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About this podcast

This episode, Stu Kedwell, Head of North American Equities, takes a look at year-end earnings from Canadian banks, and what these results could signal for the broader economy.  [15 minutes, 59 seconds] (Recorded: December 6, 2022)

Transcript

Hello, and welcome to the Download. I'm your host, Dave Richardson, here for everyone's favorite day of the week, Stu’s day, as it's just taking over the country, this whole Stu’s day thing. Everywhere I turn, it's Stu’s day!

Something like that, Dave.

Maybe not quite that much, but maybe one day.

Extremely small pockets in the country.

Yes, our parents...

That's right.

My mom gets pretty riled up about Stu’s day. So Mom, hi! Thanks for all your love and care through my little bout with pneumonia. Now, I got to say, this is going to be a particularly exciting Stu’s day, because we've gone over in previous episodes, for people who watch regularly, but for people who don't listen regularly, Stu gets pretty excited about cleaning up the weeds around the yard, making sure his lawn is absolutely pristine in the summer. But it's not just a summer thing. He gets pretty excited about cleaning off the driveway when it snows in the winter. Meticulous, you might say. And I'll just take a sip of coffee here in advance of talking about how excited you get about dollar cost averaging. Those are things that really get you going, aren't they?

Yes, it's not a long list. Those are on the list for sure.

I should mention that your wife and kids are somewhere in there too.

Yes, they're definitely on the list, too.

But nothing gets Stu more excited than bank earnings, especially year-end bank earnings. If you've been a dividend portfolio manager for 100 years like Stu, there's nothing that gets you going like Canadian bank earnings. And we're through all of them now, right, Stu?

Yes. There is something more exciting, though. It's the ex-dividend dates. When the dividends get clipped.

When the dividends get clipped.

When they get into your account, that's a pretty exciting day.

The actual receipt of the dividends. Or maybe even a dividend increase announcement, which I think we got a couple of this quarter. So what did you see in the Canadian bank earnings? Because they tell a story about where we are in terms of the Canadian economy. They give a window into a lot of things that are going on around the world. What did you see in the bank earnings this quarter and for this fiscal year?

Yes, let's just start with the top of the income statement. The first part was the net-interest revenue, and some banks had better success than others on that front. When interest rates are rising, net-interest margins often expand. But as you can see with GIC rates and some other things, the funding side of the balance sheet also played a role. So net-interest margins expanded at a handful of banks, but maybe not as much as people had hoped for, across all the banks. Loan growth was not bad, although it felt a little bit like seeing the last of a really strong loan growth with maybe the economy starting to slow a little bit. So all in, net-interest income was, I would say, okay. Non-interest revenue was a little bit more sluggish, just with capital markets and things like this being slow. So, the revenue environment was pretty much as expected. There was not a whole lot of surprises other than, at some banks more than others, net-interest margins were not expanding. Some banks had really strong increases. And those are normally the banks where you have a really large deposit franchise, and not only that, but those deposits are used in day-to-day transactions, so they tend to be pretty sticky, and they don't move into higher-interest rate product because I'm using them all the time. If I got $100 in my account and I'm getting paid and I'm using it for transactions, I don't sit there and say, well, I got to go move that necessarily to higher interest rates because I got to use it. So this big float that exists inside some banks is quite a benefit when interest rates rise for those banks. So that was one feature. And then the second thing was provisions for credit. They were okay, but still, with the sense that that too might be a little bit higher going into next year. I would say the net of it was, they were pretty much in line with expectations. The outlooks were not too far off where people's heads are at; that is, things are slowing down a little bit. Capital ratios were pretty good. A couple of banks have put on their dividend reinvestment plans, which they often do going into a slower period. And then the last point I would make is that the sands of time march on. Already we're starting to look at what 2024 earnings might look like. And so in Canada, out of six banks, three have done acquisitions, and those acquisitions are going to drive earnings growth into 2024. You're focused on the here-and-now, but then you're also looking out to what 2024 might bring, and those acquisitions should bring additional accretion above and beyond what normal bank earnings look like. So, we're focused on that as well.

Stu, how do you think about acquisitions when you're looking at the Canadian banks and banks in general? That three out of six had an acquisition that they've announced recently— or they'll be in the midst over the next twelve months—, what does that say about the state of the industry? Why do you think this is happening? Is there any message that we can take away from the fact that these transactions are happening? And then, how do you think about a transaction from an investment perspective as an investment manager?

