EQB.TO - Equitable Group

[Peregrine]

Equitable started as a small trust company in the 1970s and has since grown to become Canada's 9th largest schedule 1 bank by assets. The bank has an impressive record of growth as shown in the chart below yet it trades at a P/E of 8x and P/BV of 1.3x while consistently generating ROEs in the 15-17% range throughout its publicly-traded history.

 

 

Most importantly, Equitable achieved this growth with a high degree of conservatism, maintaining capital levels well in excess of that of the Big Banks (current CET1 at 14.5% compared to Canada's big banks at ~12%), and achieved loan loss ratios that never exceeded 0.3% in any one year (also substantially better than the big banks).

 

Equitable's loans are divided as follows:

 

1.    Insured loans: $13.4 billion (48% of total)

• Personal loans - mostly prime single-family mortgages: $9.5 billion
• Commercial loans - mostly multi-unit residential mortgages: $4 billion

2.    Uninsured loans: $14.7 billion (52% of total)

• Personal loans - mostly alternative single-family mortgages: $9.8 billion
• Commercial loans: $4.9 billion

 

Nearly half their loan book is insured by mortgage insurers that are backed by the Canadian government and sold into securitizations so Equitable assumes virtually 0 credit risk on this portfolio.

 

The other half are uninsured, of which 2/3 are uninsured "alternative" SFR mortgages. Here, Equitable primary borrowers are the self-employed or new immigrants, two demographic segments that have grown strongly in Canada. These borrowers are generally highly credit-worthy but nonetheless have more difficulty qualifying at the Big Banks because of income sources that are more difficult to prove and/or insufficient credit histories. The Big Banks use auto-adjudicated systems to underwrite mortgages against tightly defined credit boxes, which while highly effective in processing homogenous applications at very large volumes, are ill-equipped to evaluate the more heterogeneous profiles of Equitable’s core customer base.

 

Unconventional should not be confused with a lack of conservatism, however. Equitable lends only on a first-liens basis, employs rigorous income verification processes, demands down payments for its uninsured mortgages of nearly 30% on average (current LTVs are 61%) and focuses its lending on mid-priced homes in metropolitan areas that tend to be more liquid and in which they are highly familiar. These practices have resulted in an average net non-performing loan ratio of just 0.4% over the last 10 years. Moreover, the substantial equity buffer underlying the homes that Equitable lends on helps minimize damage when defaults do occur: the company’s loan losses have averaged just 0.04% per year since the company became public.

 

The company operates a branchless model, so their overhead costs are substantially lower than branch banks. Their efficiency ratio, generally in the high-30% range, routinely ranks the best among all Canadian banks. Five years ago, they started EQ Bank, an online bank that they've steadily added more and more functionality to (CAD and US savings accounts, free E-transfers, international money transfers, direct bill deposit, all with no fees) and was recently ranked the #1 bank in Canada on Forbes. Over time, management envisions EQ Bank being the platform where they offer more banking services to their customers. EQ Bank savings accounts are also lower rate than traditional GICs, which has reduced and will continue to reduce funding costs over time.

 

Since Equitable targets niche areas of lending that the Big Banks generally ignore, the bank has benefited as regulation, institutional dynamics and the oligopolistic nature of industry has bred homogeneity, allowing a smaller lender like themselves to thrive. Moreover, demographic trends are in their favor as the numbers of the self-employed and new immigrants continue to increase at a far higher rate than that of the overall population in Canada. As such, Equitable continues to find more avenues for growth even as they are now the largest "alternative" residential mortgage lender in the country. The company pays out just 10% of their earnings and despite announcing an increase in their dividend growth rate, they anticipate to be able to redeploy the vast majority of their earnings back onto their balance sheet.

 

At 1.3x BV, you're getting a bank that consistently generates ROEs of 15-17%, with a strong track record of credit adjudication, exceptionally strong capital position, proven management team and a very long growth runway.