Packed show with a great discussion of “Higher for Longer” and what it means for your portfolio, a quick review of our Copart thesis and then our feature discussion on the Canadian Banks. We review the risks facing the Canadian Banks given higher interest rates and the impact on the Canadian consumer in the short and medium term. Finally, we discuss the long term bullish outlook for Canadian Banks and the reason why prefer National Bank.
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Podcast Transcript
Barry
Hello, and welcome to the Long Term Investing Podcast with Baskin Wealth Management. I’m Barry Schwartz, chief investment officer. Baskin Wealth Management is an independently owned investment management firm with almost $2 billion in assets under management, providing customized wealth management solutions and services to families and foundations. In this podcast, we ignore all the noise and have conversations that make sense about the things that matter in today’s markets. It’s what we talk about with each other here in the office, and we want to share those conversations with you. Please stay tuned for our legal disclaimer at the end of the episode.
We are back with another episode. Ernest Wong, thank you for joining me as usual on the podcast. Ernest, it’s back to school for the kids today. Are your kids, I know you have little ones. Were they excited to head back to school after a hot summer?
Ernest
So, I have a five year old and a seven year old. I think the five-year-old was happy because for her, going to school is just playing with your friends. The older one was a little bit less enthusiastic about the process, the thought that he might be having to do homework again.
Barry
Are you guys strict with homework? Do you watch your kid’s doing homework or just leave them to their own devices in their rooms so to speak?
Ernest
I think my parenting philosophy is perhaps best for another day.
Barry
Okay, fair enough. So, I have one in second year university, so I don’t know what’s going on there. And another one goes into grade eleven and he doesn’t talk very much, so don’t know what’s going on, but hopefully we’ll get good grades, and everybody will be happy. So, if you have kids and they’re off to school, I hope everything goes well and best wishes for the new school year. So, Ernest, let’s talk about higher for longer for a minute. And we’re not talking about a new marijuana strain, we’re talking about interest rates. Everybody’s saying that interest rates are going to remain higher for longer. Ernest, do you want to just explain exactly what that means?
Ernest
Well, I think there are a lot of people who think or hope that the recent interest rate spike is a short-term phenomenon and that rates are going to fall back down to where they were, maybe not during COVID but certainly like maybe 2018 or 2019 levels.
Barry
We hope we never see interest rates at COVID levels, by the way, again, because that would mean another catastrophe. Zero interest rates are terrible.
Ernest
Yes. And certainly, you can see that reflected in the yield curve today. Short term rates which, for bonds that are maybe like three months or a year long, about 5%, I think ten year bonds are lower than that from around 4% or so.
Barry
And 30 year bonds are well over 4% but still not 5%. So it’s a very tight yield curve. We don’t want to go off that tangent and bore people, but what we mean by higher for longer is although inflation has come down from those crazy levels of the summer of 2022, they still remain at pretty good levels well over 3%. And in recent, last few weeks oil and gas prices have ticked up again, gasoline prices have come back to multi month highs and so many people are expecting that inflation will not come down to that 2% level that the central banks want anytime soon. And as well, the economy is doing so far so good, although we got a lousy economic number in Canada. But the bottom line is if interest rates are going to remain higher for a longer period of time and so though the natural question is what does that mean for stock markets? We know what it means for those that are savers, retirees who want GICs or cash like products. Higher for longer is good for them. But what does that mean for the stock markets? Naturally, everybody the first reaction is bad, but you have to look to history. Of course, the last time interest rates were higher for longer was 1994. Interest rates went up. Fed fund rates or short term interest rates as Ernest reference went up to almost 7%. Stayed there for many years. How did the S&P 500 do over that period. Well, it went from about 500 to 1500, although after that the Dot Com bubble burst and the markets collapsed. But no one knows what the natural reaction will be. Ultimately for us, it’s stock prices follow earnings. And if earnings are doing well and we have strong companies and there’s a little bit of, I mean, a little bit of inflation earnings is not so bad for our companies.
