ONE REASON BANK STOCKS LOOK ATTRACTIVE

The fundamentals for Canadian banks stocks don’t appear to support multiple expansion, but one important valuation measure suggests they are more likely to be upgraded than downgraded.

The Big 6 banks begin reporting third-quarter results on Aug. 25, and TD Securities analyst Mario Mendonca is forecasting earnings-pershare growth of just three per cent, which is below the five-per-cent year-over-year growth generated in the first half of the year.

Higher provisions for credit losses, the lack of acquisitionrelated catalysts, somewhat higher losses in oil and gas portfolios, and general weakness in the Canadian economy have helped drive the largecap banks down about six per cent on a market-cap weighted basis so far in 2015.

As a result, the big banks are the third-worst performing sub-sector in the S&P/TSX composite index, behind only energy and materials.

Mendonca uses two valuation measures to make calls on the sector: forward price to earnings, and price to book versus excess return. The latter is giving him more confidence in bank stocks.

At a current return on equity of 16.5 per cent and a bank five-year bond yield of 1.8 per cent, the banking group’s P/B of 1.8x is at a 20-per-cent discount to the implied P/B.

“History shows that as the banks approach a 20 per cent discount to the implied P/B it pays to be more bullish — but only if one is confident in long-term structural ROEs,” Mendonca told clients.

He noted the banking group during the financial crisis fell to a 40-per-cent discount to the implied P/B as investors lost faith in the sector. As banks become more conservative with capital due to factors such as increasing mortgage risk, the analyst anticipates their combined ROE will trend down to 15 per cent in the next two years. But even at that level, Mendonca noted the group’s P/B would still be 13 to 14 per cent below the implied P/B.

He noted that at a book value of 1.8x, the group’s current P/B is consistent with a long-term ROE expectation of roughly 12 per cent, something that is possible during times of stress, but not a level Mendonca thinks the banks are heading to.