Hello, and welcome to the Download. I'm your host Dave Richardson. And it is Stu’s day with Stu Kedwell, co-head of North American Equity at RBC Global Asset Management. Which means, first, he works for a bank, and then, he looks at and knows a lot about banks. We normally talk a little bit about bank earnings too, but we were having our vacations and it was hard to connect. So the bank earnings came out and we missed that conversation. Why don't we pick it up again because I think you were at a conference too, the financial services conference, and your thoughts are always evolving around banks— or not, which can also be a good thing. We'll get to that too. First of all, did you have fun at the conference? Was it like a party conference? Because bankers are known for being pretty interesting and exciting people to hang out with, right? It's pretty wild at the bank conference.

When they bring the cookies out at break time, Dave, I got to tell you... No, but it's always good to hear from everyone. Banks are great to think about in a number of ways because you have the longer-term view, which is businesses that generate a lot of capital and have pretty good operations and pay good dividends, and over a longer period of time have proven to be quite good at dividend growth. And then you have the short term, which fascinates a lot of market participants on a daily basis, particularly when we get into an economic environment that has some uncertainty and lots of things going on around Canadian housing. You name the loan category, there's probably a bit of angst, whether or not it's housing, auto, credit card, unsecured lending, commercial, you name it. So a couple of things just to start off on is, during this period of time where there's going to be a forecast for some higher credit losses, you have seen the estimates that analysts would have for banks come down through 2023. And normally, short-term movement tends to correlate pretty well with estimates revision. So estimates have been coming down and the bank stocks haven't traded as well. Are we at a point where those estimates are starting to bottom? I think we're certainly getting a lot closer, but the credit outlook is still going to be pretty important to think about. And we'll revisit that in just a second.

Hey Stu, sorry to interrupt your thought process, but we got a lot of new listeners, and we got a wide range of investment background. Loan loss provisions from banks, what are they? Why do they do this and why is it so important to understand the trend in them?

There are two types of loan losses. There's what they call loan losses provisions on performing loans. So the accounting says, when you make a loan, inevitably some of them are going to go bad. So we have to put up a provision as we make the loan, even though it hasn't gone bad yet. And then there's provisions on impaired, and those are loans that have gone into delinquency. They changed the accounting a little while ago, so you have to try and estimate in those provisions on performing how much money you might lose in the next twelve months is one stage, and then over a longer period of time, in the second stage. So banks have created all these models to try and estimate how much loan losses might arrive in the future, and it's going to have an impact on this cycle. So as you build these, eventually you would build what they call provisions on performing and then you will draw that provision down as the loan actually becomes impaired. Because you're trying to get in front of it. And a lot of bank investors historically would say you really buy the banks when provisions for credit peak. In the past, they used to really spike a lot higher because you didn't have this mechanism. You had general reserves, but it didn't work quite the same way. I think that's going to be a big difference in this cycle. And it's been one of the reasons why the estimates have come down, because people have been trying to get these provisions for performing credit into the numbers. So as the year progresses, when we get to look into estimates, those provisions for performing look like they might actually decline a little bit in the latter part of 2024-2025. So the economy will play a pretty important role in that, and that is a big difference this time. But before we even get to provisions for credit, the first stop is that a bank needs liquidity. And the banks have plenty of liquidity. It's costing them more than it used to because of higher interest rates. They need capital. The regulator spoke at the conference and some people think that OSFI will continue to take the minimum capital ratio up a little bit, maybe towards 12% at the end of this year, which means most banks would run around 12.5%. These are pretty robust capital ratios if you look back, relative to history. So banks have good liquidity, they have good capital, they have a bunch of loans on the books, some of them. There'll be some provisions as the economy finds its way. And that's really part of the process of trying to determine earnings; to try and figure out where provisions for credit might be. But when we look across the banks from a longer-term standpoint, people say, well, why don't you worry about provisions for credit? Well, two things. First is, we know banks are going to have provisions for credit. We're scenario-based investors, so we know that banks are going to go through good and bad times. And the second thing is, one of the old axioms, which is you can't lose money on the same loan twice. So once you've written it off, you've written it off. We look at earnings in a couple of ways. We look at what they call pre-tax, pre-provision earnings. That's a very exciting term; I can tell by the look on your face. So what that says is, all the money that the bank makes that would be available to write off credit if they had to. Because that's everything that's left. You paid all the expenses, you paid the depositors, you have this money left. And the only thing left to pay is taxes and your provisions for credit. Now, if your provisions for credit were 100% of that number, there'd be no tax to pay, because there'd be no earnings. So this pre-tax, pre-provision number is multiples of the provisions for credit. Each year, a bank has this self-generating capacity to deal with past mistakes that might have been made on the credit side, and then the other businesses that don't maybe use the balance sheet the same way, wealth management, advisory businesses, M&A, these types of things, there's a big focus on that growth. And that growth is important because it doesn't use capital, but also, it has really long-term growth prospects. There's the digital component of banks, as everyone gets very focused on the here-and-now. What's going on with the app? What's going on with the digitization of different processes in the background to take costs out and what have you? When you come to these conferences, you're always having discussions around the here-and-now because it's always important, but you're also trying to have discussions about how these businesses will evolve over time and which business lines are set for more secular growth. And you're trying to think through what might the banks make in the near term? And then when some of these credit headwinds pass, what might they make on the other side and how might they trade? Things like this.