Ernest
No, I think what’s often missed by the argument that rates are going to be higher so sell stocks is that lot of, especially for the companies that we like to own, like good companies that have pricing power, higher inflation means that they’re going to be raising prices by more. And so, for these companies, Visa, for example, it’s a great example they’re actually benefiting from. So, I think you really have to look on a stock by stock basis, evaluate whether you think whether they are going to be benefiting from higher interest rates.
Barry
Yeah, Visa is a good example, although is it benefiting from inflation or just offsetting inflation. Maybe a better way of putting it is these companies have the ability to not get hurt by inflation as bad versus companies that don’t have that pricing power or can’t raise prices or don’t have a mechanism where they get a share of higher prices.
Ernest
Right, exactly. And I think last episode, I think we talked about companies that have cash on their balance sheet and how for these companies, in essence, they’re saving and so they are earning substantial interest income on their cash balances. Now, I think if you contrast that to a company that has a lot of debt, it’s a really good position to be in.
Barry
Absolutely. So you should go listen to our past podcast because lots of good nuggets and insights about the things we’re talking about. So that’s higher for longer. So, the bottom line for us is this macro stuff is impossible. That’s why I know specifically you spend most of your time just looking at companies and company results and trying to find the best companies we can own over the long term. Because the macro is guaranteed to change.
Ernest
Right. And I think the thing is that it’s not that macro doesn’t matter but the definition of a very good business to some extent is that it’s not influenced by what’s going on in the economy. It’s going to grow and gain market share and be profitable regardless of what the economy is like.
Barry
That’s Right.
Ernest
And that’s the kind of company that we look for.
Barry
So, whatever the macro is doing, if you have reinvestment opportunities in your business, especially at high rates, you’re going to make a lot of money over the long term on that stock holding that investment. I’m pretty certain.
Ernest
Exactly.
Barry
Yeah. Cool. So, we wanted to talk a little bit about a company that we’ve mentioned a few times that never really gone in depth, and we will do an in depth on it in the future. But a company called Copart, you wanted to make a few comments on that company.
Ernest
Yes. So Copart is, they run an auction where if you get into a car accident, your insurance company will, let’s say your insurance company, declares it as a total loss. What they will do is they will take this car to an auction run by Copart, where buyers from around the world, maybe from emerging markets, they will buy the car, ship it to Guatemala, and then repair it and drive it. In those kinds of places, the safety standards are much lower than they are in Canada or the US.
Barry
So it’s kind of like the five second rule. Right. So, drop the food on the floor. 5 seconds may be good for someone else.
Ernest
Exactly. That’s one way you can put it, and so Copart has done spectacularly over the last few decades.
Barry
It’s been one of the best performing stocks over a ten or 20 year period. Right. Unbelievable. Why didn’t you tell me to buy it sooner? Anyways, go ahead.
Ernest
So the reason why we’re bringing up Copart is that there was a new report that came out from CCC, which I’ll add to the show notes that said that today the average front end repairable claim of a fender bender would cost about $3,700 to repair. This is up 40% since 2019, so before COVID levels. So, the report concludes, basically, there’s no such thing as a simple bumper job anymore.
Barry
Yeah, simple fender bender repair is out the window. It’s going to cost a fortune.
Ernest
Yeah. $3,700. And there’s a few reasons for this, and that’s US money. US. Dollars, not Canadian loonies. And there’s a few reasons for this. The first is that cost of everything has gone up. So the cost of parts, cost of labor, cost of rent for the garage, these are all higher. But more importantly is that cars today are significantly more complex than they were even, like, five years ago. They have a ton of sensors, they have safety detection, all these little things. And these things, as it turns out, are extraordinarily expensive to repair it. So where we’re, where I’m going with this is that over the next year and these have been like decade long tailwinds but especially over the next year as used car pricing starts to fall because supply continues to go up, and as the repair cost continues to go up, it’s more likely that insurance companies are going to declare cars as total loss because it just doesn’t make sense to repair it. What this means is that it’s great for Copart because they’re the ones who are going to be benefiting from all this volume. I think we’ll have more to say on Copart in the future. But I think near term very positive tailwinds for the business.
