Most of Canada’s big banks are set to report earnings this week, with analysts keeping a close eye out for signs of trouble from an uptick in consumer insolvencies and overall sluggishness in the economy.
Not helping matters is that the banks’ capital markets segments have weakened by an estimated 12 per cent this year, according to National Bank of Canada, which might have something to do with the collapse of the cannabis market.
In total, Canadian banks are now expected to report their slowest annual earnings growth rate since the financial crisis, with a modest three to four per cent for fiscal 2019, according to Reuters. While analysts have already begun to hedge themselves by reducing their estimates for fiscal 2020, investors don’t appear overly concerned, pushing many of the bank share prices back to their 52-week highs. Perhaps this is because many are enticed by the strong dividend yields in this persistent low-rate environment.
It hardly comes as a surprise that many advisors use those yields as a strategy, touting the tax-efficient income from owning a highly concentrated portfolio of Canadian dividend stocks when designing portfolios for their clients. Often, advisors will tell investors not to worry about near-term fluctuations and overall volatility as long as these dividends keep getting paid.
While we can appreciate the attractiveness of such a tactic especially with interest rates being so low and tax rates being so high, we think both advisors and investors are missing something rather important — that it’s the total performance that ultimately matters, not just yield.
For example, let’s take a look at the financials sector in Canada and the U.S. as represented by the iShares S&P/TSX Capped Financials Index ETF (XFN) and iShares U.S. Financials ETF (IYF). Despite having a dividend yield of approximately three per cent that is nearly double that of the IYF’s 1.7 per cent, Canadian financials have significantly underperformed their U.S. peers when factoring in share-price appreciation.
In total, we calculate Canadian financials have underperformed by an annualized 2.2, 5.4, 2.6 and 1.9 per cent over the past one, three, five and 10-year periods despite having a similar standard deviation. This is quite significant if you think about it but it does make some sense as there are plenty of benefits to looking south of the border.
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The U.S. is a much bigger market with more growth opportunities. However, this also means it’s a much more competitive environment, forcing U.S. banks to embrace innovative technologies and other initiatives.
Canadian banks are also more leveraged than their U.S. peers and since the financial crisis our shadow banking sector has exploded higher, with liabilities representing $1.1 trillion according to the Bank of Canada, which is half of the $2.1 trillion in liabilities held by the Canadian banks. The health of this sector is therefore important to the banks as it provides a place to offload subprime and other risky debt from their balance sheets.
Finally, both Canadian and U.S. financials are trading at similar levels between 1.5 to 2 times book value while Canadian banks continue to trade at an approximate 20 per cent premium to U.S. peers. This is despite the stronger and higher-growth economy in the U.S. and rapidly rising household debt in Canada.
Overall, we’re not suggesting investors undertake a tactical shift to U.S. financials, but it is important to consider all of the factors when being sold on an overweight position on Canadian financials simply because of their dividend yields.
Martin Pelletier, CFA is a Portfolio Manager and OCIO at TriVest Wealth Counsel Ltd, a Calgary-based private client and institutional investment firm specializing in discretionary risk-managed portfolios as well as investment audit and oversight services.