A modest erosion in the Big Five banks' average return on equity understates the problem they face.Mark Blinch/Reuters
Report on Business columnist Rob Carrick recently pointed out that Canadian bank stocks are a major component in the portfolios of top-performing dividend funds. Bank stocks may comprise up to 47 per cent of these portfolios with Royal Bank and Toronto-Dominion the favourites among the Big Five banks. This preference is understandable: Not only have these banks provided a generous yield, they have increased dividends by over 10 per cent a year since 2011. To be fair, the other banks have been no slouches with annual growth in dividends in the range of 4 per cent to 7 per cent over the same time frame.
So much for the past: Are Canadian bank stocks capable of delivering a similar trajectory in dividend growth in the future? It will be a struggle, based on my formula for estimating look-ahead profit growth.
At first glance, Canadian banks remain highly profitable: Five years ago, the Big Five enjoyed a return on equity in the high teens with an average of 18.2 per cent. In the financial year ended October, 2015, the return had edged down to the mid-teens with an average of 15.5 per cent. Most Canadian corporations would be delighted with a return on equity of 15.5 per cent. The typical company listed on the TSX earns about 13 per cent on its equity over a complete business cycle, but this modest erosion for the banks understates the problem they face.
Return on equity in any given year reflects not only current management decisions and product line profitability, but also the embedded profitability of decisions made in years past. For example, some of today's high-margin products may be in the mature phase of their life cycle. Meanwhile, recent product introductions into a more competitive marketplace achieve much lower margins but make up only a small part of the bottom line. So the downward trend in return on equity does not ring alarm bells initially. If the trend continues, investors slowly wake up to the fact that the company is facing a new level of competition that is eroding long-term profitability and mark the stock price down accordingly.
As a leading indicator of this potential profit erosion, we need to estimate the incremental profitability of a dollar retained in the business and compare that number to the historical average to see whether the trend is favourable.
This seems like a tall order for the individual investor, but we can easily approximate this incremental or marginal return on equity from the table provided in every bank's annual report. Take the book value per share for the current year and deduct the book value per share five years ago. This represents the amount of additional common equity retained in the business by management over that time frame. Now, do the same for earnings per share to see how much extra the company earned on that incremental equity. Divide the increase in earnings by the increase in book value and you are looking at marginal return on equity. How does this compare with the recent average? If it is a lot lower, then the company is facing some kind of profitability headwind that you need to investigate.
I can already hear management protesting that this calculation is very dependent on starting and ending dates, so you should certainly repeat the exercise over several time periods – there is nothing magical about five years. Also, an emerging-growth company may argue that they are investing in the future and that this calculation emphasizes immediate payback over R&D spending, but this argument carries less weight with a mature multinational corporation such as a bank.
Turning to the Canadian banks, the recent average return on equity of 15.5 masks a more dramatic erosion in marginal return on equity to an average of 10.8 per cent. Only Royal Bank achieved a score in the high teens – the other banks were clustered in a range of 7 per cent to 11 per cent. If this trend persists, then average return on equity will gravitate toward 11 per cent at best. With a 50-per-cent payout ratio, growth in dividends will struggle to exceed 5 per cent.
Erosion in the marginal return on equity can be triggered by several financial ratios: deleveraging a balance sheet, a margin squeeze on traditional product lines caused by new entrants to the industry, lower asset turnover as customers shop from a wider product range, or a higher tax rate. Some of these possible threats to the banking industry may prove to be ephemeral, but deleveraging the balance sheet is a trend that is likely to persist as long as banks are seen as too big to fail.
Canadian bank stocks provide a generous current yield of 4 per cent or better and trade at about 11 times earnings, so they are not in danger of imminent collapse. Part of their attraction to investors has been the robust growth in dividends over the past few years. The recent trend in marginal return on equity may not erode all the way to 11 per cent, but we should look for lower dividend growth in the future.
Robert Tattersall, CFA, is co-founder of the Saxon family of mutual funds and the retired chief investment officer of Mackenzie Investments.