Barry
Very fascinating. And of course the market has slightly figured this out because Copart’s stock has done incredibly well.
But just because the stock has done incredibly well doesn’t mean that there’s no, and you have to do the research, potential for still significant upside as long as your earnings are growing and you’re paying a rational price for the business.
So talk about getting back to higher for longer. One of the things that’s impacting the TSX this year as well is a lot of dividend paying stocks in the US. What we’ll call bond proxies for interest rates. Ernest we’ve had like a 20 year market where interest rates went down. You know, we referenced that the Fed funds rate hit 7% in 2000. Last year, I think federal funds rate were near zero, they’ve recovered now to 5%. Companies that were priced based on their dividends bond proxies did incredibly well over that 20 year period. But as interest rates start to reverse, of course the valuations are reflective of maybe you need to pay me more because I can get safety for a lot cheaper. So why I’m going on this tangent? It leads us to talk about, naturally, the Canadian banks, which are really interest rate vehicles and have not done so well in 2023, especially versus some of the larger US banks, JPMorgan and Bank of America. But, Ernest, the Canadian banks released earnings recently, and they weren’t that great. A lot of write downs and revisions, analysts are concerned about earnings growth for 2024, but there’s a silver lining to everything. And so I think today we want to talk about the Canadian banks as well as why we still like National Bank of Canada, our largest Canadian bank holding.
Ernest
So, I think the first thing to think about with the Canadian banks is that unlike the US,iIn Canada, there are essentially just six banks. And these six banks do everything. They do commercial, they do credit cards, they do mortgages.
Barry
There are like thousands of banks in the US, and in Canada you have six and some credit unions and one or two we’ll call them virtual banks.
Ernest
Right. So, the big six banks, essentially, I think they’re decent proxies for the Canadian economy. Today,most of their loan portfolios are mortgages. That’s because Canadian housing is a gigantic portion of the Canadian economy.
Barry
Yeah. More Canadians own house houses than in other countries. Right. Or is it a North American phenomenon?
Ernest
I’m not actually sure about that. I think certainly it is a phenomenon in North America where in Europe a lot of people tend more to rent rather than own their houses.
Barry
That’s why mortgages make up a large part of the North American books.
Ernest
But generally, the Canadian banks, I would say they reflect the Canadian economy. If the Canadian economy is good, they’re going to do well. The Canadian economy is bad, they’re going to do less well.
Barry
A good economy means more loans taken out, means more new issues, more investment trading. It’s just all good news and obviously fewer losses on loans. And you put that together, it’s a good combination for earnings growth for the Canadian banks.
Ernest
And then there’s, I think, from an investment perspective, maybe not from a consumer perspective, because the Canadian banking system is so consolidated, there’s all these little things where they get you to prevent you from switching, which certainly helps the customer stickiness and the market share switches banks.
Barry
Ernest so when people get married, you stick with your home bank, right? I’m with my home bank from when I was a kid, and my wife’s with, I’m with CIBC, she’s with TD and she’s never going to change, she would never give up her independence anyways but that’s whom she banks with. That’s whom her family banked with. She’s not going to switch to CIBC, and I’m not going to switch my stuff to TD. And I see the ads, they’ll give me free Air Pods if I switch. Whoop dee doo. I mean, you got to make it so you’re absolutely right. The banks make it near impossible to switch. It’s just such a pain in the butt.
Ernest
Right. I think that doesn’t mean that in the short term, there aren’t gives and takes like the deposit mix and all these kind of things that, in my opinion, don’t really matter that much in the long run.
Barry
I mean, the banks really don’t undercut each other on mortgages or interest rate money market stuff. They’re all pretty tight.
Ernest
Exactly. And so, as a result, the Canadian banking system historically has been a good one to invest in. Because Canada’s economy has done well. The regulatory setup is very favorable and the six banks control all the share.
