No wonder bank stocks are exploring record highs: The Big Six have survived the pandemic virtually unscathed, raised their quarterly dividends by double digits and are now poised to score financially as the Bank of Canada prepares to raise interest rates.
But with everything seemingly going right for the sector, how much upside is left?
Investors who have held on to the Big Six for the past year have been rewarded with gains of 39 per cent, on average, without including dividends.
That’s better than the S&P/TSX Composite Index, which has risen 18.7 per cent over the same period. It’s also better than the S&P 500, which is up 22.3 per cent in U.S. dollar terms.
The stellar gains support the idea that sticking with Canada’s biggest banks through tumultuous periods is a compelling way to generate strong returns over the long term because of the banks’ uncanny ability to wriggle out of tight spots with gargantuan profits.
The pandemic has certainly put the banks in a tight spot at times. Yet, even though the past two years have raised concerns about the economy, the Big Six reported a combined profit of $57.7-billion in fiscal 2021. That’s nearly 24 per cent more than they generated in 2019, which is the last full year before the pandemic struck.
Now what?
There are several reasons why bank stocks could drift from their current elevated levels. Valuations, often cheap in recent years, are rising to levels that in some cases look average at best.
For example, the Big Six price-to-book ratios, at an average of 1.85, are in line with the 15-year average, according to RBC Dominion Securities.
What’s more, rising share prices have sent dividend yields down. The current average yield is just 3.7 per cent, reflecting recent dividend hikes, down from an average of 4.4 per cent near the start of 2021.
Still, it’s rarely a good idea to bet against the banks, and today is no exception given that there are at least three factors that can sustain the rally.
First, interest rates are likely going up, which is good for banks because higher rates widen the spread between what banks pay on deposits and make on loans.
Gabriel Dechaine, an analyst at National Bank Financial, recently calculated that each quarter of a percentage point increase in interest rates by both the Bank of Canada and the U.S. Federal Reserve will boost bank per-share profits by 0.9 per cent.
That’s a nice tailwind when you consider that financial markets expect that the Fed will raise its key rate in March, after reports of rising inflation – the U.S. rate hit a near 40-year high in December – and falling unemployment. Some observers expect as many as four rate hikes by the Fed this year, and the market expects five hikes by the Bank of Canada.
Second, analysts expect that consumer loan growth will pick up. Credit card balances, for example, are still 15 per cent below pre-COVID levels, according to Mr. Dechaine. That will change as the pandemic recedes and government supports fade. Normalized loan balances, he estimates, should help boost bank profits by about 2.5 per cent.
Lastly, banks can control their expenses as their revenues rise, creating positive operating leverage that will likely feed into profits.
This hasn’t been easy in recent years, given slow revenue growth and the urgent need to invest in digital banking capabilities. But in a note this week, Meny Grauman, an analyst at Bank of Nova Scotia, pointed out that large banks have suggested in recent earnings commentary that 2022 should be a banner year.
“Although they will achieve this in part through ingrained cost discipline, it is underpinned by a very bullish outlook for revenue growth,” Mr. Grauman said in a note this week.
No, bank stocks aren’t cheap. But they’re still attractive.