There are all sorts of acquisitions, and I think right off the bat, there are two things to consider. Banks are big generators of cash flow. Their earnings come in, they pay half of it back to us in dividends, they keep the other half. They can then make all sorts of decisions around how fast they grow loans. If they slow down loan growth, that generates incremental capital. And when you do an acquisition, you can either use the resources that exist on your balance sheet and normally those acquisitions can be quite accretive, or you can issue your shares to buy something, and those often are not quite as accretive. The acquisitions that we have right now, by and large, were funded through the capital that's been generated in the last couple of years. Capital ratios went higher. Banks were then able to use that money that was at their disposal to do quite accretive transactions. And those types of transactions are beneficial for a number of reasons. The first is, they generate earnings growth in a normal environment. But also, in a slowdown, they generate what we call pre-tax and pre-provision earnings, which help pay for any credit losses that might come your way. So when we see banks use their balance sheet to both strategically grow their business and add additional cash flow that could be used for any types of provisions that are necessary, those are pretty good acquisitions. When they have to use their shares to buy something, it gets a little bit more complicated because what they're looking for is if the business they're acquiring grow as fast as their existing business? Because you're doing everything on a per share basis. So if I have one business, I have 100 shares outstanding in this business, and it grows at 10%, and I'm going to issue 10 shares for a business that might be accretive today, but it doesn't grow that fast longer term, I have to offset those two to say, well, am I going to be better in 5 or 10 years down the road if you do this? That's a different discussion, but in each of these cases, the three banks that are doing acquisitions, they're both strategically beneficial and financially beneficial, which is always a positive.

As we look out at what this speaks to with respect to the economy, in terms of what you're seeing from bank earnings, is there anything we can call from either the earnings or these acquisitions that suggest or give us a line of sight on where you think we're headed with the Canadian economy in particular— but these are global franchises— so really, globally as well?

Yes, they're pretty confirmatory that we're heading into some type of a slowdown. Whether or not it will be a full-blown recession or a softer landing, that's hard to say right now. A lot of the tightening that gets loaded into the system, which makes loans more expensive, eventually finds its way into loan growth. Loan growth starts to slow. That's one of the main features of economic growth. So we know that the economy is slowing when we look into these results, and we know that the banks are prepared for that. It doesn't necessarily indicate to us that the slowdown is going to be more or less, but it does indicate that, in all likelihood, the economy is going to slow quite meaningfully into next year.

And then the other thing I wanted to take out of your earlier comments about the earnings was somewhat of a surprise that net-interest margins weren't quite as strong as you might have expected, given where interest rates have moved and where we are in the economic cycle. Is that a sign of intense competitive pressures or is it something else? Are these just decisions banks are making around how they're deploying their capital, how they're using their capital within their business?

It's a bit of everything. Banks have what they call liquidity-coverage ratio. They have to hold so much liquidity. And the expense of that has gone up a bit. Just as we've talked about shorter-term interest rates being more interesting from a purchase standpoint, that means that someone has to pay more for it, and banks are in that line. It's the dynamics around the fact that a bank has so many dollars of deposits and so many dollars of loans, and if they don't have what they call a one-to-one ratio, then those extra deposits go into securities. And so, if you have some extra money as security yields have risen, you've been able to benefit from that. If you're closer to one-to-one and you have to pay a little bit more for your deposits, then it's more painful. So it's bank by bank, but in that context, the deposit cost angle is a little bit more competitive and it sometimes takes time for loans to reprice. So if you're one-to-one and your loans haven't fully repriced yet, and you had to pay more for deposits, then your net-interest margins don't expand at the same pace. If you're not one-to-one and you've been able to put more money into securities, they may have expanded a little bit more meaningfully. It's very bank by bank. It has some dependence on how you are positioned going into all of this. So, it's based bank by bank.

So I know we have to be careful on this particular podcast because of regulation in terms of how specific we get around any kind of recommendation. So we're not going to ask you for a recommendation even on Canadian banks. But when you look at banking in general around the world, given where interest rates are, where the economies are, are banks looking like an attractive long-term investment right now? Or do they look expensive relative to normal valuations given where we're going? And then is it unfair to even categorize the banks? As you said before with the previous question, is it more bank to bank where you're making those decisions?

Well, generally speaking it's an attractive longer-term industry and the reason for that is because there is a spread available and as you lend money and you have wealth management, there's ancillary business to be done. So it is a good long-term business. The next twelve months, as interest rates peak, in all likelihood, there will be dynamics at play. Some of the banks that have benefited from rising interest rates, that benefit will start to mature. Some of the banks that may have been penalized by having to pay higher for deposit costs now, that headwind might start to ebb. So it is always bank to bank. But on the intermediate term, because of that very first dynamic that banks don't pay out 100% of their dividends, they have excess capital which they can put to work in loan growth. During a period of recession, they may have to set aside a little bit more for provisions for credit. But having a capital generative business over the long haul is something that aligns quite nicely with long-term investment.

And banks are, because of the attractiveness of the dividend, something that you've generally held quite a bit over the years in portfolios you've managed. And as you say, it continues in your view to be a pretty attractive business long term.

Yes, we've owned banks in all sorts of different environments and the risk management that takes place inside banks is unbelievably significant. The number of levers that they have to pull to get through all sorts of things that come to mind. We've talked about business in general being agile and a bank's balance sheet is quite agile over time, so we feel pretty good about the sector as time progresses and they've proven it over time. They've dealt with all sorts of things in a fairly productive manner.

Wow, you have once again bowled us over with your level of excitement around this. I knew this was going to be your favorite topic. Pre-Christmas, I thought it would be a nice gift to give you as your podcast for December.

Well, thanks very much. That's a December to remember.

Oh wow, there we go. So a Stu’s day in a December to remember. Stu Kedwell, foremost expert on bank stocks and dividends. Stu, thanks very much. We'll catch up with you next week.

Great. Thanks very much, Dave.

Disclosure

Recorded: Dec 6, 2022

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