We are often asked for our thoughts on the Canadian financials relative to the global financials. Regular readers of our work will know that we favour financial services companies outside of Canada. There are many reasons, but the most compelling is that the Canadian financials have fully recovered (both in terms of valuation and earnings) from the most recent cycle, while the U.S. and global financials have not.
And cycles matter.
The financial services sector is impacted by economic/credit cycles, as well as cycles in M&A, capital markets, home prices, regulation, and/or interest rates. As a result, it is very important to identify where a certain country or sub-sector is within a cycle since its impact on earnings and valuations can be dramatic.
Although no country escaped the credit crisis, the Canadian financials experienced a shallower cycle than their global peers. As a result, they emerged from the downturn much faster and have seen their stocks fully recover, resulting in substantial outperformance. (Today, the Canadian financials are now basically generating “normal” earnings and trade at “normal” multiples, including the “big-6” banks at 11.1x and the “big-4” lifecos at 13.1x.)
This is in stark contrast to the global financials, which still have a very long way to go. For example, the U.S. financials, U.S. banks, and European banks all have to rise between 35% and 60% to get back to the level they were nearly seven years ago (!), i.e., at the start of the cycle. The chart below divides the cycle into four stages, and highlights the performance of Canadian financial and bank indices versus those of the global financials, U.S. financials, U.S. and European banks. (Note, the index levels relate to changing market caps, so EPS dilution is not a variable.)
In addition to the fact that Canadian financials have fully recovered, they are expected to be less impacted by some of the most attractive themes in global financial services today including M&A and rising interest rates. This combination seems to set the stage for relative underperformance for the Canadian financials vs. their global peers over the next few years.