Sell the Big Six? Veritas' bear case will soon be tested
Nigel D’Souza turned heads on Bay Street this week with a bold and bearish call on Canada’s banks, and – in the process – squarely framed the issue that may define the banks’ financial performance and share prices over the next year.
D’Souza is an analyst at Veritas Investment Research, and issued a report on Monday that includes Sell ratings on all six of the major Canadian bank stocks. It was a dramatic move. Indeed, among the analysts who cover each of the Big Six lenders, only one other has a Sell rating in place (that’s John Aiken at Barclays Capital, who has an Underweight rating on Royal Bank of Canada).
D’Souza thinks his peers have got it wrong.
He believes rising debt-service ratio (DSR) figures in Canada show consumers will soon face a significant increase in credit defaults. Rising loan losses will eat away at profit growth, he predicts, earnings per share will come in substantially weaker than current estimates suggest and price-to-earnings multiples on the bank stocks will fall. His 18-page report is full of data he says supports his case.
The figure he stresses the most is Canada’s household debt-service ratio, which measures the percentage of household income devoted to required payments on household debt. It climbed to 14.6 per cent at the end of the fiscal fourth quarter (Oct. 31, 2018) from 13.7 per cent at the end of 2016’s first fiscal quarter (Jan. 31, 2016). Weak Canadian wage growth makes him believe the trend will worsen. He’s calling for the ratio to climb to 15.0 per cent by the time fiscal 2019 ends on Oct. 31, 2019.
“Based on 30 years of historical data, we note that an increase in household DSR is a reliable indicator of higher credit losses,” D’Souza says. He disdains the argument that low rates of unemployment are reliable predictors of trends in bank credit losses, saying data since 2006 clearly indicate otherwise.
All but one of the banks missed earnings expectations in the fiscal first quarter. D’Souza says the bank stocks could move “materially lower” if the upcoming fiscal second quarter results show rising loan losses. Those results will be released between May 22 and May 30.
“We continue to recommend that investors consider underweighting or selling shares of the Big Six Canadian banks ahead of further credit risk deterioration,” he concludes.
Concern about the state of Canadian consumers and their ability to manage debt obligations is shared widely these days among analysts and investors who watch the Canadian banks. But D’Souza’s view is the most dire.
Analyst Gabriel Dechaine at National Bank of Canada told clients in early March that he considers a slowdown of the Canadian consumer as one of the biggest headwinds facing the banks this year. He notes household debt levels, retail sales, household consumption trends and broader sluggishness in gross domestic product growth all point to weakness in the banks’ biggest business. Thirty per cent of the banks’ revenue comes from consumer lending and related business lines.
Dechaine, however, is more worried about consumers spending less (a negative for the Canadian economy, and thus for the banks) and borrowing less (a direct negative for the banks) than he is about a looming spike in credit losses.
He says multi-year trends in Canadian bank customers’ use of credit cards and lines of credit are encouraging. He calls credit card statistics “the best proxy for assessing Canadian consumer credit quality.” These days, 90-day delinquency rates and loss rates are at their lowest levels since before the financial crisis. On lines of credit, households have been using steadily less of their available maximum for six years.
The fiscal second-quarter results in late May should provide support for one of these views. Here are some things to watch for.
-The banks’ commentary on credit quality. If there is a material deterioration or improvement in consumer credit quality, the banks will likely address it directly in their press releases, and in their quarterly slide-show presentations. The slide show presentation is likely to offer more detail.
-Provisions for credit losses (PCL). Every dollar set aside as a provision for a loan a bank thinks might not be fully repaid is a dollar that comes directly off bottom-line profit. The aggregate PCL number will be in the banks’ news releases.
-PCLs in consumer banking. To find these numbers, you’ll need to delve into a document each bank releases each quarter called the Supplementary Financial Information package. Look for a section of the document devoted to credit quality, and then find the page that breaks down the provisions for credit losses into segments. You’ll find figures for credit card losses and total retail losses, and you’ll see those numbers for a series of historic quarters running back a couple of years.
-Credit quality ratios. These figures are more revealing of trends the banks are experiencing in credit, since the ratios take into account the moving target of total loans outstanding. The two key numbers are PCLs as a ratio of impaired loans and GILs as a percentage of all loans (GIL stands for gross impaired loans). To find these numbers, you’ll also need to look in the Supplementary Financial Information package. Look for a section called Credit Quality Ratios. Larger numbers equal weakening credit quality.
-Household debt-service ratio. D’Souza cites company filings and Veritas’ own data for his figures, but you can find lots of explanation about this ratio on the Statistics Canada website. A table of recent years’ household debt data, including the debt-service ratio, can be found here: https://www150.statcan.gc.ca/t1/tbl1/en/tv.action?pid=1110006501. The historic trends reflected in the table correspond closely to the numbers in D’Souza’s report.