Roaring back

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   By Guest Blogger Ryan Lewenza

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Humility is an important quality in my line of work as arrogance and hubris can lead to big financial losses. But today my humility takes a back seat as I’m going to take a ‘victory lap’ for a good call I made last year.

Canadian dividend stocks took it on the chin in 2020, in large part due to weakness in the Canadian banks. I highlighted this weakness as a buying opportunity in a November blog post titled “What’s up with divy stocks?”. Well, right on cue, they’ve come roaring back, with Canadian dividend stocks up double-digits this year (the iShares S&P/TSX Canadian Dividend Aristocrats ETF is up 17% year-to-date).

In the blog post I noted that the conservatively-run Canadian banks often overestimate their loan losses in economic downturns and when the economy turns back up, the banks start reversing their earlier loan losses, which helps boost earnings and share prices.

Quoting from the blog post:

“Now the cool thing about this is that the peak in loan losses generally marks the bottom in bank share prices with large gains following in the first and second year following the peak. This is one key reason why I’m advising our clients to stick with their dividend stocks and in fact, that they continue to add to them. I see dividend stocks doing much better next year in large part due to my bullish view of the Canadian banks. Patience will be required as Covid-19 is surging again and the Canadian economy remains under pressure, but this patience should be rewarded with nice gains in 2021.”

Well that’s exactly what’s played out this year, as the banks are reporting strong earnings results and big share gains.

Canadian Dividend Stocks Come Roaring Back

Source: Stockcharts.com, Turner Investments

The banks have reported their second quarter earnings over the last few weeks and the results have been impressive! Why? Those reversing loan losses.

Starting with ‘Big Blue’, Royal Bank reported blow out numbers with total profit of $4 billion dollars. That’s $4 billion in just 90 days! On a year-over-year basis this equated to growth of 176%. This time last year the banks were reporting huge loan losses as they tried to estimate what the fallout would be from the pandemic. Since the economic hit was less severe and the recovery quicker than most expected, earnings have come surging back. TD Bank reported earnings growth of 150%, while CM saw the largest growth increase at 327% yoy (they took a bath in Q2/20).

The banks cited stronger investment banking earnings but also lower loan loss provisions. Royal Bank, for example, took a $2.8 billion write off in Q2 2020 but this quarter they actually ‘released’ some of their previous loan losses, meaning, they do not see those loans now going bad. When banks ‘release’ these previous loan losses they flow right to the bottom line.

This is exactly what I called for in my earlier blog, hence my self-congratulatory ‘victory lap’.

‘Big Six’ Banks Q2 Earnings Growth YoY

Source: Bloomberg, Turner Investments

Looking out over the rest of the year, the banks are projected to grow earnings at a solid clip so this could help push bank share prices even higher.

And there could be even more good news on the horizon as I see dividend increases coming soon from many of the banks. OSFI, which is the main Canadian bank regulator, has restricted the banks from dividend increases or stock repurchases since the pandemic hit. Given the uncertainty of the pandemic and economic shock this was a prudent move. This is another good example our strict regulatory oversight of the banks and why I believe we have the strongest banking sector in the world. But now as the vaccinations pickup and the economy rebounds I expect OSFI to ease these restrictions, which could lead to some nice dividend increases in the coming quarters.

Below is a chart of cash and short-term investments held on the balance sheets of the Canadian banks and with them holding back on dividend increases we’ve seen a big increase in cash and assets on the balance sheet, which could be used to fund future dividend increases.

Lastly, banks remain attractively valued at 10-11x earnings and banks tend to do better in a rising interest rate environment, which could be a strong tailwind for the sector.

So last year we called for the banks and dividend stocks to rebound this year, which has turned out to be a prescient call. But I see more tailwinds ahead so I think there’s more upside to come in the banks and Canadian dividend ETFs. We sure are happy that we added to them last year!

Canadian Banks are flush with Cash

Source: Bloomberg, Turner Investments

Ryan Lewenza, CFA, CMT is a Partner and Portfolio Manager with Turner Investments, and a Senior Vice President, Private Client Group, of Raymond James Ltd.