Bank stocks are struggling, bolstering the contrarian case to buy them - The Globe and Mail

Canadian banks were hit with tougher regulations this week, adding yet another reason for investors to take a dim view of a sector that has been throttled by economic fears, deteriorating credit conditions and a recent U.S. regional banking crisis.

And some contrarians love it.

Just about any beaten-up stock can attract investors who like to buy names when they are cheap and out of favour. But Canadian bank stocks have a special appeal to bargain hunters, in part because stable dividends offer a compelling rebuttal to doomsday scenarios.

“Canadian bank capital structure and management is typically, historically – and remains – conservative. Banks are cash flow and balance sheet machines,” Brian Belski, chief investment strategist at BMO Capital Markets, said in an interview.

Count Mr. Belski among contrarians who are looking beyond the current influx of bad news. In a note this week, he spelled out the case for “overweighting” financials – or owning a bigger slice than is currently reflected in the sector’s 30-per-cent weighting within S&P/TSX Composite Index.

Bank stocks, which are down an average of 23 per cent over the past 18 months and trading near two-year lows, are especially attractive within the sector, given their low valuations and high dividends.

He believes that sentiment toward the stocks is at extremely low levels, rivalling the early days of the COVID-19 pandemic in 2020. The largest financial exchange-traded funds have experienced net outflows over the past two weeks, offering evidence that banks are unpopular with investors and already reflecting a lot of bad news.

To be clear, Canadian banks are facing crummy conditions.

In their most recent quarterly results, released last month, the banks reported that impaired loans increased by 12 per cent, on average, as rising borrowing costs chip away at the ability of businesses and consumers to meet their debt obligations.

Loan growth is slowing to a trickle: Canadian residential mortgages, for example, didn’t rise at all between the first quarter and second quarter.

Meanwhile, expenses at the biggest banks have been increasing at a double-digit clip for the past two quarters, as compensation rises to offset inflation. Gabriel Dechaine, an analyst at National Bank Financial, expects the banks could respond with cost-cutting efforts – translation: layoffs – that could easily drive restructuring charges above $3-billion across the sector if all banks participate.

And this week, the Office of the Superintendent of Financial Institutions, the banking regulator, announced that it is increasing the domestic stability buffer – the capital that banks must hold as protection against an economic downturn. Analysts expect the increase will weigh on bank profitability.

The good news? Well, there isn’t any, other than share prices are in the dumps and valuations are well below the historical norms, offering the tantalizing possibility that bank stocks will eventually rise from these discounted levels.

For valuations, Mr. Belski uses a composite metric based on ratios for price-to-earnings, price-to-book, price-to-sales and dividend yields, which shows that bank stocks are considerably cheaper than the historical average for data going back more than 30 years.

The best bets, according to Mr. Belski: Focus on banks with diversified balance sheets and strong U.S. platforms.

U.S. exposure looked like trouble earlier this year, when regional banks there were struggling with declining deposits and threatened to drag down the broader sector. But he believes that the United States offers attractive growth prospects, and any comparisons to the financial crisis of 2008-09 are deeply flawed.

“There is no sign of a credit crisis. There is no sign of contagion,” Mr. Belski said.

He didn’t recommend individual stocks in his capacity as a strategist with big-picture views on investing. But Royal Bank of Canada, Toronto-Dominion Bank and Bank of Montreal have large U.S. footprints and are well diversified beyond, say, Canadian residential mortgages.

The dividend yields on these three banks range from 4.4 per cent for RBC, to 4.9 per cent for TD and 5 per cent for BMO. Those are sizable payouts for investors while they wait for better news, perhaps in the form of defeated inflation or less economic uncertainty.

Even large restructuring charges could help turn around sentiment toward bank stocks. During the last round of significant restructuring charges, in 2016, the banks that showed the biggest improvement in efficiency – their expenses fell the most relative to revenues – enjoyed the best rallies, according to Mr. Dechaine.

No one is suggesting that the banks’ challenges are over. But the sector has an impressive track record of rewarding investors who take advantage of downturns.

“All the bad news is already out there,” Mr. Belski said. “Remember, no one can collect on the end-of-the-world trade.”

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2023-06-24 11:00:00Z
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