A Sweet Spot for Canadian Banks

Last week the six major Canadian banks all reported better than expected quarterly earnings. The numbers were as follows;

Earnings Per Share l
Underlying Banks Estimate Actual Price P/E Dividend Yield
Bank of Montreal $ 1.68 $ 1.53 $ 66.11 10.61 $ 2.96 4.48%
ScotiaBank $ 1.31 $ 1.39 $ 58.50 11.54 $ 2.68 4.58%
CIBC $ 2.13 $ 2.29 $ 82.26 10.22 $ 3.84 4.67%
National Bank $ 1.98 $ 2.08 $ 81.59 9.38 $ 3.48 4.27%
Royal Bank $ 1.38 $ 1.48 $ 64.90 12.02 $ 2.68 4.13%
Toronto Dominion $ 1.53 $ 1.65 $ 89.62 12.59 $ 3.40 3.79%

Four of the banks – Bank of Nova Scotia, National, Royal and TD – increased their quarterly dividend, which has been accounted for in the previous table. CIBC and National Bank were also continuing with their share buyback programs.

Significant management commentary followed each of the earnings releases, but broadly speaking, executives were re-hashing the benefits of diversification, and in all cases they pointed to wealth management as the main driver of profits.

That’s useful information because wealth management is generally the most stable division, with profits and revenues easily quantifiable. So despite the fact that I was not expecting blow out numbers for the last quarter, they in fact came in much better than expected, all without any material benefit from net interest margins.

I talked about net interest margins in previous blogs, but to re-visit the concept, it is simply the spread between a bank’s cost of funds and what they can get when they lend that money out. The so-called net interest margin tends to contract in a low interest rate environment.

I am expecting a marked increase in the net interest margin through the current quarter as mortgage rates jumped without any meaningful change in the bank’s cost of borrowing. The spread expanded at the end of June when Fed Chairman Bernanke hinted at tapering, which, because of the timing, had no impact on last quarter’s earnings.

The other advantage is the willingness among management to consistently increase the dividend. The latest bump in quarterly dividends caused yields to rise above 4% per annum on all banks with the exception of Toronto Dominion.

I would also point out that none of the Canadian banks are particularly expensive in terms of their price to earnings ratios. There is good potential beyond the margin expansion as most analysts believe that Canadian banks have essentially gotten past the financial crisis and are returning to business as usual.

The risk if you are banking – pardon the pun – on the positive impact from a widening interest rate spread is the impact higher rates may have on the propensity to borrow. That’s a concern, although I don’t anticipate it to materially dampen results through the remainder of this year and perhaps well into 2014.

In fact, the recent bump up in mortgage rates may very well encourage home buyers to get off the fence and close on their financing. Homeowners with variable rate mortgages may start locking in a rate, even if it is a little more expensive. Both scenarios will benefit Canadian banks through the rest of this year.

The other leg underpinning this thesis is the current outlook for interest rates. I doubt that rates will rise significantly over the next two years as, most likely, central banks will maintain the near zero interest rate policy that currently exists. If that continues, the bank’s cost of borrowing will remain fixed, while operating within a normalized spread environment.

Now look at the options on Canadian banks and implied volatilities remain low, taking into account the above-average dividend yields on these stocks and the cost of buying calls is relatively cheap. Buying calls with at least six months to expiry could prove beneficial to our more aggressive readers.

Bottom line: the combination of low cost options, low interest rates and a widening interest rate spread makes for a very sweet spot for Canadian Banks. Goldilocks would have been proud!