Short the banks?!

By Guest Blogger Ryan Lewenza

Here we go again! For a number of years now investors have been trying (unsuccessfully) to bet against the Canadian banks by “shorting” them (shorting involves selling shares first with the expectation they will decline in price then buying them back at lower prices). The most recent big player to jump on this trade is US portfolio manager Steve Eisman. Anyone who has seen the movie (or read the great book by Michael Lewis), The Big Short, may recognize this name, as he is famous for calling the US housing market top and made millions by shorting the US banks before the financial crisis. The actor Steve Carell portrayed him in the movie. Well, he’s back at it, this time shorting the Canadian banks, largely based on his concerns around the Canadian housing market. Will he be right again?

The short thesis on our banks is that our 20 year plus housing bubble will inevitably burst, taking the Canadian banks down with it, similar to the US experience during the 2008 financial crisis. I believe this thesis is overly simplistic and misses the mark on a number of fronts.

First, there are a number of differences between US and Canadian mortgages, which I believe make us less vulnerable to a 2008-like US housing crash. In the US most mortgages are “non-recourse”, which means the homeowner can simply walk away from a home that is underwater (outstanding mortgage is higher than the home value), with little additional consequences. In Canada most of our mortgages are recourse loans, which means the lender can go after the homeowner for any shortfall if they default on the mortgage. This could include garnishing future wages, for example. Additionally, most mortgages are insured by the CMHC putting the Federal government, rather than the banks, on the hook for a mortgage default. These two important differences help to reduce risk for our banks.

Second, the Canadian banks are less leveraged to the housing sector and overall Canadian economy than they once were. During the financial crisis our banks were able to take advantage of their relative strength and stability by acquiring large US financial institutions on the cheap. TD Bank, Royal and others made large US acquisitions, which has significantly increased their exposure and revenues to the US markets. Roughly 25% of Canadian bank revenues now come from the US. TD Bank, for example, now has more branches in the US than in Canada!

Third, the banks are trading at attractive valuations making them less vulnerable to significant downside pressure. Currently the Canadian banks are trading at an attractive 10x earnings, which is more than one standard deviation below the long-term average. Shorting Tesla at 60x earnings makes more sense to me than shorting the Canadian banks at 10x earnings.

Canadian Banks Trade at an Attractive 10x Earnings

Source: Bloomberg, Turner Investments

Fourth, current valuations suggest good upside over the next few years. Below is a great chart that overlays 2-year forward returns with bank P/Es. At 10x earnings currently it suggests returns of 20% plus over the next few years based on this historical relationship (Note: the P/Es are inverted to better capture this important relationship).

Attractive Valuations Suggests Good Upside over the Next Few Years

Source: Bloomberg, Turner Investments

Fifth is earnings and I suspect this is where the short sellers believe they are going to make their money. Having worked at one of the big banks for 15 years (the green one), I had first-hand knowledge of their incredible earnings power.

You know how you gripe every month about your banking fees and high credit card charges. You can hit back at them by owning and profiting off them. Speaking about profits, banks make a lot of them. Below I show the total annual bank earnings over the last 25 years. See a trend here? Earnings have grown 13% annually since 1995 and are approaching the $50 billion level in total annual profits. Barring a complete economic meltdown, which we believe is highly unlikely over the next few years, I don’t see this trend ending anytime soon.

Annual Big 6 Bank Earnings

Source: Bloomberg, Turner Investments

Lastly, short sellers need to cover the dividend yield, which is roughly 4% for the Big 6 banks. Add in the margin loan expense in shorting stocks (roughly 5%) and the short seller would need bank stocks to fall 9-10% before they even make a dime!

We’ve written ad nauseam about our concerns over Canadian housing, buy don’t misinterpret these concerns for some deep seated worry around our banks. We don’t foresee a 2008-like US housing crash and, as we’ve laid out in this blog post, we believe the banks remain very strong and should be core holdings for long-term investors. We, of course, get our bank exposure through broad-based ETFs and, in fact, have been adding to beaten up dividend ETFs in client portfolios, which include the banks as top holdings. If my chart above proves correct, we could be looking at decent returns from the banks over the next few years. So Steve Eisman, take that!

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.