Six Canadian Banks That Should Reward Long Term Investors

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 |  Includes: BMO, BNS, CM, POFNF, RY, TD
by: Brent McCosker

With all the talk about creating a “bad” bank in the U.S. to place non-performing or questionable assets, it seems appropriate for an investor to scour the world in search of possible “good” banks.

No need to search too far: if you take a 90 minute scenic drive from Buffalo around the west end of Lake Ontario, you will end up in the financial capital of Canada, i.e. Toronto. The six major Canadian banks, all in various states of “good” health, can be found here. The banks in order of market capitalization are: Royal Bank of Canada (NYSE:RY), Toronto Dominion Bank (NYSE:TD), Bank of Nova Scotia (NYSE:BNS), Canadian Imperial Bank of Commerce (NYSE:CM), and tied for last - Bank of Montreal (NYSE:BMO) and Power Corporation of Canada (OTCPK:POFNF).

Canadian banks have a history of being conservatively run, thus making them less exciting during boom periods. But for these banks to continue their modest growth, they have found it necessary to look outside Canada. (Canada’s population at 33 million is less populated than California.) Scotia Bank, for example, recently announced an increase in its investment in Thailand’s Thanachart Bank, bringing ownership to 49%. Because of this creep outside of Canada’s borders, it is unclear how significant their exposure is to the bad asset problems in the U.S. and Europe.

Canada itself has not been immune to troubled assets. In their search for yield, Canadian banks (and insurers such as Manulife (NYSE:MFC) and Sunlife) were dealing in billions of asset-based commercial paper (ABCP) which “froze up” (not a result of Canadian winters) more than a year ago. Just recently an agreement involving the Bank of Canada (Canada’s Federal Reserve), the three largest provinces and major foreign banks gives some assurance of repayment of principal.

One could say that these concerns are already reflected in the banks’ share prices. Having hit their all time highs in early summer of 2007, the share prices have come down 40 to 60% (modest compared to U.S. banks, you say). The most recent push down since November was a result of equity offerings by ALL above mentioned banks. (There is a tendency in Canada for doing things in bunches, like line dancing, a popular dance in Canada.) The banks claim the offerings to be just cautionary measures to reinforce already sound capital ratios.

Technically, the charts look like they're finding some buying support but it is still too early to say. RBC has the weakest chart, possibly reflecting worries of its more significant exposure to foreign asset investments.

Two final points: Canada may be 6 to 9 months behind the U.S. in this economic cycle and therefore the Canadian banking industry may show a couple more quarters of declining earnings and above average default exposure. On the positive side, according to Michel Girard, La Presse Affaire (January 21, 2009), none of these banks has lowered their dividend in the past and the dividend payout ratio based on current earnings estimates is well within historic norms. But to be on the safe side, stick with the banks which pay less than a 7% dividend yield.

Investors should get better clarity on Canadian banks earnings for 2009 when they report quarterly results and give guidance at the end of February and throughout March. It would be prudent to wait for this additional data point.

The bottom line is that large, well-capitalized Canadian banks will prove to be rewarding investments. With dividend yields in the 6% range and easily achievable annual share price appreciation of 4%, these banks offer the long term investor a potential total annual return of some 10%.

*Average earnings estimates, source The Globe and Mail, Report on Business; all dollar amounts in Canadian

Author’s Disclosure: Author owns RY and TD along with call writes on the shares.

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