It’s earnings season for big banks. Canadian bank stocks have been outperforming the broader equity market, but some say the real action lies with the big U.S. banks stocks. Could it get even better in 2018? Kim Parlee speaks with Ben Gossack, portfolio manager at TD Asset Management.
Hello, and welcome to the show. It's that time of year again-- no, not the holidays-- bank earnings season. Each of the Canadian banks have reported positive earnings per share, surprises in the past 11 quarters. So the question is, will we see the same for the most recent quarter? Joining me now is Ben Gossack. He is Portfolio Manager with TD Balanced Growth Fund. We're going to talk about Canadian bank earnings, and then we'll broaden that conversation to earnings overall. How are you?
Good. How are you doing?
I'm doing well. We are not through the bank earnings season. We've actually had a couple banks report so far. So before we get into a little more of your earnings scorecard, which you've brought before us, is how would you say Scotia has done so far?
Yeah, so Scotia reported yesterday, and earnings were up about 4%. And that kind of pales in comparison to what Royal reported this morning. Having said that, all the banks are putting up really solid Canadian bank earnings. And so I think what's happening in fact at Scotia is that everyone's affected by weaker trading activity for the quarter. So underlying Scotia's results are actually a really strong Canadian banking sector and strong growth in their international markets.
What's interesting with the weak trading-- and I don't want to spend too much time here-- but this is just-- I'm assuming, and correct me if I'm wrong. I know you will. Low volatility means we're just not seeing as much trading in the market overall. Is that correct?
That's right. So what we're hearing from both Royal Bank and Scotia, and I suspect we'll hear from the other banks over the next week, just lower client activity, lower volatility, so harder for them to make money on spreads. The volatility in the wholesale market is kind of par for the course. So some quarters will have really big trading numbers. Some quarters will be negative.
I think the biggest difference that we're seeing is that for Scotia, it was actually quite negative. So trading was down 30%, and for Royal, it was down 10%. So that's sort of what caught the market by surprise, but it's something that over the course of a month or two, we'll look past that. Again, underlying fundamentals for the banks are still very positive.
Let's take a look then at your earnings scorecard and play out those really strong fundamentals you've been talking about. We've got here with, again, so far, Scotia and RBC have reported. And worth noting as well, if you take a look at some of the stock performances, August, when you were last on-- I'm going to give full props here for this-- because I think most of the great performance we've seen has been when you said, back in August, that we're going to start seeing some really great performance.
Yeah, I mean if we look at the banks there, they're up from stock performance in the low tens to mid tens. But really, that's all come from August. And again, it's the markets sort of reflecting the fact that the underlying fundamentals are really strong. The Canadian economy's strong. Jobs are strong.
And you see it there, too. I mean loans are strong. Mortgages, business side, and margins are looking pretty good.
Yeah, so Canadian P&C, that's Canadian banking. Earnings are up 8%, 9%, and in a mature banking market, putting up those numbers is impressive. And people are worried about sort of loan volume growth. Yeah, loans are growing 6%. Businesses are even stronger, again, reflecting a very strong Canadian economy. They're up 12% and 11%.
The other big factor that happened this year-- we got some interest rate hikes. And so you can see for Scotia, margins were flat on their loans. For RBC, they expanded by four basis points. So as the margins improve, that drops to the bottom line. That's another tailwind for bank earnings.
Do you see more tailwinds that happens over the next, let's say, year for Canadian banks? And again, and we still have to get through-- or excuse me, four more banks to report.
Yeah, we still have four more banks to report, and the fundamental set up for them also remains positive. And then going forward, we've put up almost 265,000 jobs this year. So as long as the economy remains robust, and we have a global synchronized expansion as well, as long as people have their jobs, then, yes, the Canadian banking sector can continue to perform. As well, a lot of the banks benefit from activity, whether it's in Latin America or the US, which is also very positive. Again, you do have to sort of deal with some of the headwinds that we see in the capital markets segment.
Right, but still, the tailwinds seem to be winning out here.
But still, the underlying fundamentals is how we value these banks, and they still remain very strong.
All right. Stay with us until we come back. We're going to shift away from the Canadian banks and to US earnings and Ben's take on what has happened so far and what you can expect. You are watching Money Talk. We'll be right back.
We're back with Ben Gossack. He's Portfolio Manager for the TD Balanced Growth Fund, as well as a few others. And we are talking about earnings. We just finished talking about the bank earnings so far, looking pretty decent, actually, overall. Like he said, strong fundamentals. And I would almost say the same things, I think, for US earnings in the past quarter, strong fundamentals. I mean things are looking pretty good.
Yeah. Actually, US earnings have been doing really well, even starting last year around this time. We sort of came out of an earnings recession. So, yes, the headline is solid revenue growth, solid earnings growth. And so it's fundamentally driven, and that's why the stock market is up 18% year to date.
Let's take a look at some of the metrics. You said that revenue earnings are growing. You brought a chart in here, which shows the S&P 500 revenue growth year over year by quarter. So if we take a look at this, obviously, that earnings recession-- I can speak-- shows up fairly nicely there in the bottom. But you can really see things have accelerated. But it's not quite-- it seems as though the year over year growth is coming down a bit.
