Why banks remain compelling for long-term investors

If you can handle potential for upcoming volatility, this is a good entry point

Why banks remain compelling for long-term investors

With all but one of the second quarter earnings of the big six banks now in, it’s obvious that the sector is holding up pretty well – and still offers good long-term opportunities for advisors’ clients.

“The banks are priced for very, very bad news with some serious pressure on earnings, which you’re just not seeing,” Rob Wessel, managing partner of the Toronto-based Hamilton ETFs told Wealth Professional.

“But history has been very kind to long-term investors who have bought Canadian banks at nine times earnings. You don’t get those valuations when there are rainbows and sunshine. We get those valuations when there are storm clouds.

“The question is: is the storm going to be severe enough to harm the foundations of the sector, i.e. the capital or credits or profitability? And, so far, that’s not been the case. So, for the long-term investors, these are very compelling valuations – if you’re in for the long-term, as long as you’re okay with working through some of the possible volatility over the next couple of months. But, if you’re a long-term investor, then history would suggest that this is a favourable entry point.”

Several banks that reported have shown disappointing results with provisions for loan losses going up and expenses remaining elevated. They have been setting aside more money than anticipated to cover bad loans, which has eaten into their profit because of the darkening economic picture.

Overall, however, Wessel said that, notwithstanding the environments and market sentiments, the sector is actually holding up pretty well. Although National Bank still has to report, the other big five banks’ earnings have been solid. Even though loan losses are rising, the capital markets are fine and credit is holding in.

“The question people need to think about is: is credit deteriorating? Or is credit normalizing?” said Wessel. “It’s doing both. So, losses against impaired loans are still way below long-term averages. It’s true that they’re rising, but, in a historical context, it’s still quite low. The same with credit metrics, so you have to take that into account. How much capital do they have? How much do they have in reserves? The role of reserve builds and the balance sheets of the companies are still extremely strong even though the sentiment is obviously still extremely negative.”

Wessel noted that the provision ratios for impaired loans rose as a result of the pandemic, then fell significantly. But, they are creeping up again after an extended period of very low numbers for the last four quarters. The markets have become very concerned about whether we’re entering an economic recession or slowdown, but Wessel said the impaired loans for the most recent quarter are still significantly lower than their long-term average.

“So, if you look at the general profitability and how the banks are performing, and then you look at credit tends,” he added, “The banks are holding in extremely well, notwithstanding the sentiment.”

“At the end of the day, all global banks or their fundamentals are holding in, but you still have very low valuations,” he added.

“The last thing I would say on the Canadians banks is they’re very cheap. They’re trading just over nine times forward earnings. That has a very, very low heavily discounted valuation. That’s pricing in some very serious bad news. So, Q2 was not as good as Q1, but it was still okay.”