Andrew Pyle
May 26, 2023
A tale of two valuations
As tempting as it was to comment on an apparent debt ceiling deal that was fermenting in Washington late this week, I thought it would be more relevant to discuss a development this week that involved a different type of artificial intelligence. I am referring to the divergence in valuations between Canadian bank stocks and tech – specifically, the new fifth largest US company by market cap - Nvidia.
This was the week where banks reported second quarter results and, coming off the events in the US banking system over the last two months, this was a highly anticipated week. Before diving into the details of both bank earnings and what happened with Nvidia, consider that the TSX banking sub-group lost close to 3.5% from last Friday to Thursday, compared to a 1% gain in the NASDAQ 100 index and a (wait for it), a 21.5% rally in Nvidia. In terms of the performance this year, banks are down 4.7% versus a 160% jump in Nvidia. The market cap of Nvidia at the high reached Thursday was a little under US$970 billion – or about 2-1/2 times the market cap of the top five Canadian banks. Compared to the largest five US banks, this company’s valuation is pretty much on par.
There are obviously a number of storylines underneath this massive divergence between a tech stock and Canada’s banking group. For one, the tech sector, as a whole, has been on fire this year even without Nvidia. Some of this is a rebound from the trouncing experienced last year. The NASDAQ 100 fell 33% in 2022 and is up 27% so far this year. This sounds like almost a full recovery until you recognize that this year’s bounce has come off the lowest level since the third quarter of 2020. From the peak reached in late 2021, the NASDAQ 100 is still off about 16%.
Prior to Thursday, even Nvidia was trading below its November 2021 peak of around $346. At Thursday’s intraday high, it was at $394. The performance in the stock is even more impressive considering that the company’s revenue actually fell 13% in its first quarter (second drop in a row), but profit rose above expectations to $1.09/share. Where Nvidia lost 38% in its graphics division, it saw a 14% increase in data centre sales and this is where the company’s graphics chips and their parallel computing capabilities are driving demand from power generative Artificial Intelligence (AI) and large language models.
To label AI as a frenzy is an exaggeration and I do not think this is in the same camp as say cryptocurrencies. Companies are willing to pay up to not get caught behind and there is already a push to take this new technology from cloud server to the next position closest to the end user – the cell tower. Still, there are pushbacks to the rampant growth story. First, there has to be a commensurate revenue stream to support all of this AI spending. Even if there is a massive build-up of orders for chips and towers, how much of this is being front-loaded? Keep in mind that Nvidia designs the chips that go into these cloud servers. Other companies make the chips – predominantly Taiwanese Semiconductor – and supply uncertainties persist. Second, there appears to be a bit of a resistance forming against “unleashed” AI and that might affect the growth projections put forward by those companies that stand to profit from this segment.
I could have asked ChatGPT to write this week’s commentary, but I think I might relegate it to finding me some nice recipes for smoking bacon on the Traeger this weekend. Bottom line, the response to Nvidia’s results and commentary looks a little hyperbolic and analysts didn’t exactly get the story that wrong. After all, the stock had fallen four consecutive sessions and was down 5% below its May 18th high before the results. Over the past week Ally and I have been cutting our NASDAQ exposure and that was before the Nvidia pop. It’s not to say that we don’t think that tech isn’t going to play a growth role over the long term. It’s just that we see that the rally this year has probably run its course and there are sectors with better value propositions. One of those would be the banking group – both Canada and the U.S.
Halfway through the year, there were a number of challenges facing Canadian banks. Housing was looking shaky after last year’s rate hikes. Net interest margins were not going to be as robust as desired, as banks had to pay more for deposits. Household debt to income ratios continue to hit record highs. And, to top it off, most economists expect either a slowdown or recession in final fiscal quarters. None of these issues have suddenly emerged and that is why banks have been the second worst performing sector on the TSX this year (after the 5.5% drop in energy). From last Friday, the group is down 4.5% and most of this stems from second-quarter results that disappointed.
True, we are seeing weakening in loan demand and indications of pressures on households (as highlighted in the recent Bank of Canada financial conditions report). Net interest margins, however, were not an issue last quarter (the difference between what banks are earning on loans versus what they have to pay on deposits). The major drag on earnings came from an increase in loan loss provisions which are going to exceed $3 billion across the six largest banks. I gave an interview with BNN this week on why banks put aside a portion of their earnings in the event of losses on their loan portfolios as some investors confuse this with an actual loss that has impacted a bank’s net income.
Back at the start of the pandemic, when we shut down much of the economy, banks had to take enormous amounts of earnings into provisions. This was in addition to a mandated stop to dividend increases and share buybacks. At the time this was a very defensive move since no one knew what the final outcome would be, nor what governments and central banks would be prepared to do. The increase in provisions drove earnings down sharply, but after a year, banks were able to bring a large share of those provisions back into earnings, as the economy rebounded and loan impairments were nowhere near what was feared.
This time last year, provisions were low because the economy was strong and few were expecting a slowdown or recession any time soon. Fast forward to today and the tide has shifted. Most economists predict a much weaker period in the second and into 2024, resulting in higher unemployment and increased challenges for households and businesses to service their debt. Indeed, we are seeing a gradual rise in mortgage delinquencies, but they remain well below pre-pandemic levels. At the same time, despite the intuitive increased risk in commercial credit, there has only been a slight bump up in net impaired loans as a ratio of net loans and acceptances according to Bloomberg. Credit card delinquencies are also moving higher, but are below the peak seen in 2021.
Our view is that the provisions taken by the major banks will be adequate to insulate against a slowdown in Canada’s economy and even a moderate recession. Inflation will eventually decline back towards the Bank of Canada’s target, allowing for some easing in policy in 2024. Right now, the bank group as a whole is trading at price/earnings multiples that are not far from the lows (near 9.0) back in the fourth quarter. Compare this to a trailing price/earnings ratio of 184 for Nvidia, although forward earnings estimates bring that ratio down to about 54. Yes, this is about an extreme apples versus oranges comparison as you can get. Still, from a value perspective and given the potential for any slowdown to also impact capital expenditures, Canadian banks look pretty good here.
On behalf of the Pyle Group, have a wonderful weekend.
Andrew Pyle
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