Impressions from recent interviews with banks and life companies (lifeco)

Transcription

1 1 May 19, 2016 INVESTMENT STRATEGY NOTES Nick Majendie, CA Director, Wealth Management ScotiaWealth Senior Portfolio Manager, with responsibility for advising the Anchor Impressions from recent interviews with banks and life companies (lifeco) Stock market outlook For commodity producing economies such as Canada, the latest Composite Leading Indicators (CLI) published by the Organisation for Economic Co-operation and Development (OECD) on May 11 th are encouraging. The headline of that news release was: Stable growth momentum in the OECD area and improved outlook in major emerging economies. 1 The OECD also stated that: Stable growth momentum is anticipated in Canada and the euro area as a whole, including Germany and France. Signs of growth stabilization are also emerging in Japan. However, the OECD did mention that growth was easing in the United States and the United Kingdom, with the outlook for easing growth now confirmed in Italy. Importantly, from the commodity point of view, the news release also stated that for the major emerging economies, the outlook has improved since last month s assessment. Signs of a positive change in growth momentum are now emerging in Brazil and Russia, while in China and India CLI s point to stable growth momentum and firming growth, respectively. 1 Stable growth momentum in the OECD area and improved outlook in major emerging economies. (2016, May). Retrieved from We still think that the strong move off the bottom on February 11 could lead to a degree of consolidation/correction over the summer months, but believe that a correction in time or degree would allow a more aggressive equity posture at some point in Q3. The significant moves by global central banks since February seem to have significantly reduced the risk of a global recession in the short term and a reacceleration of global growth in the latter part of 2016 would be a further tail wind for the TSX. Overall impressions from recent company interviews in the financial sector We are in the middle of our spring/early summer round of interviews with the CEO s and CFO s of companies in our equity universe. So far, we have talked with 30 of those companies. Ten of those corporations are in the oil and gas and pipeline sector and we have a few more interviews yet to go. Three are in the mining sector with only one of them a gold stock. We have also interviewed a number of the infrastructure companies that we highlighted at the beginning of the year and for which we have started a new discretionary managed portfolio to allow clients to participate in a sector in which Canada has a number of globally competitive companies with strong growth prospects and a highly predictable dividend growth profile over the next five to ten years. In addition, we have talked to Canadian National Railway and two of the REIT s in our universe.

2 2 Finally, we have completed our interviews with the six major Canadian banks, which will be announcing Q2 earnings in the latter part of this month and with Manulife Financial and Sun Life Financial who have recently reported their Q1 earnings. Brief impressions of these financial companies prospects follow: 1. The six Canadian banks We talked to all of the major six Canadian banks prior to their blackout period commencing the beginning of May. The discussions chiefly centred on the outlook for the U.S. and Canadian economies, capital adequacy, the potential headwinds from lower energy prices and a Canadian residential housing downturn and financial technology (Fintech) competition. In terms of the economic outlook on both sides of the border, Royal Bank was the most conservative in regards to their 2016 gross domestic product (GDP) forecast for Canada at 1.7%. However, their forecast for 2017 Canadian GDP growth at 2.3% was the most optimistic of the group. Generally speaking, the rest of the banks were looking for 2016 GDP growth to be marginally below 2% and 2017 to be modestly above that level. As for the U.S. GDP forecasts for this year and next, we place the most emphasis on the estimates of TD and BMO s economists as those forecasts benefit from the significant presence of both banks in their own footprint south of the border. TD is looking for GDP growth of 2.0% in the U.S. this year and 2.3% next year while BMO is projecting U.S. GDP growth to be slightly above 2% this year and moderately higher next year. In terms of interest rate hikes by the respective central banks, none of the six expect any in Canada this year and TD even said that they expected no movement by the Bank of Canada until They have also recently changed their U.S. interest rate hike expectations from one in June and one in December respectively to one in September. On the subject of capital adequacy, all of the banks felt they were reasonably well placed in terms of their Common Equity Tier 1 (CET1) ratios under Basel 3 rules. CIBC remains the highest, coming in at 10.6% in Q1. The lowest is National Bank which reported a CET1 ratio of 9.7% at the end of Q1 slightly lower than the Royal Bank and TD at 9.9%. Most of the six felt comfortable with their capital levels. In fact, TD pointed out to us that they now carry vastly more capital than they did 10 years ago while the bank s operations are in fact much less risky now than they were back in the early part of this century. They said, for example, that in 2000/2001, 42% of the bank s earnings came from wholesale operations and 58% from retail. Now it is 10% and 90%. In addition, Basel three rules now require much stricter counterparty concentration limits, as well as individual and sector risk constraints. Interestingly, (priceearnings) P/E multiples are lower now for the six banks than they were years ago although some of that discount can be ascribed to lower domestic growth prospects as the Canadian consumer is considerably more leveraged today than in the earlier period. According to TD, the short interest in Canadian banks is higher than it was in the financial crisis, which, to a contrarian is good news for the outlook for these stocks. The major reason for the short position would appear to be the negative interpretation of the current Canadian housing market and its potential impact on banks as well as the fear that energy loans going bad will materially hurt the earnings of our domestic banks. We would dispute the first assertion. Admittedly, the Toronto and Vancouver real estate markets are at record levels but other major cities in Canada have

