The first in a three-part series on why now is the time for companies to invest.
Of the close to 16 shareholder proposals that are up for a vote at five of the top six Canadian banks’ annual general meetings (AGMs) this year, most were around the environment, or climate change, including some on greenhouse gas emissions. Two of the issues were related to increased investment in fossil fuels.
At the time of this writing, the Toronto Dominion Bank (TD) has not yet made its proxy circular available.
InvestNow Inc. submitted a shareholder proposal to the Bank of Montreal (BMO) and Canadian Imperial Bank of Commerce (CM), asking that the banks make clear their commitment to continue to invest in, and finance, the Canadian oil and gas sector. And further that the banks conduct a review of any and all of their policies to ensure that there are none that have the effect of encouraging divestment from the sector.
InvestNow Inc. is a not-for-profit organization that challenges the divestment movement and advocates for investment in Canada’s oil and gas sector. The proposals were submitted by Gina Pappano, Executive Director of InvestNow.
Pappano said her proposal is also on the ballot at TD, and she has spoken to all three banks, and had good engagement with all. “My proposal was left off at RBC and Scotia on a technicality. But I will file with them next year. I chose to file because I felt that the engagement I had wasn’t enough, and I wanted an alternative view presented at the AGMs,” she said, adding that she will be presenting at all three AGMs.
“Last proxy season, asset managers rejected many proposals that they saw as not financially material, highly prescriptive or both. This proposal seems to tick both those boxes,” said Lindsey Stewart, director of investment stewardship research at Morningstar Research Services.
“[The proposal] doesn’t request any kind of reporting aimed at advancing shareholders’ understanding of the banks’ climate financing policies. It does, however, request that management make a somewhat vague statement of “commitment” to a fossil fuel sector that the banks already finance,” he added.
In its supporting statements, InvestNow points out that public policy framework and public conversation are both directed against investment in the oil and gas sector: “The result is chronic underinvestment in that sector,” InvestNow says, “It asks that BMO and CIBC explicitly state their commitment to Canada’s oil and gas sector, and end or temporarily suspend support for policies like net-zero targets. The embrace of such policies – which have the effect of suggesting that oil and gas extraction, development, and use are not of essential value – sends a negative signal about investment in the sector,” it notes.
It also says that the banks should “Focus on investment in, lending to, and financing of the oil and gas industry to create more supply and reduce energy costs for Canadians and the world.” InvestNow says support for the sector is important because:
BMO asked shareholders to vote ‘Against’ this proposal because “It is unnecessary in light of BMO’s commitment to be our clients’ lead partner in the context of our Climate Ambition, which supports the net zero strategy of the Canadian oil and gas sector, and the role of the board and management in setting the strategy of the Bank.”
The bank adds that climate strategy is an integral part of its overall strategy that is approved by the board and cannot be delegated to shareholders.
“Our approach has been to support our clients in their own decarbonization journey towards net zero, not to divest. Divestment strategies do not support real-world emissions reductions and could result in a disorderly net-zero transition that does not address the economic and social needs of the communities affected. We support our clients in their efforts to reduce emissions and anticipate that our clients will, over time, transition their businesses in support of a low-carbon economy,” it said.
CIBC also asks shareholders to vote ‘Against’ the proposal, pointing out that it has set a net-zero ambition for its operational and financing activities by 2050, and has released 2030 financed emissions targets for its high carbon-intensive portfolios: oil and gas and power generation.
The bank acknowledges that there are factors outside of CIBC’s control that will influence decarbonization globally across sectors and economies, such as the development of new technologies, industry-specific solutions, shifts in consumer behaviour, and the impact of geopolitical events.
It points out that in 2022, CIBC, “Provided industry-leading advice and capital markets solutions through our global Energy, Infrastructure, and Transition group within CIBC Capital Markets, to support clients, including those in the oil and gas sector, impacted by the shift in how the world produces and consumes energy, and develops infrastructure.” It also made significant progress towards its goal of mobilizing $300 billion in sustainable finance by 2030, and its commitment to invest $100 million towards climate tech and energy transition funds through Limited Partnerships.