Sure. I mean the US has been recovering for quite a while, and so, yes, it's good. Is it as good as it was before? That tends to moderate as we lock some of those good quarters. And the US has been putting up economic growth of around-- nominal growth around 3% to 4%. And so in Q3, we grew revenues around 5% to 6%. So it makes sense. On top of that, we have a sort of global synchronized expansion. So this makes fundamental sense to have sort of mid-single digit revenue growth in an economy that's growing sort of 3% to 4%.
And then you layer on top of that the earnings growth, which you would expect to be a little stronger than the revenue growth, which it was.
Right. So if we look at Q3 earnings, they grew about 8% to 9%. So you take that 5% revenue growth. You add some margin expansion, and then we get 8%. Now, 8% isn't the highest that we've grown this year. So you can see--
Not the 15%.
It's not the 15% or 11%, but I think what's really important is that those big numbers were on over quarters that contracted the year before. And I think what's really important to highlight is that 8% growth was on a quarter that grew 4% last year. So these are really-- 8% on a quarter that grew 4% the year before is actually really solid.
And again, this is all very fundamentally driven. And so because it's fundamentally driven, the stock prices will react positively to that.
So is this-- and this is what-- I mean this is the question everybody always asks. But given the incredible run we've had, can we expect the same kind of revenue growth, earnings growth, stock price growth for 2018?
Right. So if we look at '17 and then sort of phase into '18, we're going to get about 11% earnings growth. That's what we're factoring for 2017. Now, about 75% of that earnings growth, a large part of that, came from the energy sector. And if you remember, we fell from $100 oil to about $26 oil. And we got back to the sort of the 50s level. So we have the easy comps. So energy companies are putting out double-- are doubling their earnings that they had from the year before. So that provided a big tailwind for the market this year.
As well, tech benefits from various strong secular trends in terms of the internet, mobile, and the cloud. And so they put up about 20% earnings growth. So that represented what we got in '17. And so when we look into '18, we're also expecting, at this point, about another 11% growth in earnings.
When we look at this, tell me, what is this reflecting?
All right, what we want to point out is that we try to look at the market in sort of three buckets. So you have your secular growth sector. So that would be your tech stocks, your consumer discretionary stocks, but we really mean sort of Amazon and Priceline, as well as your health care companies. And then we compare that to your cyclical sector. So they do well. They do poorly in some years. That'd be your materials, your industrials, your financials. And then you have your stable sectors. So that would be sort of your telcos, your utilities, your staples.
And so what's happened is that a lot of people say we're paying a lot for earnings lately. We're trading at an 18 multiple. That's quite high. And so what we think is important is to actually look through what we're paying for. What is that earning that we're paying for?
So what kind of earning is it?
Well, what's the composition?
What kind of quality is that earning? So 15 years ago, 50% of earnings came from those cyclical sectors. And so typically, you don't pay up for an oil and gas stock. You don't typically pay up for a bank stock, because in the good years, they do well. In the bad years, they give it up. But a company like Visa or Microsoft that has a quality franchise that's capital light higher margin company, the investors will pay out the higher multiple. That now represents 50% of our earnings.
So there's almost a leadership change between the cyclical sectors and the secular growth sectors. And so that does sort of justify that we should pay a higher multiple because of the change in the composition.
Can I repeat this back to you? This is my exercise in active listening to make sure that I understand. So it's taking-- those other industries took more capital to make the earnings in one sense. So if you're using more capital, you hit bad times more easily. Because with capital light industries, you're not using as much capital. So therefore, it's almost more efficient that you're getting more out of it.
Right. If I'm a mining company, and I got to get all this equipment and pull assets out of the ground. If I'm a software company, I hire a few people. We build some stuff on the cloud--
And then it multiplies.
-- we sell it many times. That's the difference in capital intensity. And then I get a subscription revenue that comes through. That provides me a steady cash stream, and the market will pay up for consistent earnings.
So the composition of these earnings is changing, and therefore, the valuation, you're arguing, could be-- should be different for those types of earnings.
Yeah, so we can say historically we're paying a higher amount for our earnings. But we also should take into account that the earnings that we're paying for are higher quality today than they were 15 years ago.
That's interesting. We've only got about 45 seconds. Any companies, any names that you like right now just given that thesis?
Sure. So I've been on before, and we've been really pushing the US banks. That continues to be a sector that we really like. So Bank of America might be our poster company. But that could also apply for JP Morgan, PNC. They all benefit from higher rates and taxes and sort of regulatory reform.
Apple is another stock that we've talked about many times. We were probably pushing it really hard last year on this cycle that we're seeing now with the iPhone X. That will continue to last into next year. And also, a company like Accenture. Everybody is facing digital challenges, and Accenture is a company that consults all industries in helping them prepare for this sort of data-driven economy that we're in now.
Ben, always a pleasure. Thanks so much.
Thank you for having me.
Ben Gossack. He is a Portfolio Manager at TD Asset Management and managing many funds, including the TD Balanced Growth Fund.