Pessimism is overdone for financial stocks: Leith Wheeler

Bill Dye says Canadian banks and insurers are fundamentally strong.

Michael Ryval 7 January, 2016 | 6:00PM
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Canadian financial-services stocks took a hit in 2015, yet the view going forward is not so bleak, provided you have a longer-term horizon, says Bill Dye, head of Canadian equities at Vancouver-based Leith Wheeler Investment Counsel Ltd.

"There's certainly a lot of pessimism priced into Canadian financials. But these things are levered plays on the Canadian economy, to some extent," says Dye, who is on the team that oversees the $2.2-billion 4-star rated Leith Wheeler Canadian Equity. "In the short term, it depends on one's view of the Canadian economy, and the fact that oil is trading at US$35 is quite concerning. The real issue is: Is Canada going into recession? We don't think it is. But it is certainly a risk."

Dye admits that 2016 will be a tough year and GDP growth will be around 1%. "We'll be moving ahead, but very slowly. And we won't be seeing much inflation in this environment." Indeed, given the slow pace of growth, Dye believes there is a 50-50 chance of the Bank of Canada cutting interest rates again.

The financial-services sector has been hurt by a host of issues, ranging from the impact of weak commodity prices on borrowers in the resource sector, potential losses on retail lending in Alberta and Saskatchewan, poor equity markets that have slowed asset-management divisions and lower new-issue activity in capital markets. "The stock market is suggesting that it's going to be lower for longer, in terms of commodity prices," says Dye, adding that life insurance firms have been hurt by continued low interest rates.

On the positive side of the equation, Dye argues that Canadian financial-services companies are fundamentally strong and have demonstrated their ability to survive challenging periods. "Their earnings will continue to grow. There will be a time when we get higher valuations, although I don't know if it will be in 2016," says Dye, a 30-year industry veteran who joined Leith Wheeler in 1985 after graduating from the University of British Columbia.

"If you think the economy is going into recession, you don't want to own financials," says Dye. "We don't think that way. It will be very slow and, over a three-year time horizon, earnings will move up. These businesses look attractive relative to other opportunities."

Yet markets are in a "show-me" mood, which has sent valuations down. "They have to show that their loan growth is not bad and loan losses are manageable and capital-markets activity is reasonable," says Dye. "Markets are concerned there may be earnings declines. That's where the tension is."

Take  Royal Bank of Canada (RY), one of the top fund holdings. In 2014, it was trading at 12 times forward earnings. Today, the valuation has dropped to 10.75 times. "As a group, the banks grew earnings as expected in 2015 at about 6%," says Dye. "But toward the end of the year the market became more concerned about the future. The pessimism is reflected in the valuations."

In a similar vein,  Manulife Financial Corp. (MFC), another top holding, has seen its forward price-earnings ratio fall from 12.5 times to 10.5. "The uncertainty surrounding China is a concern to the market," says Dye, noting that the company is a 60-40 mix of insurance and wealth management.

A bottom-up stock picker, Dye is expecting 3% earnings growth in 2016 for the banking sector, which is somewhat higher than the broad market's expectations. "It won't be a great year for the banks. But they are diversified businesses and have a lot of levers to pull," he says. "For stocks to move up, they have to show earnings growth and we have to see a bit of strength in the Canadian economy."

Despite the current pessimism, the firm's generally optimistic view is reflected in the 40% financial-services weighting (which excludes real-estate stocks that are also in the financial sector) in Leith Wheeler Canadian Equity, compared with 33% in the benchmark S&P/TSX Composite Index. Besides Royal Bank and Manulife, other top holdings include  Toronto-Dominion Bank (TD).

"It has one of the two top Canadian retailing branches, based on scale and brand," says Dye. "It also has attractive exposure to the U.S. retail banking industry where the economy will be stronger than in Canada." Like its peers, TD's valuation has slipped to 11.25 times earnings on a forward basis.

Because the short-term outlook could be "very choppy," Dye says it's critical to adopt a three-year view. "The Bank of Canada may cut rates and the economy may skirt close to a recession. I don't know. But the buyers of these businesses would have to think the economy will muddle through the next three years."

When viewed against other Canadian sectors, Dye argues that the financials are attractive from a risk-reward perspective. "You won't get rich. There's a good chance you'll get a 9% return (compounded) over the next three years. That's based on a combination of an average 5% earnings growth and a 4% dividend."

Dye says the expected return from financial stocks is quite attractive. "But there will be a fair amount of volatility because their balance sheets are quite levered," he adds, noting that the banks' typical asset-to-common-equity ratio is 19 to 20 times. "They are highly levered businesses."

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Michael Ryval

Michael Ryval  Michael Ryval, a regular contributor to Morningstar, is a Toronto-based freelance writer who specializes in business and investing.

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