Buying the Canadian Banks

by Craig on 19/11/09 at 9:21 am

The Canadian banks are set to report their Q4 earnings starting with the Bank of Montreal on Tuesday November 24th, with most other banks reporting the first week of December.  On October 24th, Buying the Banks Ahead of Earnings, we cited a number of factors we believed would help the banks beat earnings estimates and investors should consider adding exposure ahead of the earnings reports. Since the report, the TSX Bank Index is up about 5% but we believe there is more to go in the coming weeks.

Why We Believe the Banks Will Beat EPS Estimates

1) Steep Yield Curve – The yield curve in Canada has remained very steep during the past quarter.  As measured by the 10-year Government of Canada bond yield of 3.41% and the 3-month T-bill yield 0.29%, the yield curve still has a slope of over 300 basis points (3% steep). Since 1993, during quarters with a yield curve slope of over 300 basis points, bank earnings have on average expanded by over 10% and only once was earnings growth negative. Just as important, there is a linear relationship with the yield curve slope and bank earnings.  The steeper the better.

2) Brokerage Revenue (Canadian Bank Earnings May Be Even Rosier)- The banks brokerage divisions finish their quarter a full month before the parent and this provides some insight as to the impact of brokerage earnings on the banks overall earnings. While only one division, brokerages are a major component of the banks business and the earnings tend to be volatile. This year, the country’s six biggest brokerage houses enjoyed a great environment for equity underwriting. After the credit crisis froze capital markets last fall, many companies needed to raise money once things began to improve. Almost $50 billion worth of stock sales occurred during the past year with Royal Bank’s RBC Dominion topping the list, followed by Scotia Capital, TD Securities, BMO Nesbitt Burns and CIBC World Markets. Barrick Gold’s (TSX:ABX) $4.4 billion record stock sale to cancel many of their existing gold hedges helped.

3) It’s the Economy – We may not be out of the woods completely, but we can definitely see sunlight. The economy has continued to improve over the past quarter, which should limit the banks needs to increase reserves for bad loans. While unemployment is still high, rising stock markets and rising home prices in Canada should help keep consumers confident. Confident enough to not baulk on their credit card or mortgage payments.

4) Low Expectations – On October 24th, the consensus earnings estimates were expecting less than 1% earnings growth relative to the previous quarter for the banks as a group. This has crept a little higher to a growth of 2.2% following a number of earnings revisions. But still, 2.2% is virtually no growth and given the other factors we have highlighted, we believe the banks are set to exceed these estimates. 

The accompanying table includes the big Canadian banks earnings estimates, announcement date, the highest EPS estimate and also the earnings revisions during the past 4 weeks. Also worth noting is the dividend yields for the banks remain attractive, especially considering the level of interest rates. And these are much safer now than six months ago.

Trading Idea – Buying the Canadian Banks

Bank of Montreal (TSX:BMO $53.35), Toronto Dominion Bank (TSX:TD $68.40), Bank of Nova Scotia (TSX:BNS $49.16) and Canadian Imperial Bank of Commerce (TSX:CM $67.80) appear to have greater exposure to Net Interest Income. Although this does fluctuate from quarter to quarter. However, Royal Bank’s (TSX:RY $57.88) brokerage division lead all others in underwriting during the past year.  Take your pick.

Also worth considering is dividend yields. CIBC and Bank of Montreal have the highest yields at 5.1% and 5.3% respectively.  However these two also have some issues, CIBC with loan losses and Bank of Montreal with significant exposure in the U.S. If you are a yield hunter, we would prefer Bank of Nova Scotia’ 4.0% yield for safety.