When trying to understand the difference between the price of a stock and the value of a company it is helpful to think of actual industries and companies where this may be happening. One of the largest such sectors in Canada is our banks.
Strong consistent profits and performance of the Big Six banks has been a hallmark of this sector for many decades. The year 2020, however, has proven itself to be a difficult one for our blue-chip banks with the average price of stocks declining by roughly 40% in March, and even at the end of October they were still down 15% for the year!
What caused this dramatic decline? More importantly what can we learn about short- and long-term value of a company from these unusually dramatic stock price changes?
First, we need some context. Global stock markets dropped around 35% in March 2020, so seeing our banks go down by similar amounts sort of makes sense. Everything seemed to be going down, and the banks joined in.
Second, if the economy shrinks then so do bank profits, at least in the short term. Fewer people and companies take out loans, and more loans end in bankruptcy. Both are bad for banks. In addition, history teaches us that during recessions bank stocks go down, and we had a very severe recession this year.
Third, interest rates, especially long-term rates for things like mortgages dropped a lot. Five-year mortgages went from roughly 3% to well under 2%. On the surface this may not seem like a very big drop, but it represents a decline of 30-40% in the rate, and therefore a big hit to lending earnings.
All three of these reasons tell us why the short-term stock prices of our banks dropped. But did the total value of these banks decline by the same amount? That is the most important question, and as is the case with every investment we hold that is the one thing we and our managers stay focused on. When the stock price of a specific company does not reflect what we believe is its real value, we see this as an opportunity to invest.
We are not saying in this article that Canadian banks are, or are not, undervalued. Instead, the purpose of this article is to help our clients better understand how a potential mispricing can take place. Our track record, and that of our managers, has been to identify where these mispricings are actually taking place and taking advantage of them. This usually means successful investors will look wrong in the short run, but over the longer run they will prove their worth.