Canadian banks are undervalued, Beutel's Mark Thomson says

The financial sector dominates S&P/TSX earnings.

Sonita Horvitch 3 August, 2016 | 5:00PM
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Mark Thomson, managing director of equities and chair of the board at Beutel, Goodman & Co. Ltd., says that the stocks of the major Canadian chartered banks are not getting sufficient applause, given the banks' dominant contribution to the total earnings of the S&P/TSX Composite Index.

He attributes this, in part, to the "negative narrative formulated by non-domestic short-sellers of Canadian bank stocks." This, he says, is "inhibiting the valuation on Canadian bank stocks."

Thomson points out that there is a big gap between the Canadian banks' collective weighting in the Composite Index of 22.3% versus their 51.1% contribution to the index's total earnings. The financial-services sector, as a whole, has a weight of 35.6% in the benchmark and accounts for 61.6% of its earnings.

By contrast, he says, the Canadian energy sector at a weighting of 20.1% of the index accounted for 2.4% of its total earnings. Materials, with a weighting of 14.1%, contributed 3.4%.

"Gold stocks, which have been strong drivers of the Canadian equity market so far this year, represent, in the main, companies that are marginally profitable with stocks that are expensive." (Gold stocks are a significant weight in the materials sector.)

Thomson says that the naysayers regarding Canadian bank stocks are "extrapolating" into Canada the challenges that have faced the U.S. banking system. "This negative sentiment has even afflicted some domestic Canadian bank analysts."

To Thomson, the major Canadian chartered banks "represent stable businesses that generate a lot of capital." Since the 1990s, the major Canadian banks have, he says, both improved the quality of their loan portfolios and reduced their dependence on their lending business in favour of their fee-generating business.

At present, he says, some 45% of the loan book for the banks is represented by mortgages that are guaranteed by mortgage insurers, versus 25% in the 1990s. Furthermore, he says, the banks' fee income currently represents 50% of their total net income versus 30% in the '90s."In all, the negative narrative surrounding the banks has been built on a faulty matrix and this provides investment opportunities."

At recent tally, Beutel Goodman had assets under management of $37 billion in both equity and fixed-income portfolios. A traditional value manager, Beutel Goodman's discipline in stock selection is, says Thomson, to "buy them at a substantial discount to the estimated value of the underlying business, based on the present value of future free cash flow."

Mark Thomson
Mark Thomson

The firm's flagship big-cap Canadian equity portfolio has assets under management of $15 billion. This includes Beutel Goodman Canadian Equity, which Morningstar's manager-research team has designated as a Gold medallist fund, the top rating.

The strategy for this portfolio is "to buy stocks that will generate a minimum total return of 50% over the next three years," says Thomson. The team will, he explains, automatically sell one third of a holding once the stock reaches the team's target price, and then reassess the stock.

The Canadian big-cap portfolio has been overweight in the financial-services sector for some time. It currently has 41.6% in this sector versus its 35.6% weight in the benchmark. At the other end of the spectrum, the portfolio is substantially underweight in energy and materials. These sectors represent its two biggest underweight positions.

The two top weightings in the portfolio, at almost 9% each, are  Toronto-Dominion Bank (TD), with a dividend yield, at recent count, of 3.85%, and  Royal Bank of Canada (RY), whose dividend was 4.1%.

Each bank, says Thomson, has roughly 25% of the domestic banking market for a total of 50% of that market. "Their respective market shares provide each bank with considerable operating leverage." Both banks are "well managed and have generally proven to be good stewards of capital."

However, Thomson adds that Royal's purchase of U.S.-based City National Corp. for US$5 billion, which closed in early November last year, was done at a valuation on City National that "was quite high."

A non-bank financial that is also among the top-10 holdings in the Beutel Goodman Canadian big-cap portfolio is Brookfield Asset Management Inc. (BAM.A). The company has a range of operations that include asset management, real estate, renewable energy and infrastructure. "It is a complex structure and is somewhat inscrutable, so it requires particularly thorough analysis," says Thomson.