3 3 seen much more gradual moves in house prices and, of course, house prices in Alberta are strongly to the downside. What foreign investors and particularly U.S. investors do not, in our opinion, sufficiently appreciate is the difference between our housing market and the American housing market. For a start, a significant portion of Canadian residences are federally insured by (Canada Mortgage and Housing Corporation) CMHC and because, unlike the U.S., mortgage interest is not tax deductible, Canadians have a history of wanting to pay down their mortgages faster. These facts are reflected in the Canadian banks percentage of insured mortgages on their books as well as the high Loan to Value (LTV) of the mortgages they are carrying. As an example, approximately 46% of Royal Bank s mortgage book is insured while the LTV is 55% on average on all of their mortgages. The lowest in terms of insured mortgages is National Bank at 41% - although its LTV at 59% - is almost the highest in the group: CIBC s LTV stands at 60%. CIBC s insured percentage is also the highest at 61%. In terms of the energy situation, Canadian banks energy loans are in the range of 1%-3% compared to 8%-9% for Citigroup and Morgan Stanley. Admittedly, American banks have reserved for bad energy loans more aggressively than Canadian banks because they use an expected loss model as opposed to Canadian banks using an incurred loss model but investors have unduly fixated on this, in our opinion, after National Bank recently pre-announced a $0.54 per share increase in energy provisions for Q2, putting the rest of the Canadian banks under some downward pressure. As for Fintech competition, all the Canadian banks are aware of the dangers and opportunities. Bank of Nova Scotia (BNS) sent its Board of Directors to Silicon Valley to witness some of the ideas that were being developed by companies there to gain market share in the financial sector. However, as an industry, the Canadian banks have been generally either developing partnerships with companies with promising technology in this area (witness the recent Apple Pay deal with TD and RBC soon to be followed by the other three major Canadian banks) and/or large internal investments. For example, National Bank, which is the smallest of the major six banks, spent $150-$170 million annually on technology between 2011 and 2014 and will have increased its technology investment to $170-$200 million a year from 2015 to With the recent modest pullback in Canadian banking stocks, we believe the group represent good value at current prices. In our view, all of the six banks have potential one year total shareholder returns (TSR s) of plus or minus 10% while we also estimate three year TSR s of roughly the same order of magnitude. Bank of Nova Scotia the parent company of Scotia Campital Inc. and National Bank remain our preferred vehicles. 2. Manulife Financial and Sun Life Financial Sun Life Financial s (SLF) Q1 earnings were well received by the market while Manulife Financial s (MFC) Q1 results were considered in line with expectations. The major area of difference between the two companies is the market valuation that investors are placing on each. SLF is trading at approximately 1.3 times book value per share while Manulife trades at a discount to book value. Were MFC to trade anywhere near the Price to Book Value multiple that the market is according SLF, the upside in the shares would be substantial. Much of our conversations with the two companies revolved around assessing the reasons for the different valuations on each and the prospect for change in the short term. We believe that there are three major differences between the two lifeco s which

