The Risk and Opportunity of Investing in Canadian Banks
A foreigner visiting a Canadian city for the first time could tell a lot about us by standing at any major intersection. Tim Horton’s would occupy one corner, on the second could be a Shoppers Drug Mart or gas station or LCBO, and the remaining two corners would be banks. The six large banks are the figurative and literal cornerstones of our financial system. Due to their collective size, the bank sector represents approximately 25% of the total market capitalization of the S&P/TSX Composite Index.
Despite their dominant weighting in the TSX, we have generally avoided investing in this sector for the past three years due to concerns about valuation and slowing earnings growth as the economic cycle was nearing maturity. For a period after the 2016 U.S. election we were invested in U.S. banks instead, where valuation and growth were relatively more attractive. At the beginning of 2020, we did not have direct exposure to U.S. banks either.
Although risks have increased, including further short-term economic weakness and likely increase in loan losses, the virus-induced global market sell-off has significantly reduced valuation to levels that we consider reasonable. Over the past three weeks, we have been adding Canadian banks to our managed portfolios as part of a broader strategy to become more offensive in our asset allocation.
Attractive dividend yields within the Canadian bank group, currently ranging from 5% to 7%, form part of our long-term investment thesis. The Canadian bank group has an enviable track record of dividend sustainability over the past 75 years, even as banks around the world have resorted to cutting or suspending dividends during economic slowdowns. As a measure to preserve capital for the economic shock currently unfolding, banks across Europe have already cut or suspended dividends at the request of regulators.
Notwithstanding their track record, we have added Canadian banks to our managed portfolios with the recognition that extreme and unprecedented circumstances could lead to similar regulator action in Canada. While ad hoc limits on dividend payouts could be imposed by Canadian bank regulators (Office of the Superintendent of Financial Institutions), dividend policy is subject to specific capital adequacy ratios. This regulatory framework includes a sliding scale which dictates the ratio of bank earnings that could be distributed to shareholders based on capital levels. These constraints would kick in if regulatory capital dropped below 7.0%. The average Q1 2020 reported capital ratio for the bank group was a healthy 11.6%.
Our asset allocation decisions are based on weighing potential risks and returns. We think a combination of lower valuation and adequate capital ratios are meaningful counterbalances for the near-term risks facing the banks. Canadian banks now carry an 8% weight in our model portfolio, and we may add to this position should opportunities arise in coming weeks.
We are always happy to have conversations about our market outlook and investment strategy. We know this is a challenging time and encourage you to contact us if you have any questions. Stay safe and healthy.