To Pappano, success for the proposal would mean that the banks abandon Net Zero targets. “The banks have said that Net-Zero targets are not divestment, but I see them as a commitment to wipe out a profitable sector by 2050. To me, that is divestment. Divestment does not help reduce overall emissions. So why should the banks do it in Canada?” she said.
“It’s unsurprising that the banks’ boards feel such a statement is not necessary; shareholders are likely to feel the same way,” said Stewart. He noted that proxy voting has become a complex and contentious area, and shareholder proposals that appear to pull in different directions are becoming a recurring feature at shareholder meetings.
He adds that these proposals are a good example of that, and it shows how much attention is needed on the part of governance and stewardship professionals to weigh the benefits and drawbacks of each proposal and vote in line with the end-investors financial and sustainability objectives.
“It’s a delicate balancing act and it certainly isn’t getting any easier,” he said.
From the banks’ standpoint, though, as for any company, sustainability is one of many risks to consider. At Morningstar, we analyze all risks the same, with any risk that could affect our future cash flows and therefore our valuations all up for equal consideration.
Could this proposal be considered a sustainability risk? “In my view, it depends on how you define ‘ESG risk’. There are many ways people interpret this. If you are thinking about pure regulatory or political blowback, you create risks by investing in or not investing in fossil fuels, it all depends on who has political power at that point in time, and that can change,” said Eric Compton, Morningstar equity analysts covering the Canadian banks.
“If you’re thinking about credit risks, for example, some may say it is risky to lend to industries that face structurally lower demand in the distant future; this is what I would call basic lending 101. All banks think about credit risks whenever they make loans, and there are no risk-free loans, and they account for this in how they price and structure the loan. Does lending to a cyclical industry like fossil fuels increase credit risk? Yes, as does all lending in some sense, and every industry has its own unique risk profile. What’s more important is that the bank is pricing and structuring its loans correctly, and if they are, they actually create value for shareholders as it increases profitability,” he said.
Canada has underinvested since the financial crisis and is now over-using labour to make up for it
The first in a three-part series on why now is the time for companies to invest.
Investing in big, new industrial projects right now might seem asinine to business strategists. Higher interest rates have everyone fixated on recession — not whether there will be one, but when and how deep.
The prospect of a prolonged banking crisis piles on considerable risk. History suggests that these conditions cause business investment to dry up, remaining arid until it’s clear the economy has legs. At times like these, CFOs are supposed to be closing the vault to all visionary spendthrifts, conserving cash to survive the the big bad.
But is that really where the economy is at?
Visionaries might counter that demand is where it should be, and that our current problem sits squarely with tight supply. Ergo, we need more industrial capacity to make sure that production can meet demand.
Even if they’re right, that’s no easy feat — getting a building up usually takes more than a year from start to finish, sometimes several. More machinery is a quicker fix, if you can find a place to put it; but it is more than likely tied up in the supply chain snarls that it would be attempting to rectify. So, how can this possibly be an ‘investment moment’?
Since business investment in physical assets shouldn’t be, and on balance rarely is, a knee-jerk reaction to an instant development, then there must be good structural or longer-term reasons for this being an “investment moment.” It turns out there are not just one or two good reasons. In fact, there are enough that airing them requires more than a stand-alone article, which is why this will be the first of three on the subject. So, where do we start?
Let’s first consider the possibility that we have underinvested since the global financial crisis (GFC). Most would agree that the global economy has on balance spit out sub-par growth since 2008, not really generating a convincing recovery. Then consider the bubble of activity that preceded the crash back in 2008. There was arguably a lot of pre-GFC investment to support the unsustainable level of production, excess that had to be re-absorbed before a true, new investment cycle could begin. Since that pre-event bubble was so huge, investment didn’t really need to ramp up for years — in fact, long enough that business in general might misinterpret it as a structural change, to a low-investment “new normal.”
