A new commentary explains how turbulence could arise — and why that’s not necessarily bad news for investors
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Canada’s financial giants have been the subject of increasing short-seller interest this year as challenges in the economy are expected to impact their business. Other developing risks may add to their pain in the coming years — though that may not be a bad thing for investors.
“We believe that in the next two years the Canadian banks are likely to experience higher volatility,” wrote analysts at Hamilton Capital in a recent note.
One key threat comes from rising acquisition risk, particularly for Canadian banks with US commercial banking platforms. Based on recent high-profile bank mergers south of the border, the note concluded that US bank mergers and acquisitions are in a position to accelerate.
Given the strategic significance that US platforms have for banks’ expansion plans, those with US platforms will likely feel pressure to continue on their acquisition path. As competition to purchase companies is likely to heat up, it creates a significant potential danger for bank share prices.
“In the last 20 years, one constant in bank valuations has been the tendency for multiple compression/volatility post large acquisitions,” the authors said. “It is very easy to envision an acquiring bank losing 0.5x-1.0x of its relative price-to-earnings multiple after announcing a larger transaction.”
The note tagged TD as the bank most at risk, citing its lower-quality Southeast platform built mostly from failed/failing US banks, its apparent intention to find a deal given its higher capital ratios, and its lack of a US commercial bank acquisition in the region since 2010. “However, BMO, CIBC and RY are also potential acquirers thereby increasing acquisition risk,” it said.
Another likely source of additional volatility — both upside and downside — is a change in accounting for loan losses. “To simplify, the banks transitioned last year from an ‘incurred loss’ model (i.e., report losses when they occur) to an ‘expected loss’ model (i.e., book estimated losses before they occur),” the note explained.
With that change, the banks now have to make forecasts of loan losses in their existing loan portfolios based on their outlook for the broader economy. Market watchers saw a possible sign of impending uncertainty in this area last quarter as loan losses — one of the two most important drivers of bank-earnings volatility, aside from capital markets — underwent greater-than-expected step-ups across a number of banks.
“Reduced visibility in this critical expense will very likely make it more difficult for analysts to forecast quarterly EPS, increasing the probability of beats/misses and resultant share price volatility,” the note said.
Assuming banks’ share prices see heightened, the note said, it could be favourable for the Hamilton Capital Canadian Bank Variable-Weight ETF (HCB). Focused on the Big Six, the fund aims to benefit from historical mean-reversion tendencies of the banks, particularly in times of greater market volatility.
“At the end of each month, the three most oversold banks are rebalanced to represent ~80% of HCB, while the three most overbought banks are rebalanced to 20%,” the note said. “If either or both of these issues create volatility – and mean reversion persists – this could favour the Hamilton Capital Canadian Bank Variable-Weight ETF over an equal-weighted portfolio of Canadian banks.”
