Sector Scan: As Canadian As... Big Banks

November 6, 2017 Mark Fairbairn

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Holding bank stocks in your portfolio is right up there with tuques and Timbits as a symbol of Canadian identity—it’s hard for us not to invest in them, as this industry represents nearly a third of our nation’s key market index.

Now that 10 years have passed since the start of the global financial crisis, it’s timely for us to revisit the banking sector, at home and around the world. Canada’s has shown resilience next to global peers: surviving the 2008 crisis without a casualty, while the United States and Europe saw numerous bank failures. The Canadian banking system is perceived as the soundest, as ranked by the World Economic Forum survey.

While banks remain a solid and staple investment at home, it’s easy to see this sector’s greatest growth opportunities are abroad and in emerging markets. Your bank of the future might even be a tech company.

Canada’s banks go cross-border shopping

While some 80 domestic and foreign banks are licensed to operate in Canada, our top six banks hold over 80% of market share in assets, deposits and mortgage lending.

Conservative and concentrated, the Big Six are now highly international, with half of their total assets in foreign markets, as reported by the McKinsey Company1, given little room left to grow in a mature home market. For instance, Canadian-owned Toronto-Dominion Bank is now, through acquisitions, the eighth-largest U.S. retail bank by assets.

A business model based on leverage

At its most basic, the banking business model is virtually the same the world over: it accepts deposits and makes loans, as an intermediary between those who have excess capital and those who need it. Banks lend out capital they get from depositors, creditors and investors to third parties.

From there, practices and regulation in the banking sector vary wherever you go. Canadian banks have been strictly regulated, which served us well through the financial crisis. Other countries may allow banks to be more aggressive, take on more leverage and risk, and offer less transparency.

Outside of Canada, it can be hard to see what's behind a bank’s assets, which adds risk to investments; you don't know the quality of their loans; and you don't know if unscrupulous practices might drive any underlying profits.

Narrowing down the opportunities

We think about banks in terms of risk and margin of safety. For instance, to ensure a high margin of safety in our investments, Atlanta-based Earnest Partners, a sub-advisor on the MD International Value Fund, looks for four characteristics in banks: high lending margins, low cost structure, solid underwriting procedures, and solid legal protections for investors and lenders. 

“Banks in international markets that exhibit these characteristics generate superior risk-reward trade-offs...Low leverage and high levels of capital give investors extra cushion and protect them in times of slowing economic growth or rising interest rates,” say the Earnest team.

Earnest focuses on countries where banking represents a small share of GDP and where businesses don’t need to overextend capital or relax credit standards to generate attractive returns.

It sees the best opportunities in places like Brazil, India, and the Czech Republic, from the point of view of profitability and credit performance.

Most important is existence of a legal system that protects investor property rights, and a tested bankruptcy system that protects the rights of lenders.

“We pay extra attention to these matters. For example, the poor system of property rights protection in Russia creates ‘tail’ risks of losing your entire investment if, say, a local Russian Federal Security Service official lays an eye on your company,” say Earnest analysts.

ING: A digital-ready leader in Europe

Europe may be in the early stages of economic recovery, but its banking sector is still a lightening rod to public sentiment, roiled by events from Brexit to political unrest to the decline of southern economies.

Even as the banks’ business improves, a more positive backdrop is tempered by an uncertain regulatory environment. Valuations are generally attractive, but include a built-in risk premium, so investors need to be selective.

In this context, sub-advisor AGF singles out ING as a favourite European bank. “It has high return on equity, a strong balance sheet, high capital levels and good capital generation capability. Further, we believe they are a leader in digital banking, and they continue to gain market share, enabling the company to generate loan growth even in conditions where there is little industry loan growth.”

J.P. Morgan: A U.S. giant still stands to gain

AGF is far more positive on U.S. banks, expecting this sector to benefit from rising interest rates and a “lighter” regulatory environment.

“Over the long-term, J.P. Morgan is the bank where we continue to have the highest conviction,” says the investment team, citing earnings power, market share gains, diversified revenue streams, and a strong customer service culture.

“Historically, J.P. Morgan has generated returns above its cost of capital, and we expect it will continue to do so in the future. Further, any excess capital may be returned to shareholders in dividends or share buybacks. Despite the strong share price performance, we believe there is still long-term value in the stock.”

Why the next big bank will be a tech platform

As technology disrupts the banking world, consumers in emerging markets have been the first to quickly adopt new models of banking, at ease to do everything via a smartphone. Technology platform companies such as Alibaba Group, Amazon, and Tencent Holdings, are staking claims into traditional bank boundaries.

In just four years, a spinoff of Chinese e-commerce giant Alibaba Group has accrued the world’s largest money market fund, designed for AliPay, counting more than 370 million account holders and over $210 billion in assets—it’s named Tianhong Yu’e Bao Money Market Fund, translating to leftover treasure.

Tencent Holdings—an MD holding we wrote about in March that’s not a bank stock–is a leader in mobile payments through its stake in China’s first private online bank, WeBank. WeChat Pay runs on the popular instant messaging app WeChat that has 889 million users.1

All in balance: we’re holding back a bit

MD portfolios are underweight in the banking sector relative to market indices, both at home and internationally. While banks dominate Canada’s capital markets, there’s a big world out there and we are part of it, through our careful selection of investments.

We think banks can add value, but we also have other opportunities at our disposal to improve portfolio performance.

We view these investments in context of opportunities available across sectors, whether in health care, consumer products or even the restaurant business—where, yes Canada: there is a Timbit or two in our portfolios through a holding in Tim Horton parent company Restaurant Brands International (RBI).



1 The new dynamics of financial globalization, McKinsey Global Institute, August 2017. [Links to PDF (english only):
McKinsey Global Institute The New Dynamics Of Financial Globalization

 

Mark Fairbairn

Mark Fairbairn, CFA, B.Eng., is a Senior Investment Analyst with the Investment Management team at MD Financial Management. He is responsible for the non-North American equity funds and pools as well as the currency overlay program within the equity funds.

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