Why You Can Still Count on Canadian Bank Stocks

Investors have become cautious in Canada, thanks to a 500-basis point rise in short-term interest rates and its impact on consumers and the housing market. But our economy is holding its own and there are opportunities to be found, says veteran stock picker, Doug Warwick.

“So far, we have been okay. Rebounding commodity prices are supporting the economy and the price of oil helps our balance of payments,” observes Warwick, lead manager of the $9.1 billion 4-star neutral-rated TD Dividend Growth – F (also available in Series D). A veteran stock picker who entered the financial services industry in 1980, Warwick is managing director at Toronto-based TD Asset Management Inc. and oversees three funds with total assets under management of $20.7 billion. “We have population growth, and that supports housing prices, although it is a little inflationary. Year-to-date forward-looking earnings estimates have dropped a little, which explains some of the weakness in Canadian stocks,” he says, noting that in contrast, U.S. equity indices are strong although the gains are confined to the so-called Big Eight technology stocks, such as Alphabet Inc. (GOOG).

Happily, Warwick notes that the Bank of Canada is standing pat on further rate hikes, although it expressed concerns in early September about potential hikes down the road. “Their words were, ‘future rate hikes are not off the table,’” says Warwick, who shares duties with Jennifer Nowski, vice president. “They are still worried because inflation is not down to their target yet. Still, we are making good progress.”

Math Adds Up for Canadian Financial Stocks

Fortunately, as well, valuations are attractive. “The TSX is trading at 13.5 times earnings, which is a 10% discount to the long-term average of 15 times,” observes Warwick, who argues that Canadian financial service stocks look especially appealing. “Canadian banks are trading at less than 10 times earnings, and insurers are less than nine times. The weighted average dividend yield for nine major banks and life insurance companies is greater than 5%. That’s a nice yield—with potential for growth over the long term.” As for resource stocks, Warwick has historically favoured certain energy producers, which he notes are trading at five times cash flow. “The cash flow is strong and perhaps even continuing to grow.”

Watch Out for a Rally Next Year

Warwick is in fact bullish and expects that Canadian financial stocks will rally in 2024, with the catalyst being the fact that Canadian banks have a fiscal year-end of October 31. “Investors will soon be looking to the next fiscal year for banks. We see continuing dividend hikes, although they might be modest. We also see share buybacks and dividend hikes from the energy sector. And if there is a rotation out of U.S. technology, which is extremely expensive, that could support other areas of the market, including the Canadian market.”

In Warwick’s view, the question is not if the rotation will happen, but when. “A lot of these stocks are extremely over-priced. A lower valuation will be warranted at some point,” says Warwick. “I still like technology and believe it’s wonderful, especially AI [artificial intelligence]. But we have seen this many times before: the market gets far ahead of itself and then it reverts back. They will trend back to more reasonable valuations.”

We Don’t Want a Deficit in a Slowdown

On the negative side of the balance sheet, Warwick worries about the rapid and significant monetary tightening in the past 18 months. “The Bank of Canada and Federal Reserve have been buying back bonds that they sold in the quantitative easing period. There has been quite a bit of tightening and I worry that they might overdo it,” argues Warwick. “I’m also worried that with the size of the fiscal deficits the government may raise corporate taxes, especially on the banks,” says Warwick, adding that the scale of the deficit puts undue pressure on the private sector and is very worrisome. “If you are trying to slow the economy, you should not be running a deficit. That contributes to inflation and only forces the central bank to raise rates to slow the economy.”

Year-to-date (Sept. 29), TD Dividend Growth – F has returned 0.04%, versus -0.02% for the Canadian Dividend and Income Equity category. However, over the longer term, the fund has excelled. Over the last five, 10, and 15 years, the fund returned an annualized 6.46%, 7.83% and 7.71%. In contrast, the category returned an annualized 5.07%, 5.83% and 6.