Drag that on for long enough, and when the economy is finally ready to ramp up, business capacity is years behind. There is a good chance that our post-COVID recovery is discovering just that. Suddenly, we need the capacity, but we can’t get there right away. The result? Inflation that’s not a temporary blip, as we were promised, but a nagging problem that in the absence of a supply-side fix, has us artificially suppressing demand. If this is true, monetary policy ought to be seen as a temporary rein, buying time for business to boost capacity. If they can handle the higher borrowing costs, that is.
If that seems like a stretch, consider that in Canada, business investment as a share of gross domestic product has been well below the long-term average for years — and that at a time of suppressed global growth. More importantly for global capacity, U.S. business investment as a share of GDP took a long time to recover post-GFC, and has not yet returned to pre-GFC levels. The case seems compelling: there’s a need for a significant rise in business investment to support the global economy’s present and future demands.
A second and related point is that we appear to be over-using labour. It makes sense — when caught short, it’s far easier to add workers than to add plants and equipment (assuming the two are reasonably substitutable). Then, when it becomes apparent that labour is getting tight, business panics, and over-hires; better to have a healthy buffer of workers than to run lean and risk losing enough head count that lines or even whole operations get shut down.
This is far more visible than the investment situation. Everyone knows we have record-low unemployment in most OECD nations. In Canada, there is a higher number of employees for each unit of GDP, a feature of the post-GFC period. Compared with the long-term trend, a crude calculation has us employing 700,000 to 800,000 excess workers. Cut that in half, and it’s still huge.
The flip side of this is labour productivity, which has swooned in recent years. The remedy isn’t to replace all of these workers with robots. But clearly we have a critical labour shortage, and business is generally desperate for remedies. Higher business investment would relieve this pressure, and free up workers for those other parts of the economy where tight labour supply is severely constraining output.
Labour constraints aren’t likely to improve. A third argument for higher investment is our structurally skinny demographic situation. Many are hailing Canada’s outsized immigration influx in 2022 as a cure to this chronic ill. Not so fast; immigration numbers were boosted last year by 607,782 non-permanent residents (we typically receive about 26,000), abetted by Ukrainians fleeing the war. We can’t (nor should we) count on similar future surges, unless we can be assured that it is possible to boost Canada’s regular immigrant intakes.
There are plans to increase immigration to 500,000 per year; we’ve struggled in the past to get that number much above 300,000. I have argued elsewhere that as attractive as Canada is, there is increased competition from other population-constrained high-income countries; and increased competition from faster growth and the attendant opportunities in the home country.
A key means of securing our future is increasing capital’s contribution to output — which as a bonus, generally improves productivity. This is just a start — there are at least six more key reasons to hail this point in time as an investment moment. If the CFOs were twitchy after reading the first paragraph, they will now be in a full-blown sweat. This article’s three factors are reason enough to begin thinking about keeping the coffers open, and the dust off the blueprints. To be continued.
Peter Hall is chief executive of Econosphere Inc. and a former chief economist at Export Development Canada.
Following multiple recent bank collapses, some on Wall Street estimated the Fed would step back from its by-now customary rate hikes when it convened to discuss its monetary policy last week. That did not happen, however, and Fed chair Jerome Powell announced another 0.25 percentage point rate increase.
One prominent investor thinks that was unnecessary and counterproductive.
“Obviously he (Fed Chair Jerome Powell) didn’t need to do what he did,” billionaire Barry Sternlicht said, likening the act to “using a steamroller to get the price of milk down two cents, to kill a small fly.”
With regional banks already under severe pressure, Sternlicht, the co-founder and CEO of Starwood Capital, a hedge fund that oversees over $100 billion, believes the latest rate hike could potentially cause more damage to banks.
While Sternlicht is worried about the latest increase’s impact on the economy, going by one of his picks, he appears well-prepared to withstand any more rate hikes.
Sternlicht is invested heavily in MFA Financial (MFA), a dividend stock yielding a monster 15%.
MFA is structured as a REIT, a class of company’s long known for their high-yielding dividends. MFA’s portfolio is composed mainly of residential whole loans, residential and commercial real estate securities, and MSR-related assets.
