Banks, Trimming Trusts and Free Martha!

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In this, “Been Away For a While” edition:

  • An evaluation of TD Bank’s recent quarter
  • Trading Notes: Northland Power, BFI Canada, Manitoba Telecom
  • Closing Bell: “Free Martha!”

It was only a matter of time before I wrote about the big banks. That I hadn’t already owes much to the fact that financials, although performing quite well, have been decidedly less interesting to discuss than income trusts. Forgive me and my obsession. In fact, it’s ironic that I invest in financials at all, given that I spend so much time trying to keep the banks from making money off me. I’d rather eat leftovers on the set of Fear Factor than pay bank fees or incur high trading costs. I have yet to find religion, so this is my belief system. And yes, it makes me very happy.

The only financial stock in my portfolio is TD Bank (TD – TSX). Added within the last year, it is Canada’s third-largest bank by market cap, behind only Royal Bank (RY – TSX) and Bank of Nova Scotia (BNS – TSX). Beyond that, my only exposure to the sector is indirectly held through a number of mutual funds. With the latest earnings reports in hand, I’ve been reviewing my holding to see how it stacks up vs. the rest of the group. In fact, I anticipate the bank earnings with as much excitement as most people do a new season of The Sopranos. When looking at the banks, there are so few options in Canada and comparisons are fairly easy to make. The metrics that I use include return on equity, tier one capital ratio, loan loss provisions, dividends, stock performance, and a consideration of risks and opportunities.

You’ve spent 15 months waiting for Season 5. You only have to wait 3 months for the next round of bank earnings.Bada bing!  

Return on equity
When evaluating stocks, one of the key measures of profitability is return on equity (ROE). This statistic allows us to compare the company’s use of its equity with other investments. In other words, are they allocating their resources in a profitable manner or is good money being flushed down the toilet? On this measure, the quarterly results just announced by the banks compare favourably with a year ago. A number of factors contributed, including strong capital markets and an improving credit environment. In the latest quarter, the bank group averaged a 19% return on equity, with CIBC(CM – TSX) and TD topping the list at more than 21%. Meanwhile, Bank of Montreal (BMO – TSX) at 18.3% and Royal at 17.8% offered the weakest results. Based on ROE, I’m satisfied that TD is making good decisions and generating positive value for shareholders.

Tier one capital ratio
Another key metric is tier one capital ratio. Also known as core capital, this provides a measure of the capital adequacy of the bank. Over the past year, the banks have done a good job increasing these ratios and the group average stands around 10%. CIBC (11.1%), TD (10.9%), and BNS (10.9%) scored top marks, with BMO (9.7%) and Royal (9.3%) once again at the rear. Again, I’m satisfied.

Loan loss provisions
In trying to assess bank performance, it’s important to note the quality of the loan book. Over the past quarter, the banks have benefited from an improving credit environment and significantly reduced their exposure to bad loans. This reminds me of another pearl of wisdom offered by Warren Buffett. When asked to account for his investing success, he suggested it had less to do with picking winners and more to do with avoiding losers. By this measure, the banks have been increasing their level of success. As a percentage of loans, the lowest provisions belong to BMO, Royal and TD. No alarm bells here.

Of course no discussion of the banks would be complete without a consideration of dividend yield. In this regard, the group is closely packed around 3%. CIBC and Royal have the highest target payout ratios (40-50%), with the rest of the group, including TD, a tad behind (35-45%). Most of the banks have been increasing their dividends every 2 or 3 quarters and this trend is expected to continue. I’d like for TD to raise their payout ratio and it might just happen unless they want to be left behind. Clearly, the banks understand that investors are hungry for income and any bank that fails to deliver will eventually be punished. Using the extra cash for stock buyback programs is fine, but all things being equal, I’d rather have the cash in my pocket.

Risks and opportunities ahead
For TD and CIBC, so much depends on the performance of the equity markets. Both are vulnerable to the bears but free to run hard with the bulls. In part because of this exposure, most commentary that I’ve come across expects TD and CIBC to have the highest earnings growth among the banks in the near term. The latest quarter saw TD blow by analyst estimates, although the bank did caution investors not to expect many surprises for the rest of the year.

For the entire group, retail margins are razor thin, with a low rate environment and fierce competition for products such as mortgages. TD is behind many of its peers in terms of execution at the retail level, but the gap is narrowing. CEO Ed Clark has been drawing positive reviews for the bank’s recent execution and improving the retail operation is surely on the agenda. It’s like my Dallas Cowboys. We all know that Quincy Carter and Troy Hambrick aren’t going to lead the team to the Promised Land. In order for the Vince Lombardi Trophy to assume its rightful place in Texas, the team knows what needs to be done. Just do it. As you can see, I’m suffering from a severe case of NFL withdrawal.

Comparing TD’s retail operations to one of Quincy Carter’s horrific bounce passes really isn’t fair…to TD  

Another factor that has merited considerable attention is the topic of bank mergers. I find it impossible to make investment decisions based on merger speculation, as the “who’s,” “what’s,” “where’s” and “when’s,” are in a constant state of flux. And don’t forget that mergers are still at the pleasure of the federal government, making for quite the wildcard. What’s the punch line? Because I can’t get a handle on the various merger scenarios, I’m going to continue making my investment decisions based on the fundamentals.

