Are Canadian Bank Stocks Oversold?

Bank stocks are our of favour. Is it time for contrarian investors to buy?

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Canadian bank stocks are off their 12-month highs, as investors worry that recent failures in regional banks in the United States could spread across the broader banking sector. Contrarian investors with buy-and-hold strategies are wondering if this is a good opportunity to buy Canada’s banks for their portfolios.

Market outlook

Soaring interest rates are often positive for banks, as they can drive higher net interest margins, but the steep rise in rates in the United States and Canada over the past year is putting borrowers in a difficult position. The longer interest rates remain elevated the more likely it is that commercial and retail borrowers will struggle to cover the increase in payments.

The Bank of Canada and the U.S. Federal Reserve are trying to get inflation back to their target rate of 2%. One way to achieve that goal is to push up interest rates until they force the economy to slow down and bring the tight jobs market back into balance. Economists say there is typically a lag of 12-18 months from when the rate hikes are implemented to the time they start to have a material impact. Investors are concerned that the moves have been too aggressive, and the economy will be pushed into a deep recession.

The sharp jump in the cost of living isn’t going to reverse. The pace of the increase in prices will simply slow down. This means people are still going to struggle to pay the bills and that situation will get a lot worse if there is a meaningful increase in unemployment.

The Canadian banks all increased provisions for credit losses in their fiscal second quarter (Q2) of 2023 quarterly reports, so they are already seeing some customers starting to get into trouble. A lot of focus has been on household debt and the large mortgage portfolios held by the banks. This is a concern, but things would have to get pretty bad in the housing market before the banks start to take material hits due to their low average loan-to-value ratios.

Commercial real estate, however, could be the next big story in the banking sector. Once again, analysts think it is likely to be the U.S. regional banks that get into trouble first. Another meltdown in this segment of the market could have a domino effect on bank stocks everywhere.

Upside for Canadian banks?

The Big Five Canadian banks all have strong capital positions according to their most recent earnings reports. Their common equity tier-one (CET1) ratios range from 11.9% at CIBC to 15.3% at TD. Canada’s banks are required to have a CET1 ratio of at least 11%, so all are comfortably carrying excess capital.

Canadian banks tend to have more diversified revenue streams than many of the regional banks south of the border, and they are on average much more profitable than American banks with a higher return on equity. As such, the pullback in their share prices might be getting overdone, even with the known economic headwinds.

Four of the five largest Canadian banks raised their dividends when they reported the fiscal Q2 2023 results. This suggests the management teams are not too concerned about profits in the next few years.

Best bank stock to buy now?

All of the Canadian banks should be solid long-term bets at their current prices.

Bank of Nova Scotia and CIBC might be the most oversold and now offer dividend yields of 6.4% and 6.1%, respectively, for investors seeking passive income. Bank of Montreal and TD are also trading well below their 12-month high and offer dividend yields of close to 5% right now. Royal Bank trades at a higher multiple than its peers and provides a lower dividend yield but is also the largest Canadian bank by market capitalization and the one that is probably the least likely to cause investors to lose sleep.

This article represents the opinion of the writer, who may disagree with the “official” recommendation position of a Motley Fool premium service or advisor. We’re Motley! Questioning an investing thesis — even one of our own — helps us all think critically about investing and make decisions that help us become smarter, happier, and richer, so we sometimes publish articles that may not be in line with recommendations, rankings or other content.

The Motley Fool recommends Bank Of Nova Scotia. The Motley Fool has a disclosure policy. Fool contributor Andrew Walker has no position in any stock mentioned.

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