As of the end of last year, MFA’s investment portfolio totaled $8 billion, although that declined from $8.3 billion at the end of 4Q21. Elsewhere in Q4, net interest income dropped by 20.7% from $70.15 million in the same period a year ago to $55.65 million. That said, at $0.48, adj. EP increased meaningfully from the $0.08 generated in 4Q21, and came in well ahead of the $0.30 forecast.
Of course, the most appealing aspect here is that sky-high yield. The quarterly dividend payout currently stands at $0.35, generating a yield of 15.3%.
That is no doubt attractive to Sternlicht, which has allocated 68% of his portfolio to his MFA holdings; he currently owns 10,638,539 shares worth $97.13 million.
Sternlicht is not the only one showing confidence in this name. Stephen Laws, an analyst at Raymond James, holds a positive outlook for MFA. His optimism is based on “selective new investments, conservative leverage, strong portfolio returns, and shares trading at ~80% of economic book value.”
“Given our outlook for attractive portfolio returns, an increased focus on business purpose loans, and the current valuation relative to our target, we believe the risk-reward is compelling,” the 5-star analyst further added.
As such, Laws rates MFA shares an Outperform (i.e. Buy) along with a $12.5 price target. This suggests the shares will climb 37% higher over the coming months. (To watch Laws’ track record, click here)
The Street’s average target is a little under Laws’ objective; at $12.33, the figure makes room for one-year returns of 35%. Rating wise, based on 2 Buys and 1 Hold, the analyst consensus rates the stock a Moderate Buy. (See MFA stock forecast)
To find good ideas for dividend stocks trading at attractive valuations, visit TipRanks’ Best Stocks to Buy, a newly launched tool that unites all of TipRanks’ equity insights.
Disclaimer: The opinions expressed in this article are solely those of the featured analyst. The content is intended to be used for informational purposes only. It is very important to do your own analysis before making any investment.
A couple of things have happened to First Republic Bank (NYSE:FRC) since I submitted a contrarian call to buy the community bank’s shares about two weeks ago. FRC stock has whiplashed ever since and the bank has seen significant deposit outflows in the days following the bank failure of Silicon Valley Bank. A series of 8K disclosures were meant to reassure investors that First Republic Bank has sufficient liquidity to manage a heightened level of deposit outflows, but investors have chosen to bet against the bank and they clearly expect the worst to happen. I continue to believe that First Republic Bank is not at risk of going out of business and that the common stock potentially offers very risk-tolerant investors triple-digit return potential!
To account for extraordinarily high levels of volatility in the financial market, I have chosen to take a very small position in First Republic Bank: FRC accounts for just about 1.05% of my investment portfolio which chiefly consists of non-financial stocks. Given the asymmetric risk profile that I see with brutalized community banks, I believe investors could earn multiples of their investment here… if fears subside and confidence returns to the community banking sector. However, there is a chance that First Republic Bank might be shut down or be forced to do a highly dilutive capital raise which would likely seriously impair the remaining value of the equity. Therefore, investors must recognize that there is the potential to lose the entire investment if things turn south.
Since my last call to consider FRC in the midst of the banking bloodbath, shares of First Republic have revalued lower by about 60%. However, the bank has made a number of 8K disclosures throughout the banking crisis that were meant to inform investors about the strategic actions the community bank has been taking.
It all started with an 8K disclosure dated March 12, 2023 in which First Republic Bank announced that it secured additional liquidity from the Federal Reserve Bank and JPMorgan Chase & Co which brought its unused liquidity to a massive $70B. Undoubtedly, huge deposit outflows forced the company to bolster its cash position.
Just days later, on March 16, 2023, First Republic Bank announced that eleven lenders banded together and deposited a combined $30B into the bank (8K source) in order to signal confidence in First Republic Bank’s liquidity situation. This move also failed to calm investors and the lender’s shares have continued to sell off since.
Additionally, last week, First Republic Bank announced that a number of executives have agreed to reduce their annual bonuses to zero for 2023 while others have forfeited vesting all performance-based incentives (Source). The latest 8K, dated March 22, 2023, was meant to instill confidence in the bank yet again and align shareholder and executive interests. Since shares continued to fall last week, it is safe to say that the latest measures have not yet had a positive effect on investor sentiment.