4 4 explains the superior current valuation of SLF. Two of them involve businesses that are susceptible in a period of low interest rates and market volatility namely the Variable Annuity business and the Long Term Care business. Although MFC has hedged against low interest rates, it has a good size Variable Annuity business in the U.S. as it does with Long Term Care. Both these businesses involve long term guarantees, which could be very challenging if interest rates stay low for a long time. We think it would be tough to sell these businesses in the current environment. MetLife in the U.S. is trying to do exactly that currently. SLF was perspicacious in selling its variable annuity business five years ago in a more favourable environment. SLF is concentrated in the group business, which is not as capital intensive and is re-priced on a regular basis. The third area of difference is MFC s direct exposure to energy loans through its Alternative Investment group. SLF has no direct exposure. We believe that it is likely that there will be similar TSR s for each over the next year. MFC s upside on a longer term basis would be considerably higher if the three abovementioned concerns were addressed or the interest rate outlook changed. That is possible in the case of the direct energy loans particularly with an improvement in energy prices over the next couple of years which we fully expect. However, we suspect that the challenges of the other two businesses are far more intractable. Portfolio change There were no trades in our portfolios over the last two weeks. Nick Majendie, CA Director, Wealth Management, Senior Portfolio Manager, ScotiaWealth PLEASE NOTE: IMPORTANT DISCLOSURES AND DISCLAIMERS ARE CONTAINED ON THE FOLLOWING PAGES.

5 5 i The Bank of Nova Scotia is the parent company of Scotia Capital Inc. ( SCI ) and is therefore a related issuer of SCI. Scotia Managed Companies Administration Inc., a wholly-owned subsidiary of SCI, is the manager of the Anchor. ScotiaWealth, a division of SCI is the portfolio advisor to the Anchor. Nicholas L. Majendie, who is employed by ScotiaWealth, provides portfolio advice to the Funds. This information reflects Mr. Majendie s opinions as of the date of these notes. These opinions may change at any time and neither Mr. Majendie, ScotiaWealth nor their affiliates undertake to update the information or opinions. This information and opinion does not constitute investment advice or an offer to trade securities. Anchor hold securities of the following issuers referred to in this note: Bank of Nova Scotia, Canadian Imperial Bank of Commerce, Canadian National Railway Company, National Bank, Royal Bank of Canada and The Toronto-Dominion Bank. Nick Majendie, who provides portfolio management advice to the Anchor, personally holds securities of the following issuers referred to in this note: Bank of Nova Scotia, Canadian Imperial Bank of Commerce, Canadian National Railway Company, National Bank, Royal Bank of Canada and The Toronto-Dominion Bank. Commissions, trailing commissions, management fees and expenses all may be associated with mutual fund investments. Please read the prospectus before investing. Mutual funds are not guaranteed, their values change frequently and past performance may not be repeated. These Anchor are distributed under a Simplified Prospectus. The Simplified Prospectus, Fund Facts and Annual Information Form are available from ScotiaWealth or on This publication is intended only to convey information. It is not to be construed as an investment guide or as an offer or solicitation of an offer to buy or sell any of the securities mentioned in it. The author is an employee of ScotiaWealth, a division SCI, but the data selection, analysis and views expressed herein are solely those of the author and not those of SCI. The author has taken all usual and reasonable precautions to determine that the information contained in this publication has been obtained from sources believed to be reliable and that the procedures used to summarize and analyze such information are based on approved practices and principles in the investment industry. However, the market forces underlying investment value are subject to sudden and dramatic changes and data availability varies from one moment to the next. Consequently, neither the author nor SCI can make any warranty as to the accuracy or completeness of information, analysis or views contained in this publication or their usefulness or suitability in any particular circumstance. You should not undertake any investment or portfolio assessment or other transaction on the basis of this publication, but should first consult your investment advisor, who can assess all relevant particulars of any proposed investment or transaction. SCI and the author accept no liability of whatsoever kind for any damages or losses incurred by you as a result of reliance upon or use of this publication in contravention of this notice.

6 6 The statements in this newsletter may contain statements related to future financial performance of certain securities, indices or the Anchor Managed funds that may constitute forward-looking statements. These statements may be identified by words such as expect, look forward to, anticipate, believe, seek, estimate, project, potential, predict, or words of similar meaning. Such statements are based on the current expectations and certain assumptions of the author, and are, therefore, subject to certain risks and uncertainties. A variety of factors, many of which are beyond the author s control, affect the performance of the securities and capital markets indices and therefore the performance of the Anchor funds and could cause the actual results, performance or achievements of the securities, indices or the Anchor funds to be materially different.