“All happy families are alike; each unhappy family is unhappy in its own way.” – Leo Tolstoy, Anna Karenina
Like Leo Tolstoy’s famous observation about families, the same can be said about companies. Happy companies look strikingly similar – things that should be going up, are going up; things that should be going down, are going down. How or why a company is unhappy is instead highly variable. Sometimes it’s about growth, other times it’s about costs, governance, valuation, fears about the future, or debt. There are seven ways to Sunday for a company to be unhappy but only one way for a company to be happy.
What is also true is that happiness and unhappiness are rarely perpetual. Unhappy companies eventually go under, get acquired or resolve their issues to become happy companies. Likewise, it is not lost on us that no company is invincible and a prolonged period of “happiness” is almost always both a symptom of a strong franchise and favourable market conditions.
There is an overwhelming tendency for investors (and advisors to investors) to favour happy companies and stay far away from the unhappy ones, regardless of valuation in both situations. To that point, while we do own companies that are doing well and fall into the “happy” camp, we also can see opportunity in investing in an unloved unhappy company as it works through its problems.
CANADIAN BANKS SHIFT FROM HAPPY TO UNHAPPY
For years, Canadian banks were the “Happy Companies” of Canada. Steady economic growth, cheap capital and a very strong financial footing exiting the global financial crises had made Canadian banks market darlings for well over a decade. Indeed, for the 17 years between 2002 and 2018, banks have only underperformed three years and outperformed the rest. Sell side bank analysts regularly begin discussions with how relatively overweight they think the Canadian investor ought to be in any given year to the banks.
Today, things are different, and the famously happy Canadian banks have found themselves markedly unhappier in recent years. 2023 is the second year in a row and the fourth time in five years where the Canadian banks have underperformed the broader TSX. The reasons for the challenges are highly variable.
Royal Bank has been contending with an underperforming US subsidiary, City National, and has recently been forced to inject capital into the ailing division. TD is contending with the fallout of an unconsummated acquisition and government scrutiny over poor anti-money laundering practices. BMO on the other hand is dealing with a successful but ill-timed US acquisition. Bank of Nova Scotia’s problems with anemic growth, rising costs and poor capital allocation decisions have been plaguing the company for years. The issues just listed are not comprehensive – virtually every large Canadian bank is unhappy in its own unique way. Valuation for the banks have fallen to the low end of their range, reaching a low in late 2023 – a level not visited since 2020.
Source: Bloomberg
Source: RBC Capital Markets Quantitative Research, Bloomberg, RBC Economics, RBC Capital Markets
DIVERSIFICATION, AN INVESTING GUARDRAIL
To benefit from diversification and minimize the risk of over concentration, one ‘guardrail’ QV has put in place is a 25% maximum exposure to one sector. As a result, QV has typically maintained greater diversification than the fairly concentrated overall Canadian market.
This allocation isn’t necessarily reflective of a negative view of the banks, so much so that better risk adjusted returns can be had by having more of a portfolio broadly invested in more areas of the economy. I have written about the benefits of diversification in the past, and while we believe that Canadian banks are high quality companies, it is not lost on us that they are still vulnerable to economic and business headwinds. We take these things into account when we consider that there are many more options besides banks for us to invest in, like insurance companies or diversified financial conglomerates.
OPPORTUNITY IN NATIONAL BANK
In the same way that we were not holding over 20% of our portfolio in Canadian banks over the last 15 years, we are also not abandoning our bank holdings today either. In fact, we have taken advantage of some of the very negative sentiment in late 2023 to initiate on National Bank. We have held National Bank in high regard – we like that the business is more heavily geared towards fee-based businesses, which we believe will allow National Bank to grow without having to heavily rely on large amounts of capital. While the bank itself is at a relative premium to some of its peers, given that the broader group is at lower-than-average levels itself, we think we are getting a good deal on this investment. Today we remain comfortable with our exposure to banks, and if anything, see incremental opportunities in this significantly less loved industry.