What was First Republic Bank’s strength before the crisis, its banking business, has become its major weakness. The bank’s focus on venture banking — taking in deposits from venture capital-backed companies and making loans to them — has revealed an unforeseen vulnerability after Silicon Valley Bank shut its doors. The key problem with SVB was not deteriorating credit quality, but rather that the bank was forced to liquidate its bond portfolio at a significant loss in order to fund deposit outflows. Most banks now have unrealized investment losses, according to JP Morgan, including First Republic Bank… which is not a big issue of these assets don’t have to be sold. Additionally, FRC’s capital position is not necessarily much worse than those of other community banks.
Since First Republic Bank has a considerable focus on business clients — 63% of its deposits came from its venture banking business which are at a higher risk of leaving the bank due to the FDIC’s $250,000 insurance limit — the bank has seen considerable deposit outflows. The bank said in its 8K disclosure for March 16, 2023 that “daily deposit outflows have slowed considerably” which is also what U.S. officials have remarked on lately. About 79% of First Republic Bank’s deposits were uninsured as of the end of FY 2022. Before the crisis, First Republic Bank’s business deposits were growing steadily and according to the bank’s Q4’22 update, the bank had exceptionally good credit quality, too.
However, my guess is that the bank will sell a portion of its loan book in order to raise cash which would the best solution for First Republic Bank, and certainly preferable over an equity raise. The bank owned $166.9B in loans at the end of the December-quarter which mostly were collateralized by real estate. I can see FRC selling a portion of its loans at a fair price to larger banks in a big to shore up its balance sheet.
First Republic Bank is by far the worst performing community bank, largely due to its high percentage (79%) of uninsured deposits and the need to raise $30B in additional deposits from other companies.
It is impossible to know precisely at this point how many deposits First Republic Bank has lost, but the Wall Street Journal, citing insiders, said the bank has lost about half of its deposit base, which would calculate to about $70B.
This means that FRC is also going to report at a significant decline in its book value in Q1’23. First Republic Bank reported a book value of $75.38 at the end of FY 2022. Assuming a 50% decline in book value, chiefly due to deposit outflows and a shrinking balance sheet resulting from the crisis in the financial sector, FRC may report a BV around $37-38 per-share at the end of the first-quarter. Of course, more aggressive assumptions about deposit losses would translate into even higher book value declines. A, say, 60% decrease in cash/deposits implies, roughly speaking, a 60% decline in book value… which could put the Q1’23 BV closer to $30 per-share. Since First Republic Bank’s shares are trading at $12.36, the valuation implies an 84% discount to BV. If deposits indeed declined by 60%, then the valuation may more accurately reflect a 59% discount to book value.
FRC offers by far the biggest book value discount and therefore also has the highest perceived risk. However, fear clearly is present here and investors may overestimate the decline of FRC’s deposit base.
If deposit outflows continue, the big banks might decide that it is a better idea to convert the $30B in deposits into equity, which of course would heavily dilute shareholders. First Republic Bank has enough liquidity, in my opinion, through the Bank Term Funding Program, the FED’s discount window and other banks, so I don’t believe the bank couldn’t fund incremental deposit withdrawals. What would change my mind about FRC is if the company would have to liquidate (a portion of) its bond holding portfolio and realize losses, or if the bank would do a dilutive equity offering.
First Republic Bank remains a high-risk, high-potential rebound stock in the community banking market, despite the stock being down dramatically since I took my initially position more than a week ago. The reason why I am sticking to my guns here is that I consider it highly unlikely that the FED will allow fear and panic to spread in the financial market as it has learned the lessons from 2008 financial crisis. This lesson is that failing to provide a liquidity backstop will eventually lead to a crisis much bigger, much harder to control and much more expensive than the initial, forceful intervention. First Republic Bank likely has suffered very considerable deposit outflows since I last covered the stock, but recent liquidity measures have proven to support the bank while deposit outflows appear to have stabilized lately. With the stock now trading at an 84% discount to book value, I believe investors continue to face a very attractive trading opportunity!
First Republic Bank Stock: Why I Am Sticking To My Investment (NYSE:FRC)
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