Finally, with interest rates likely to increase at some point (who knows when?), the banks could come under some pressure. But I’m not convinced that rates are going to spike anytime soon, so I think there is still money to be made in the financial sector. Plus, I don’t think financial stocks are the interest-rate sensitive animals they used to be.

Stock performance
I don’t care if I own the top gainer year-in-year out. I do however expect above average performance or else I might as well find a new hobby. In terms of stock performance, BNS has averaged 20% a year for the past 5 years to top the category. Over the same time period, TD has experienced considerable volatility and has returned much less to investors. Over the past year, TD’s stock price is up around 40%, trailing only CIBC’s stellar 55%. Royal is the clear laggard, returning less than 10% over the same time period. What does this say about valuation? Based on earnings estimates for 2004, National Bank (NA – TSX), CIBC, and TD have the lowest price to earnings ratios in the group. No warning signs here. I expect the shares to continue rising, albeit at a slower pace than seen over the past year.

The fact of the matter is, I’d be quite happy to hold any of the big Canadian banks. The cynic in me is saying that it doesn’t matter which bank you own. Just pick one and eventually it will be the toast of the town. It’s fun talking with older investors who speak of purchasing stocks like CIBC many years ago at a split adjusted price of something like $5. Some of these investors rarely even look at the stock ticker and they surely don’t care about which bank is currently in favour or which one is in the doghouse. They figure that it all works out in the wash. Right now, TD and CIBC have been drawing strong reviews, while RY has been sent to the penalty box for problems with its US operations. But as recently as last year, TD was the object of ridicule and scorn given lackluster capital markets, a low tier 1 ratio, and an inability to correctly estimate how nasty their loan book really was. How quickly things can change. As an investor, I’m a happy holder of TD and I hope they make lots of money from other people. But when it comes to fees and such, I practice a NIMBY philosophy…Not In My Back Yard.

Trading notes

  • I recently eliminated my entire holding in Northland Power (NPI.UN – TSX). The current yield on the units dipped below that of my other power holdings, Calpine Power (CF.UN – TSX) and Transalta Power(TPW.UN – TSX). Calpine and Transalta are each backed by a large corporate sponsor (Northland is not) and their distributions are expected to be mainly tax deferred (Northland’s are largely taxable). Therefore, I didn’t think that I was being adequately compensated for the added risk. The power trusts are highly sensitive to interest rates and have benefited a great deal from the current cycle. When rates turn, the units prices will be left highly vulnerable (so if we’re going to have rates heading north, let’s hope the increases are modest and gradual). In any event, given the stellar performance of the power trusts and my overexposure to the sector, I’m quite comfortable taking some profits and storing the cash for a new day.
  • I sold 25% of my holdings in BFI Canada Income Fund (BFC.UN – TSX). The company recently received Quebec government approval to significantly expand the Lachenaie landfill. The approval was largely expected, but when it comes to government, one never knows. The news spurred an already advancing unit price and compressed the current yield to less than 7%. Investors are anticipating growth in distributions. I’ve said it before and I’ll say it again: There’s nothing more beautiful than making money from trash. What a wonderful world in which we live. However, when I bought the units I was expecting the distributions and some modest capital appreciation. Instead, the units are up almost 40% since my purchase last August. This appreciation is equivalent to 4 years of distributions, but were earned in only 7 months (plus 7 months of actual distributions). If I didn’t take any profits, I’d explode.
  • In the previous edition of Market Guy, I speculated that it might be a good time to pare the holding in Manitoba Telecom (MBT – TSX). Well, a couple of weeks ago I pulled the trigger and reduced the position by one-third. I’m locking in some profits and hedging my bets just in case the company decides not to convert into an income trust. I’m content to ride the remaining shares.

Market Guy’s Closing Bell
In between marking papers I had the chance to watch CNBC’s coverage of the Martha Stewart verdict. It made for fascinating TV and I couldn’t look away. They had legal experts in the studio, police setting up barricades, a verdict tally board outside the courthouse (complete with markers and a confused correspondent who initially reported that Martha had been acquitted on all counts), a ticker devoted exclusively to Martha stock quotes, crazy trading in that stock, and producers running down the courthouse steps, waving signs and scarves to alert reporters of each verdict. If that wasn’t enough, CNBC offered a very special “U.S. vs. Martha Stewart: GUILTY: One Hour Special.” And if you missed that, they were also promoting “U.S. vs. Martha Stewart: GUILTY: One Hour Special: Encore Presentation.” I’m still waiting for the “U.S. vs. Martha Stewart: GUILTY: One Hour Special: Encore Presentation: The Highlight Show with Maria Bartiromo live from the NYSE.”

Outside the courthouse: I’ll bet this guy loves telling the girls that, at least for one day, he was known as “Mr. 8.”  

So what’s missing here? I really wanted a crowd shot and was desperately hoping to see some guy wearing a “FREE MARTHA!” t-shirt. If nobody has thought of this already, then capitalism is in a sorry state.

The Market Guy is an Instructor with the Department of Psychology at Carleton University. He’s not a professional advisor. He’s just a guy who loves investing and talking about the markets. He’s in the middle of marking 90 first-year oral presentations and then moving on to 1500 pag