Warwick notes that in 2022 the S&P/TSX Composite returned -8.5%, while TD Dividend Growth- F returned -0.83%. “Bank stocks did not perform well last year, and we’re up only a little bit this year,” says Warwick, adding that the portfolio is heavily weighted to banks as it is comprised of 46.70% financials. There is also 17.50% energy, 10.60% industrial services and 5.40% consumer services. “When you look at bank stocks over a 50-year period, it’s unusual to see two consecutive years of poor performance. I’ve never seen three years of underperformance. The banks do appear to be getting their expenses under control. I expect a better year for the banks in 2024.”

Still Banking on Financials

Warwick and Nowski’s team, which includes 20 equity analysts, is primarily bottom-up oriented. “We have always been heavy in financials because we like them. They are less cyclical than the broader market,” says Warwick. “The Canadian financials are disciplined in pricing their products and have a high return on equity of 14-15%, on average, although life insurance firms are a bit lower than that. Historically, they have generated very good shareholder returns.”

Moreover, argues Warwick, the Canadian banks are far less risky than many years ago. “If you go back 40 years, banks would borrow at the teller wicket and lend to corporate Canada. They were very cyclical and would have loan losses at the bottom of every economic cycle. But the banks have broken into a number of business lines that are much more attractive. For example, there’s wealth management. Maybe your assets under management go up and down by 10% a year---which means your profit does the same. But it doesn’t go from 100 to zero. You also have an insurance business and a mortgage business which is fantastic, because losses on mortgages are extremely low. They have government guarantees and are extremely good assets to hold. And there is also US exposure, which gives them geographic diversification. Most important, they have a lot more capital. There is an 11% minimum capital ratio now, and that’s up considerably from 4-5% 25 years ago. The industry is much safer because there is more capital supporting the business which makes the investment much less volatile.”

In selecting stocks, the team favours those with attractive valuations and takes a buy-and-hold approach in buying companies. Indeed, turnover is less than 10%. “We like firms with good market share, which usually means a higher return on equity. We also like recurring revenue and growing cash flow because it often leads to growing dividends. I’m also attracted to reasonable valuations,” says Warwick, adding that for diversification purposes the portfolio does hold several U.S. stocks, such as Microsoft Inc. (MSFT) and UnitedHealth Group Inc. (UNH), a leading U.S. managed healthcare provider. “They allow us to invest in sectors that are not well represented at home.” The fund is yielding 2.76%, before fees.

Top Canadian Dividend Stock Picks

Running a portfolio with 70 names, Warwick cites Cenovus Energy Inc. (CVE), a leading energy Canadian producer with an output of over 800,000 barrels of oil equivalent a day. “We are overweight energy relative to our benchmark [a blend of 60% S&P/TSX Sector Indices and 40% S&P/TSX 60 Total Return Index],” says Warwick, noting that energy producers comprise 12.50% of the fund. “Cenovus has been integrating other players in previous years and has bought interests in a couple of refineries in the U.S. That should improve earnings in the second half of 2023.”

The stock, which is trading at five times cash flow, had a recent dividend hike of 30%. “With present oil prices, they are continuing to reduce their debt. When they get their debt to a target ratio, they will increase their share buy-backs and dividends,” says Warwick, noting the stock is yielding 2%.

Another top holding is long-time favourite Royal Bank of Canada (RY), Canada’s largest bank. Pointing to the $13.5 billion acquisition of HSBC Canada, Warwick notes that the bank will be able to increase its market share without many anti-trust objections. “B.C. is a good market and gives RBC a good Asian connection,” says Warwick, adding that RBC is trading at around 10.5 times forward earnings. The stock is yielding 4.5%.

RBC’s capital ratio may decline to about 12% after the acquisition is completed next year, and down from 14.1%. “But it will still be above the 11% minimum,” says Warwick. Meanwhile, he notes that RBC chief executive officer Dave Mackay has pledged to reduce the firm’s headcount to get expenses under control. “The whole sector will start to do better shortly. Royal Bank will lead on that.”