Housing Slowdown Makes Bank Stocks More Attractive

Canadian bank valuations have plunged in the past four years amid a slowdown in the housing market, making the country’s lenders including Toronto-Dominion Bank and Bank of Nova Scotia more attractive to investors.

Bank stock values closely track resale home prices, which rose at the slowest pace in almost four years last month, a Bloomberg chart shows. As a result, Canadian lenders are trading at about 11 times earnings, down from almost 19 in September 2009.

“We think the banks are really cheap,” David Baskin, president of Baskin Financial Services, whose Toronto-based firm oversees about C$500 million ($482 million) including bank shares. “People will become more comfortable with the Canadian housing market again and they’ll recognize that these fears were overblown.”

Bank stock valuations have been a leading indicator to the changing pace of resale home prices since 2009, Bloomberg data show. The ratio of stock price to earnings for Canada’s eight-largest lenders soared in February 2009, about three months ahead of a surge in the growth of home prices, according to Bloomberg data. Bank stocks were most expensive at the end of September 2009, while home prices peaked in May 2010.

Banks Index

The chart is based on the year-over-year growth of the Teranet-National Bank Home Price Index and the price-to-earnings ratio for the Standard & Poor’s/TSX Commercial Banks Index. The index is comprised of Royal Bank of Canada, Toronto-Dominion, Scotiabank, Bank of Montreal, Canadian Imperial Bank of Commerce, National Bank of Canada, Laurentian Bank and Canadian Western Bank.

The price-to-earnings ratio of the banks index has fallen to 11.1, from a high of 18.6 in September 2009. The annual growth of Canadian home prices has followed a similar trend, declining to 1.8 percent last month from 12.7 percent in May 2010, according to the Teranet-National Bank index. Bank shares are cheaper than three years ago amid a slowdown in home price gains and prospects of rising borrowing costs.

Bank stocks will quickly regain their value when it becomes clearer to the market that housing has bottomed out and starts showing improvement, said Mario Mendonca, an analyst with Canaccord Genuity, a Toronto-based firm that charted the correlation between bank valuations and home prices in a June 17 note to clients.

‘React Aggressively’

“Bank stock valuations will recover,” Mendonca said in a July 10 telephone interview. “What I’m suggesting is it will not be a gradual thing: bank stocks will react really aggressively.”

Banks shares are already starting to rally. The eight-member banks index has risen in four of the past five weeks, gaining 3.3 percent over that time.

“I’d expect to see bank valuations move up again,” Franklin Templeton Investment’s David Tuttle said in a July 12 interview from Toronto. “The price-to-earnings chart for the banks is currently trending well below where it had been for the last 10 years, and that is a reflection of a slower growth economy.”

Spokesmen for the eight Canadian banks either declined to comment or didn’t immediately provide comment on the story.

“The housing market is a reflection of consumer sentiment,” said Tuttle, a research analyst at Templeton Global Equity Group, which manages $105 billion in assets. “If the consumer becomes a little more concerned about economic growth going forward, you tend to see loan growth come off in a big way for the banks, which is a huge driver of profitability.”

Shifting Focus

Canadian banks have been shifting focus to business lending and wealth management to counter a slowdown in domestic consumer lending, the largest business segment for the firms. Canadian personal and commercial lending accounted for as much as 68 percent of last year’s profit at CIBC, for example, according to financial statements.

Canadian home resale prices increased last month at the slowest annual pace since October 2009, led by declines in Vancouver and Victoria, British Columbia, according to the Teranet-National Bank index. Prices rose 1.8 percent in June from a year earlier, based on an 11-city composite reading, the July 12 report by Montreal-based National Bank Financial said.

“That should make people happy,” Baskin said. “That means there’s less people buying at terribly inflated prices, so they’re not paying too much and the banks don’t have as much to worry about, about prices declining.”

‘Constructive Evolution’

The Teranet report adds to evidence that Canada’s housing market is becoming a drag on the economy, a slowdown that has been encouraged by policy makers to quell overbuilding and rein in borrowing. Bank of Canada officials have said there are signs of “constructive evolution” in household finances.

Canada’s economy will expand 1.7 percent this year -- the slowest pace since contracting in 2009 -- and 2.4 percent in 2014, according to median forecasts of analysts in a Bloomberg survey. That lags behind the U.S., whose economy is expected to expand 1.8 percent in 2013 and 2.7 percent next year, according to a separate survey.

Economists expect the Bank of Canada to raise interest rates in the fourth quarter of next year, when the overnight rate will move to 1.5 percent, from 1 percent now, according to the Bloomberg survey’s median forecast.

Bank of Canada Governor Stephen Poloz kept the main rate unchanged today at his first policy decision and said there will be a “gradual normalization” of borrowing costs over time as slack in the economy disappears and inflation picks up.

Mortgage Rates

Royal Bank raised its mortgage rates three times since June, with rates at 3.69 percent for a five-year fixed term loan compared with 3.09 percent at the beginning of last month. Toronto-Dominion, Scotiabank and Bank of Montreal followed with mortgage rate hikes.

Even as bank valuations have dipped, the banks are still relatively expensive compared with lenders in other countries, Franklin Templeton’s Tuttle said.

“Canadian banks do not offer valuations at what we would consider bargain levels,” he said. “We are finding substantial opportunities in Europe because the valuations are just screaming cheap there. Even in the U.S. on a relative basis banks just offer a great deal more value.”

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