Are Canadian Banks Overvalued?

Royal BankIt seems these days that caution has been thrown to the wind, and investors have been looking for higher yields and even better returns on investment.  With blue chip stocks paying dividend yields higher than government bonds and some corporate bonds, it’s no wonder dividend stocks are the flavour of the month.  A lot of attention has been centered on the Canadian Banks lately, and with yields of 3.5% to 4.7%, these stocks are looking attractive to investors.  But with three of the six big banks trading near their 52 week highs, and all six trading at or near 2007 price levels, are Canadian Banks Overvalued?

Why investors are buying Canadian Banks

Let’s look at some reasons why Canadian Bank stocks are suddenly so popular, and why investors are flocking to them:

  1. In Canada (unlike the US) banks are regulated by the Federal Government. Their balance sheets are in good shape, their leverage is low, and they avoided (to a large degree) investment in the sub-prime market.  While European and US Banks faltered during 2008 and 2009, Canadian Banks did extremely well in the global economy.  Canadian Banks are viewed by many economists as the safest banks in the world.
  2. Unlike US and European Banks, Canadian Banks did not need elaborate rescue packages or bail-outs from government. Not a dime went into Canadian banks from the government piggy-bank. While loan provisions tightened up during 2009 and 2010, unlike US banks, Canadian Banks still lent money to credit worthy customers and businesses.
  3. Countries like China and Russia, that normally buy US dollars to hedge economic conditions, invested in Gold and Canadian Dollars instead of US Dollars.  As well as our strong resource based economy, this helped strengthen the Canadian Dollar. This gave Canadian Banks more solidity than their US counterparts, and helped attract foreign investment into Canada instead of the US.
  4. Canadian Mutual Fund, ETF, and Pension Fund managers are the largest buyers of the Canadian Banks.  Because most mutual funds and ETF’s are not mandated to hold large amounts of cash, they must always remain invested in the market. They have no choice but to buy the banks, even when these stocks are trading at their 52 week highs.
  5. Canadian ETF’s that track the TSE and TSX-60 have seen enormous contributions to their products (over mutual funds). Because Index ETF’s follow the TSE or TSX-60 for example, like mutual funds, they must buy the stocks (regardless of price) that comprise that index – that is also the big six banks.

How well did Canadian banks recover?

How well did banks recover from the Crash of 2008? In February 2009, Canadian banks were hit hard form investors selling their shares, due to US and European banking fears. Ironically Canadian banks were in sound fiscal shape, as they were not holding sub-prime assets. Like most blue chip companies, banks were decimated and trading at their all time lows, some at half of their share value from a few months previously in 2008 (see table below). Now in October 2010 banks have recovered their share price and are trading above or near their 2007 prices (before the crash). The results I have complied below show an astonishing recovery:

Bank Name Symbol (TSE) Current Price 2009 Low Price Change Recovery
Bank of Montreal BMO 60.11 28.29 31.82 112.5%
Bank of Nova Scotia BNS 55.07 31.07 24.00 77.2%
CIBC CM 76.46 45.88 30.58 66.7%
National Bank of Canada NA 65.42 31.30 34.12 109.0%
Royal Bank of Canada RY 55.00 30.41 24.59 80.9%
TD Bank TD 75.30 43.46 31.84 73.3%

The real question:  are banks maxed out or is there room for more growth?  The answer to that question depends on whether you think we are in the first year of a bull-market or on the verge of a major correction or double-dip (though the stock market tends to be a leading indicator).  Regardless, Canadian Banks have shown astonishing resilience and recovery during the financial crisis, and look well suited for future growth.  And the prospect of Canadian Banks raising their dividend yields is very promising.