Sionna Insight
Suspension of disbelief
In comic books, villains always lose, heroes always win, Superman can fly, and
Spiderman effortlessly scales walls. It is all achieved because readers set aside rational
beliefs to accept the incredible or fantasy as fact. It is a phenomenon that writers call
the suspension of disbelief. Of late, net margins and return on equity (ROE) have
soared, flying, like Superman, to all new record levels. Basing stock valuations on these
inflated metrics requires a suspension of disbelief about cyclical and secular forces in
corporate profitability. Current levels will ultimately prove unsustainable and mean
reversion will drag ROEs lower. Simply put, reversion to the mean suggests that over
the long-term a data series (P/E ratios, interest rates, economic growth, margins, etc)
will always migrate back towards their long-term average. In the past, the timing of
ROEs’ mean reversion has coincided with overall economic cyclicality. Today’s
economic uncertainty may prove to be the proverbial straw on the camel’s back that
results in a secular change in earnings. With history as a guide, a return to “normal”
ROEs may prove to be a very painful experience. While almost all industries have
experienced above average levels of
S&P / TSX Net Margins (%)
profitability, trends in the Canadian banking
industry suggest that previous aboveaverage ROEs are likely soon to be industry
lore.
12%
10%
S&P / TSX Average Net Margin = 5.8%
Since 1979, there has never been a
sustained period where corporate
profitability and ROEs were maintained at
today’s record levels. In fact, from current
lofty levels it is more probable that net
margins will drop to below trend levels.
From 1985, the S&P/TSX net margin has
averaged 5.8%. The last number of years
has produced an astounding increase in
corporate profitability and net margins.
Since the 2001 trough, corporate net
margins have increased from approximately 4% to over 11%. Recent net margins are
almost two times the historical long-term average. There is no evidence that the
Canadian business model has undergone a
S&P / TSX Return On Equity (Recurring Earnings)
structural change that justifies the belief that
profits will remain sustained at these levels.
8%
6%
4%
2%
Oct-07
Oct-06
Oct-05
Oct-04
Oct-03
Oct-02
Oct-01
Oct-00
Oct-99
Oct-98
Oct-97
Oct-96
Oct-95
Oct-94
Oct-93
Oct-92
Oct-91
Oct-90
Oct-89
Oct-88
Oct-87
Oct-86
Oct-85
0%
18%
16%
14%
12%
10%
8%
6%
TSX Average ROE (1979 - 2007) = 10.2%
4%
2%
Dec-07
Dec-06
Dec-05
Dec-04
Dec-03
Dec-02
Dec-01
Dec-00
Dec-99
Dec-98
Dec-97
Dec-96
Dec-95
Dec-94
Dec-93
Dec-92
Dec-91
Dec-90
Dec-89
Dec-88
Dec-87
Dec-86
Dec-85
Dec-84
Dec-83
Dec-82
Dec-81
Dec-80
0%
Dec-79
ROE has experienced a similar rise of late.
As outlined in the chart, based on recurring
earnings, the long-term average return-onequity (ROE) for the S&P / TSX is 10.2%.
Driven by stronger levels of profitability,
ROE has averaged 13.7% in the last five
years, peaking at current levels of
approximately 15.0%. Shaded areas
represent recessionary periods of economic
contraction. Historically, every such period has resulted in a decline in reported ROE. In
fact, when driven by an economic contraction, ROEs on average fall 7 percentage points
from peak levels.
One specific example of a sector that
S&P / TSX Bank ROE
exemplifies this trend is the Canadian banking
industry. The Canadian banking industry is
unique. A well disciplined oligopoly,
Average Bank ROE ('79 - '07) = 14.92%
Canadian banks have consistently generated
ROEs in excess of the overall market
average. As outlined on the following chart,
bank ROEs have averaged 14.92% since
Average Bank ROE (last 10 Years) = 16.53%
1979. For the last ten years, bank ROEs
have expanded, averaging 16.53%, with the
Average Bank ROE:
1979-2007:
14.92%
last five years averaging 17.12%. Profit
2001-2007:
17.12%
margins and ROEs over the last five years
Last 10 Years: 16.53%
have been propelled by several unlikely-tobe-repeated tailwinds. First, investment
banking-related earnings were supported by
the biggest private equity driven market in the
history of mankind. Second, the era of securitization provided ample opportunities to
generate strong returns with supposedly no risk and with little effect on bank balance
sheets. Finally, loan loss provisioning dropped to record lows. Arguably, we could be
entering a period of time when bank ROE trend to below average (past economic
slowdowns have all resulted in below average levels of profitability). In an environment
of slower economic growth, rising loan loss provisions, and lower investment banking
fees, it is difficult to envision a scenario where bank ROEs do not drop from their current
record levels. In valuing Canadian bank investment opportunities, Sionna is assuming
that earnings power will revert towards historical long-term averages. In contrast,
consensus analyst estimates reflect 2008 and 2009 ROEs of 21.6% and 20.7%,
respectively. Historically, bank ROEs have bottomed at much lower levels. It should be
noted that the average of the five trough ROEs reported by Canadian banks is 11.6%,
almost half of current analyst expectations. If history is repeated, bank ROEs at these
trough levels will even make Sionna’s conservative estimates seem overly enthusiastic.
20.0%
15.0%
10.0%
5.0%
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As we have said many times, our best prediction at any point in time is what has tended
to happen in the past. In valuing businesses, Sionna’s intrinsic value model utilizes tenyear average ROE as a key input for determining normalized earnings power. Typically,
a ten-year period will capture enough history to be representative of a corporation’s
earnings power over a cycle. Today’s market is grappling with the potential of a
softening economy. Economic cyclicality will ebb and flow but a reversion to the mean
of historical ROEs is of greater concern. In the past, every economic slowdown has
resulted in a period of time where ROEs decline from above-average to below-average
levels. To discern value in today’s market, Sionna is conscious of the reality that
profitability levels of the last five years are unlikely to be sustained. Only in comic books
can Superman fly or ROEs remain at today’s lofty levels forever!
Colum McKinley, CFA
Portfolio Manager
June 30, 2008