Barry
I read a study that I don’t know up until what point it was it might have been up to 2015 or 2016, but if you held the Canadian banks over a 25 year period, your compound rate of return was better than had you owned Berkshire Hathaway. It was like high teens compound rate of return owning the Canadian banks for a 25-30 year period. That’s kind of stalled out recently.
Ernest
Right. And I think over the long term, over the next few decades, I think there’s a good chance that this is probably going to continue because of all the stuff that we’ve talked about in the past,
Barry
The underperformance or the outperformance?
Ernest
Outperformance. Good performance. Because I think Canada has good economic prospects with lots of resources, strong immigration. And so on.
Barry
So they’re still a good bet, but they’re facing some material headwinds.
Ernest
Yes. And exactly. And so Baskin is currently underweight relative to index on Canadian banks, despite what we talked about, because we think that the near term outlook is not great.
Barry
Yeah. When we build a portfolio, our default Canadian bank is National Bank. For some portfolios, we may add a second bank, but it’s rare. So out of a 30 plus stock portfolio, a client generally will have only one Canadian bank in their portfolio. So I think that’s materially underweight.
Ernest
And the reason is because when we invest, like we said in the beginning, we don’t usually like to invest in companies that are too sensitive to economic conditions. We want businesses that are going to grow, share and remain highly profitable throughout the economic cycle. And while that’s probably going to be true for the Canadian banks, I think that there’s just better opportunities currently in the market even.
Barry
Okay. And we’ll get into the recent performance and evaluation. So go ahead. You have more?
Ernest
Yes, there was a good report that I saw that said Canadian bank stocks typically don’t bottom until loan losses have peaked.
Barry
Okay. You tell me when loan losses peak. I’ll tell you when Canadian banks have bottomed.
Ernest
Today loan losses for things like credit cards and auto are still a little bit below pre COVID levels. So that’s for a few reasons. Number one is that everybody saved a lot of money during COVID and that’s still running off. And number two is that the economy’s been good.
Barry
People are employed, so when people are employed, they generally pay off their credit card and loans when they’re not employed, obviously those things it comes down to, what am I going to pay off first?
Ernest
I think there is a decent probability that the Canadian economy is going to be facing some strong headwinds over the next two or three years. Yeah, the most important one is housing. No, I think a lot of people tend to confuse housing, like expensive housing, with risks inside the bank mortgage portfolios, and those are two related, but not exactly the same thing. Most borrowers of mortgages today are still paying much lower interest rates than than the market rate, than the current, than where current mortgage rates are. And that’s because their mortgages haven’t renewed yet. Yes, this is going to change over the next few years.
Barry
Yeah. People got mortgages at a fixed rate mortgage at 2%, although some of those variable rates are confusing because some banks offer pure variable rate mortgages where the interest rate payment adjusts with each change in interest rates, and some have fixed variable rates where it doesn’t adjust. But your amortization goes skyrocketing and it can get confusing. But you’re absolutely right. The piper is coming to collect very shortly in the next while, starting now, as people renew their mortgages.
Ernest
Now, I don’t think the risk is that the banks are going to lose money on their mortgages.
Barry
Let’s explain it for people. Ernest, how would a Canadian bank lose money on their mortgage?
Ernest
So just to take it a step back, you take out a mortgage to buy your house. Right at the time of renewal, like, you have to go and renew your mortgage. The bank will either say, okay, this is the new rate, take it or leave it. If you don’t like their rate, then you can go find another lender.
Barry
Yeah. You go to a mortgage broker and most mortgages in Canada are for five year terms.
Ernest
Right. And so in the worst case scenario, if you can’t find anybody to lend you money, then you’re going to have to sell your house, but you’re still on the hook for all the mortgage debt that you borrowed. And so in Canada, the amount that the banks can lend you to borrow a house is very highly regulated so you are borrowing less than the value. So if the amount that you’re borrowing is more than 80% of your house, you need to buy insurance, mortgage insurance.
Barry
You have to meet certain credit scores and so on and so forth.
Ernest
And the banks generally focus on the highest quality borrowers. They don’t lend to junk. All their borrowers are super prime. And more importantly, I think Canadian banks focus on a whole portfolio solution, what they like to call it. And what that means is that they can see the borrower’s credit card. They know how much deposits they have, so they have a much better understanding.