On the basis of the Beutel Goodman equity team's research, the stock is trading at "a large discount to the underlying value as determined by the sum of the different pieces." Another feature of the company that Thomson likes is that "CEO Bruce Flatt and other members of the top management team have a significant financial stake in the stock, making them fully aligned with shareholders."

Brookfield Asset
Management Inc.
Royal Bank of Canada Toronto-Dominion
July 29 close $45.09 $79.59 $56.89
52-week high/low $46.52-$37.11 $80.97-$64.52 $58.13-$47.75
Market cap $42.6 billion $117 billion $104.2 billion
Total % return 1Y* 1.8 8.6 11.8
Total % return 3Y* 23.2 11.4 13.1
Total % return 5Y* 19.9 12.7 11.4
*As of July 29, 2016
Source: Morningstar

The Beutel Goodman Canadian big-cap portfolio has a modest overweight position in the industrial sector at 9.7% versus 8.4% in the index. Here the major holdings are the two rail companies, which dominate this sector:  Canadian National Railway Co. (CNR) and  Canadian Pacific Railway Ltd. (CP).

"They are good businesses, have good management and throw off a lot of cash flow," says Thomson. Their earnings are currently slightly depressed, he says. "Their volumes and revenues are down, reflecting a fall-off in the shipment of commodities, but their stocks are well priced."

Of the materials sector, Thomson says that the only companies that "earn their cost of capital and generate solid free cash flow over time in this sector, are the fertilizer/agricultural specialists." The Canadian big-cap portfolio has holdings in both  Agrium Inc. (AGU) and  Potash Corp. of Saskatchewan Inc. (POT).

Of the two, Thomson says he prefers Agrium, which is "both a fertilizer producer and a retailer of agricultural products." The retailing business accounts for some 50% of Agrium's earnings, he says, and is capable of "generating exceptional earnings and free cash flow over our three-year investment time horizon." At present, he says, the prices for agricultural chemicals are weak. There is new supply coming on stream and, on the demand side, grain prices are under pressure, he notes. "But I expect that the market will digest this new supply over the next few years."

Consumer discretionary stocks represent 12.1% of the portfolio and 6% of the index. Here Thomson is highlighting the global auto-parts giant  Magna International Inc. (MG). "The company has a diversified customer base and has seen a significant improvement in its operations under the helm of CEO Donald Walker," says Thomson. "Walker has also steered the company to a more shareholder-friendly approach," he says. "Over the last two years, the company has paid out significant amounts in dividends to shareholders and has embarked on large share buyback programs."

At present, says Thomson, investors are concerned about the auto cycle, particularly in the United States, and the possibility that Magna's earnings may have peaked. There are also concerns about the impact on the company from the Brexit vote in the United Kingdom, he says. "But even if Magna's revenue is flat, its excess capital and improved profit margins in its European operations will work to the benefit of shareholders." Furthermore, he says, the valuation on the stock "more than discounts peak earnings."

In the consumer-staples sector, which is 5% of the fund and 4.2% of the index, Thomson has trimmed holdings in the stocks of two major Canadian supermarket chains:  Loblaw Cos. Ltd. (L) and  Metro Inc. (MRU). "I still like the grocery business, but it was a question of valuation," he says. "The stocks reached our targets and, in keeping with our discipline, we sold one third of our holdings."

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Securities Mentioned in Article

Security NamePriceChange (%)Morningstar Rating
Brookfield Corp Registered Shs -A- Limited Vtg55.45 CAD2.76
Canadian National Railway Co176.96 CAD1.54Rating
Canadian Pacific Kansas City Ltd116.06 CAD0.63Rating
Loblaw Companies Ltd143.38 CAD3.82Rating
Magna International Inc73.46 CAD0.01Rating
Metro Inc73.00 CAD2.50Rating
Nutrien Ltd72.63 CAD6.62Rating
Royal Bank of Canada132.77 CAD0.65Rating
The Toronto-Dominion Bank80.88 CAD0.69Rating

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Sonita Horvitch

Sonita Horvitch  

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