I think a lot of the listeners are going, that doesn't sound like it's worth the cookies. Sounds like you need a bigger reward to attend that conference than what you got excited about. But you do remain a very sophisticated, yet simple man, and that's why I think everyone loves you. Are you optimistic about where we are with banks? Again, we're at that stage where we're still expecting those provisions to be rising at this point, as we look out over the next twelve months.

Anytime you look at a business where there's a near-term set of concerns or a near-term frustration, you have to take a step back and say, is the provision of the service valuable over time, and does the bank have the resources to get through this period of time? So when you answer yes to both those, then it's hard not to be optimistic on the intermediate term. You're sitting there saying, I've got a security that I think is undervalued relative to where it'll be in a couple of years. I'm collecting a nice dividend. I have strong management teams who are looking at every facet of the bank, whether it's new revenue streams, expenses, all sorts of things, to optimize that income for me, not just today, but over time. So intermediate term, it's hard not to be optimistic. In the next twelve months, we've talked a lot about the uncertainty on the economy, and that's when you want to be very aware of all the categories where provisions for credit might come up. And what you want to ensure is that any types of losses that might come in that front don't dwarf the bank's resources or their ability to pay for them. In Canada, the thing that receives the most attention is what they call the variable rate fixed payment mortgages. So those have to reset as the term comes up for renewal. Fixed-rate mortgages have to reset. And a lot of this happens at the end of 2024 into 2025. And that's going to be a bit of an impact. It's already having an impact. But what will it do to consumer spending? What will it do to these types of things? It's not so much that that makes the mortgage business filled with losses, but there's unsecured credit, there's credit cards, there's auto lending; you have to work through all those categories of loans in those different scenarios. But again, it's all measured against the bank's overall earnings power and ability to cover those off.

So, Stu, one of the big portfolios that you manage is a Canadian dividend portfolio. That means you're going to really have, under any circumstances, these Canadian banks in that portfolio, both the big banks and some of the smaller banks as well. How do you manage through this? Is this a case where you're going to manage the weight relative to the rest of the portfolio in terms of taking it down and then looking to add back, or do you hold it fairly stable? And then if you were to take it down, have you even got alternatives, in a relatively small equity market like Canada, to find other dividend producers to up the weight on those to counterbalance what you might be selling on the bank side?

The first lever is the sector as a whole, and the concerns that are front and center today aren't new. So I think you can take that to say we've probably brought the banks down within the portfolio to the lower bound of where we would want them to be. So we are actively looking through this period of time to figure out the period of maximum pessimism, so to speak, and how do we build our positions back up into that. The second thing is, within the banks, we look at who's done acquisitions, who has cash flow to come in the door outside of traditional business growth. We look at different business lines. We've talked about capital markets perhaps being early cycle, the benefits of wealth management over time, strong deposit franchises, all sorts of things. So you are always doing that within the sector and then you're always comparing it relative to the other opportunities that might be available. So you can do just very simple ratios. You can say, well, these two stocks, three years ago, the ratio between them used to be one for one, and today that ratio might have moved to two to one. And you can say, we think both of those businesses compound over time, but this one has doubled relative to this one in a very short period of time. Perhaps it's time to make a rotation. My partner has a great line: you're always trying to identify the horses you want to ride, and sometimes the horses go on the stable and sometimes they go out on the track. So that's just portfolio management, always looking at all those ratios. You can look at a grocery store and say, that's trading at all-time highs. And this stock, which is also connected to the Canadian economy, maybe grocery parts are connected, parts are more necessary, but this one has done quite a bit better than this one. At the end of the day, three to five years from now, they're all really connected to the same prosperity, so maybe there's the opportunity to move, rotate the portfolio.

Yeah, and sorry to pivot on you in the middle because I think we've talked about before, we generally have a quick conversation before to just cover off anything we want to talk about, and we were going to talk about banks in general. But then I got into the essence of the portfolio management, and I think it was important for listeners to see, I may have this one holding I've got that I really like, and I think it's a great horse and it's going to have a great lifespan. But there may be some times where I don't want to have as much as I had before. And so, I may just pause for a bit, but I've got to look for something else that's better. And there's something there. The way you talk through, it was really good at showing people how you think about that. You're not going to sell everything, but park it for a while and maybe pay a little bit less attention to it and then come back to it later.

I think the idea is, if you have a business in the portfolio, you think that that business over time can compound for you, between dividend and growth, somewhere between 7 and 9%. And if it gets down to the prospects being 6%, maybe you do something. If it got down to being prospects of 5% and you had another business over here where the prospects were 11%, then you've got 500 basis points of return potential, so you make the swap. We get the benefit of having a longer-time horizon. Normally, what they call time arbitrage is the single easiest and best tool as an investor. Because you're going, I know this will happen, I just don't know exactly when. When you find situations like that, you definitely want to take advantage.

Excellent. That was some great stuff, Stu.

All right, Dave.

We should maybe hang around the banks a little bit more. That was an interesting discussion.

Those are good cookies, Dave. They are good cookies.

They are good cookies. Well, I can see by the black circles under your eyes, it was a wild week. So I'm glad you're getting out and enjoying yourself a little bit because I know you would just work too hard.

All right, well, thanks very much, Dave, and we'll talk to you soon. And stay well.

Thanks, Stu. Talk to you soon.