About a year ago, I wrote about the “Great White Short”. As a recap, a prevailing thesis for several prominent investors south of the border was that Canadian banks would face significant hardship in the next recession. The basis was a view that the Canadian consumer was stretched financially, the housing market faced collapse and the Canadian banks had been overly aggressive in underwriting. They predicted various doomsday scenarios would follow, ranging from significant underperformance for Canadian bank shares to bankruptcy for those banks unfortunate enough to have one too many mortgages on their books.
One year later, what has happened? To start off, no Canadian bank has gone bankrupt – none even came close. To be clear, operating earnings per share (EPS) [which takes into account the effect of higher provisions for loan losses] did fall substantially in 2020, with a median earnings drop of 18% for the Canadian banks. Provisions for loan losses (PCLs) went up over 100%, which is substantial. When we look at the earnings behaviour of the Canadian banks versus their US counterparts, widely considered to be better capitalized and having less risk, Canadian banks did comparatively better. We can also see this in relative share price performance, with Canadian banks so far outperforming their US counterparts. So far on a year to date basis, provisions are no longer growing – in fact, they are shrinking. The talk today is about the potential for capital releases, dividend increases and restarting share buybacks.
Source: BMO Capital Markets
*Canadian Big 6 banks are BMO, BNS, CM, NA, RY and TD. US Money Centre banks are JPM, BAC, WFC and C
Source: S&P Capital IQ
This example illustrates how difficult it can be to accurately predict the future, which is part of the reason why we typically do not base investment decisions solely on our predictions for the future. For example, two years ago, even if someone accurately predicted that we would enter one of the worst recessions since the Second World War, that same person likely would not have predicted how unevenly the recession would impact different industry groups. Amazon’s business has never been better throughout this recession, while 10,000 independent restaurant chains have closed in Canada. Perhaps the doomsayers could have been more right about Canadian banks, had governments elected not to pursue massive fiscal and monetary stimulus programs. The difficulty in predicting the effects of events in the future is one of the key reasons why we rarely start conversations with definitive predictions like “the housing market is going to fall 25% – what do we need to sell?”
How do we assess downside risk, then, if we are not making predictions about when the next recession will start? We try to look at downside more holistically. Among others, here are three things we look at regularly. First, we have a strong focus on balance sheet today. Specifically, are capital positions and balance sheets of the companies we invest in today strong enough should the economy take a turn? Secondly, we look at past management behaviour and ask whether we trust this management team to adapt rapidly to negatively changing conditions. Third, we look at whether current valuations are appropriately compensating us for macro economic risks.
We remain of the opinion that downside risk is best assessed when evaluated without a specific downside event in mind. When we considered these factors for Canadian banks in early 2020, we were comfortable with the risk of holding them. One year later we remain happy with the way our investments have adapted to the COVID-19 environment. We believe the banks we own are well positioned for continued economic recovery over the next 12 months.