December 5, 2017

On Tuesday, the S&P 500 was down 0.4% and Toronto was down 0.3%.

Toll Brothers was down 7.4% to $46.93 after releasing Q4 earnings and 2018 outlook that “missed analyst expectations”. At a quick look the Q4 results look pretty strong to me and I think it is the analysts and not the company who have some explaining to do. This stock has been volatile and could certainly go in either direction. But I think it still offers good value. The U.S. housing recovery appears to be still in progress.

Constellation Software was up 2.5%.

The Melcor REIT was down 3.1% to $8.55 after it issued units yesterday at $8.50. This one is certainly worth considering given its yield of 7.9%. The unit price is below book value due to concerns about the Alberta economy including the potential for vacancies in its rental spaces and possible loss of market value on its buildings. A 7.9% cash yield never comes without some level of risk, but this seems likely to work out well over time.

To the extent that “the market” even noticed Melcor Developments today it was unenthused by the sale of the 5 buildings to the REIT.  It is unclear to me if the buildings were sold below book carrying value or not. It appears they may have been transferred at $1.5 million below or around 2% below book, given that was the discount to appraised value as at September 30 and they may have been carried at that value. Furthermore, since the REIT is about 53% owned by Melcor Developments and is consolidated into Melcor Developments balance sheet, it might be the case that no loss or gain would be booked. But I suspect there would be as the buildings would now likely be carried at the purchase price rather than appraised value.

Bank Profits

I am currently taking a very close read of Royal Bank’s Q4 and fiscal 2017 results.

Even after many years of looking at bank balance sheets, I remain shocked by the level of leverage employed. And I am stunned by the level of profitability that Royal Bank has in personal and commercial banking which represents 50% of its total earnings.

Royal reports a return on equity on personal and commercial banking of 28.5%. And that is not due to anything unusual this year. The prior three years averaged a bit higher than that.

Part of the reason is extreme leverage. In this business segment, Royal has assets that are 21 times higher than the common equity that it attributes to this business. That means its equity ratio is just under 5% of assets. Now, on a risk-adjusted basis they would be leveraged “only” a bit under 10 times and have common equity somewhat over 10% of risk-adjusted assets. But 10% is still low for any industry except banking.

I just find it ironic indeed that banks and the whole financial and credit rating system would insist that most companies need common equity of more like 50% and so may leverage more like only two times, but banks can apparently safely leverage with risk-adjusted assets at 10 times common equity and actual assets at 20 times common equity.

Also a 28% ROE seems very attractive indeed. It raises the question of whether banking is susceptible to disruption and new entrants who would be satisfied with lower profits in relation to equity.

And the high leverage raises the question of whether this is really safe. Is a bank leveraged like this as safe as it thinks? Maybe so, given federal mortgage insurance. But the safety of Canadian banks would remain to be seen in the event of a truly deep recession or in the event that housing prices were to go into free-fall. (What has rocketed up, may not be expected to come down, but the possibility may be there). The ability of Canadians to pay their loans is one thing in an environment where new loans to make payments on old loans are very easily available. If the lending taps were to be turned off, that ability would be somewhat different. I am not predicting anything here, but this sort of scenario is perhaps not impossible.