The bank essentially wants what’s called employment or T4 income to get it. Even if you’re retired and you have a lot of assets and you want to buy a leisure property with a mortgage, the banks aren’t going to lend it to you even if you have a lot of money in the banks, because they want to see that income coming in, that employment income. And so our Canadian banks are very conservative when writing mortgages. If you were a consultant or self employed, you’d have a hard time getting a mortgage at a Canadian bank. At least definitely today.
Ernest
And if you look at the composition of their mortgage books. Most of their mortgage loans are about 50% to 60% loan to value so there’s a substantial cushion in there for home price declines before the banks actually lose money.
Barry
Correct. But of course, a lot of those loans were made when interest rates were a lot lower and housing prices were higher because of those low interest rates. Are housing prices, guess said another way, housing prices really have to collapse a dramatic amount before banks are screwed on those mortgages.
Ernest
No. And even then, hypothetically, let’s say there was a mortgage that had a 50% loan to value and housing fell 50%. Still fine. Right, and even if it fell more than that, like you still have the borrower’s income, the loss is not going to zero.
Barry
So very few Canadians are going to be handing back their keys to the Canadian banks.
Ernest
Yeah, basically there’s no risk to the mortgage books inside at least the big six banks.
Barry
Great explanation.
Ernest
Now, what is an issue is that the standards that like, as you mentioned, that the banks are underwriting mortgages is tightening. It’s getting harder to get a mortgage. Whether you are an investor buying rental properties or whether you’re just trying to qualify for a mortgage, these things are all getting tighter. And I think the worry is that these combined with the impact of interest rates, higher interest rates, is going to push the Canadian economy into a recession. And like I said in the beginning, Canadian bank stocks don’t tend to bottom until loan losses peak.
Barry
So, recession is a slowdown, a negative growth and you’re referencing, as mortgage rates go up, consumers will be spending more on their mortgages and will have less money to spend on goods and services and that naturally will hurt the economy and cause a recession.
Ernest
Exactly. Okay, so here’s one tidbit, is that Scotiabank says that their variable rate mortgage holders are spending 15% less on discretionary goods.
Barry
Another kick in the tush, of course, is inflation has made going out to eat, buying groceries more expensive. And then we see, of course, a proposal by the Toronto government thinking of adding a 1% municipal tax. That’s going to help things. That’s great forward thinking. But anyways, if you wanted to create a perfect slowdown in the economy, Ernest, you would raise interest rates. And I think we’re going to see those results coming in, in the next few months.
Ernest
Yeah. So I think that’s where we are with the Canadian banks.
Barry
The question is… Okay, you’re not telling me anything I don’t already know, and a lot of sophisticated people out there in the market, they have all that information as well. No one’s going to call you up Ernest tomorrow and say, holy smokes, I’m so worried about the Canadian banks and this and that and the other thing. Smart players have figured this out, right? And you’ll see it in the results of the Canadian banks and their valuations they’re trading. It really keeps valuations, historically speaking, as long as loan losses don’t get dramatically worse. As you said, Canadian bank stocks don’t rebound until loan losses have peaked.
Ernest
Right. So today, the Canadian banks are trading, I think, near the low end of historical valuations. So if you’re willing to ride out some volatility in the next maybe year or two, I think you probably will be rewarded with a higher valuation and some dividends. So, longer term, probably fine. Short term, certainly some risks.
Barry
Certainly some risks. And let’s talk quickly about our favorite bank, National Bank of Canada. Not immune, of course, to all these issues, but in our opinion, much more resilient, for the reasons why – go ahead.
Ernest
So, National, unlike the other banks, National is the smallest of all the big of the big six.
Barry
Yeah, no one’s ever heard of it. Really, outside Canada. It’s Quebec based.
