Canadian banks trade above 13x, returns continued to be solid, averaging 11%. The historical analysis demonstrates that Canadian banks are momentum stocks and that higher valuations don’t necessarily indicate an underweight signal. By way of context, the TSX Bank Index has generated a ~8% CAGR (price return) since 2002 proving that the latter are solid long-term investments.

• Canadian banks improving capital position. Since the financial crisis, Canadian banks have continued to build excess capital. The group has increased their CET1 ratio (avg.) from 7.1% (2008) to 10.9% (F2017E). As of Q3/F17, Scotiabank enjoyed the strongest relative capital position with a CET 1 ratio of 11.3%, followed closely by NA, and BMO (11.2% each). At the low-end is now CM that accounted for the closing of PrivateBank last quarter. CM’s CET1 ratio dropped sequentially from 12.2% to 10.4%. Generally, we believe excess capital will be used for: (1) increased usage of NCIB (although still modest to overall shares outstanding); (2) dividends (we forecast group dividend growth of 5% in 2018E); (3) acquisitions (expect bolt-on acquisitions as global valuations remain high); and (4) organic growth.

• P/E implied valuation accounting for excess capital. Lastly, we take each Canadian bank's current P/E (2018E) and adjust it for the PV of excess capital. For the latter, we have assumed a CET1 floor of 10.5%, which is consistent with most bank’s comfort level. We note the regulatory minimum ratio is 8.0%. For the purpose of this analysis, we assume incremental capital will be depleted by 2020 (i.e. in 3 years) and we discount the excess capital by 10% (estimated cost of equity) to derive the PV of excess capital. The analysis is shown in Fig. 6. Our implied P/E (F2018E) for Canadian banks (adj. for excess capital) moves down on average 0.7x. This would place the group P/E at ~11x, in line (instead of slight premium) with its historical average. Under this exercise, we estimate Scotiabank's implied P/E valuation (adjusting for excess capital) trades at 10.5x (excess capital of 1.0x), a significant discount to its historical average of 11.5x (Fig. 6). We found that CM also trades at a discount, but more modest at -0.3x, while TD, BMO, NA, and RY adj. implied P/E multiples generally trade in line with their historical averages.
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Bank Stocks Are No Longer Cheap, but They’re Still Worth Owning

  
The Globe and Mail, David Berman, 16 October 2017

The great Canadian bank stock sale is over. But don't worry: There are more gains ahead.

After a five-week rally, bank stocks have jumped more than 8 per cent on average. They have now emerged as clear leaders within the S&P/TSX composite index, after briefly lagging the index earlier this year.

But valuations that were cheap by historical measures near the start of September, before the current rally kicked in, are now in line with the long-term average. While that doesn't mean that bank stocks are overpriced, it does suggest that they're no longer a steal.

If you recall, Canadian banks were going nowhere for the four-month period between May and August (inclusive), marking a curious departure from what looked to be an upbeat operating backdrop at the time.

I wrote about this apparent mismatch on Sept. 5. The Canadian economy was humming, the price of crude oil was moving up and banks had reported strong third-quarter profits that were, on average, 11 per cent higher than last year. Best of all, the Bank of Canada was raising its key interest rate, which generally increases bank profits on their loans.

Add an average dividend yield of 4.1 per cent, and – barring a housing market catastrophe – Canadian bank stocks looked hard to pass up.

Yet, share prices were going nowhere. At their low point, on Sept. 7, stocks were trading at levels seen in early December.

Investors appear to have recognized the big opportunity here and, five weeks later, bank stocks are no longer looking unloved.

The S&P/TSX composite commercial banks index, which consists of the Big Six banks, Laurentian Bank of Canada and Canadian Western Bank, has rallied 8.3 per cent from its September lows. The sector has outpaced the 5.6-per-cent gain in the broader Canadian market – itself an impressive feat – and demonstrated that when things are good for Canada, they're very good for the banks.

Royal Bank of Canada, Toronto-Dominion Bank and National Bank of Canada, in particular, have hit record highs within the past week.

Bank stock valuations are now in line with 10-year historical averages. According to data from RBC Dominion Securities, the Big Six bank stocks trade at 11.6-times estimated 2018 profit, which is above the historical average of 10.9-times estimated profit.

Bank stocks also trade at their average historical price-to-book value of 1.8. And that 4.1-per-cent dividend yield before the rally has retreated to 3.8 per cent, attributable to rising share prices.

A nice buying opportunity has passed, but there is no need to fret: If you're inclined to make bets on individual stocks, rather than own the entire sector (I own units in the BMO Equal Weight Banks exchange-traded fund, which gives me exposure to the Big Six), good deals can still be found.

Among the biggest banks, Canadian Imperial Bank of Commerce stands out with price-to-book and price-to-earnings multiples that are below the peer average. The stock also comes with a sector-leading 4.6-per-cent dividend yield.

CIBC has another thing going for it: The stock lagged the returns of its big bank peers in 2016. As I've pointed out in previous articles, lagging bank stocks have a tendency to close the gap with their peers, meaning that last year's underperformer tends to be this year's outperformer.

So far in 2017, CIBC has bucked this trend with a year-to-date gain of just 2.5 per cent – compared with a group average gain of 6.8 per cent. Perhaps this stock-picking strategy won't work this year. Or perhaps CIBC remains an outstanding buying opportunity.

But there's another reason to stick with bank stocks following the group's impressive rally. While valuations have risen from bargain levels, they're not excessive today. That means there is room for stocks to rise further with profit growth, dividend hikes and interest-rate increases – all of which seem likely.

There are good times to buy Canadian bank stocks; there are not bad times to own them.
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