Ernest
Yes, they’re Quebec based. They focus mostly on Quebec. And I think just if you look at the metrics, Quebec is probably a little bit more protected from a broad economic slowdown than the rest of Canada because they have less household leverage. Housing is a little bit cheaper on an income basis, and the economy is doing well. Unemployment fundamentals are very strong so certainly less of the elevated housing risks that some people associate with Toronto.
Barry
And, and on a holistic basis, it’s banking and mortgage business is not as big a chunk versus some of the other Canadian banks.
Ernest
Yes. And I think that’s partly, again, reflective of the fact that Quebec housing is more affordable relative to other provinces and a different makeup.
Barry
The prices never, aside from maybe Montreal and the Laurentians area, in terms of cottages, things never went bananas. Maybe like Ontario or Vancouver, maybe now Calgary, where prices are going up quite a lot.
Ernest
And National has done a very good job over the last few decades just managing a well run bank. They have a strong wealth management franchise. They do a good job in growing their deposit base and that’s reflected in their return on equity, which is, I think, one of the highest.
Barry
One of the highest. And their regulatory capital, their buffer before TD decided not to go ahead with the First Horizon acquisition. National had the strongest capital. And if the regulators come back to the banks and say, you know what, guys, you got to raise capital more National, we think, as well as TD, which is another one of our bank positions, those two have the strongest capital, so can withstand more of a downturn and won’t be forced to raise equity at lousy prices.
Ernest
Exactly.
Barry
Yeah. So, very interesting points about National Bank not going to be immune. Of course, Ernest, if we do have a slowdown consumer spending, slows down, that’s going to impact everyone, and there’ll be knock on effects for National with its wealth management division. But you have to weigh the odds. Of course, in the short term, these companies have been beaten up. The funny thing is, and I’d laugh about this with David Baskin, you know. Whether you’re concerned or not about the banks, don’t be concerned about the bottom lines of the banks. TD is still on track to have $14 billion of profits in 2023. Royal Bank $16 Billion of profits. There may not be earnings growth in the next short period of time, but the banks are still making a fortune. There’s no risk to dividend cuts. The capital ratios will probably still improve because they are generating excess capital here. So we’re not going to cry for the banks, but the bank shareholders may cry a bit. The earnings I think we talked about Ernest. The earnings of the Canadian banks have gone nowhere since 2021,and unless a miracle happens, it’s hard to see a big increase in earnings in 2024 for the Canadian banks. So we always say stocks follow earnings. Their earnings going nowhere. You’re going to have to bide your time, but as a long term investor, a few years of mediocre performance shouldn’t knock you off course. Right?
Ernest
Exactly.
Barry
Anything else you want to add? Did we cover everything about the Canadian banks?
Ernest
Yes. I think one thing that is an added bit of a risk to the Canadian financial system is that because the Canadian banks have done such a good job in lending, a lot more people are now going to non-bank lenders who are unregulated and without reporting or any visibility into what’s going on inside that market. That’s scary. I think if there was any issues, I think you’re probably not likely to see it in the Canadian banks, but that’s something to watch for as well.
Barry
Yeah, the horror stories. So, I mean, this is what happens when you want to beat down inflation. There’s knock on effects. The banks knew ahead of time what the risks were during COVID Ernest. They had to run stress tests where interest rates would go back up to 5%. And that’s kind of a tell, I think, for the market, about where the interest rates are going. It’s hard to imagine they’re going much above 5% because that’s what the regulators made the banks take the stress test on. Lo and behold, we’re here. Shocking how it happens, but I think we gave a good, balanced explanation of the pros and cons for Canadian banks going forward, and that’s it. We’ll see you back here real soon. Thank you very much, and as always, please, we appreciate your feedback.
Reach out to me or Ernest with any questions or comments, and have a great one. Bye.
This podcast is for informational purposes only, and any forecasts on the economy, markets or individual securities should not be viewed as investment advice, a recommendation, or an offer or solicitation to buy or sell any securities. Clients of Baskin Wealth Management and the speakers on this podcast may own shares of the companies discussed. Information on this podcast is current as of the time of production and is subject to change. If you have any questions or would like to subscribe to these podcasts, visit our website a baskinwealth.com.
