Six Canadian Banks That Should Reward Long Term Investors

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 (RY), Toronto Dominion Bank (TD), Bank of Nova Scotia (BNS), Canadian Imperial Bank of Commerce (CM), and tied for last - Bank of Montreal (BMO) and Power Corporation of Canada (POFNF.PK).

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 (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.

Hillbent.com, Inc. or its affiliates may own positions in the equities mentioned in our reports. We do not receive any compensation from any of the companies covered in our reports.

Comments

[prudentinve...:]

The Canadian economy is heavily dependent on natural resources, energy, timber, minerals, etc. There is also considerable manufacturing of autos and other engineered products. So Canada is not immune from a significant downturn if the global (and especially the US) recession continues.

Although Canadian banks have, not surprisingly, been managed much more prudently than US banks, they are still vulnerable to an asset crash. Alberta in particular has had frothy real estate values, so is particularly vulnerable if energy prices do not recover in 2009.

Feb 08 09:46 AM

[Fliujniligui:]

If you want a pure defense play, Buy National Bank of Canada which is omitted in this article. NA works mainly in Eastern Canada and almost uniquely in Québec. Québec is still creating jobs, is much more "socialist" state which means most of the jobs are steady (teachers, nurses, doctors and social workers) and there was no boom in house prices here. The part of our economy depending on resources is depressed for a decade now since most of it is forestry and trees grow better in Brazil than here... Paper companies and lumber are on the brink of bankruptcy for decades and they do not represent downside risk for NA since most of bad assets linked to these are just inexistant now. NA was caught up in 2007 when Commercial Paper froze but with the accord to deal with it, this is ok now. Why the author has omitted NA is a mystery for me.

There is another omission of pure quality mid-cap bank in Québec. Laurentian Bank (LB) which has not the exposure to commercial papers from NA. Author is well on the track but maybe some insight from someone who lives in Canadian grounds will help a little.

Feb 08 10:42 AM

[bigtime99:]

National Bank is the only one that has cut dividends in the last 100 years...I would buy the bigger banks instead, who won't be cutting and have enormous cash flows.

Feb 08 12:08 PM

[cloclo:]

Whatever you do, remember that the Canadian government will withhold 15% of your dividend for taxes. To recoup at least a portion of it as a foreign tax credit you may have to file IRS form 1116 with your 1040 tax return, and that may complicate the preparation of your U.S. federal income tax return a little bit. People who promote foreign stocks seldom say anything about the tax consequences.

Feb 08 12:37 PM

[DOK FROTH:]

Canadian BIG 5 banks are cheap at the moment.They are considered widows and orphans stocks usually in Canada.
Just remember if the Canadian dollar rises your 20% US Dollar discount will be affected if you sell your shares.
Foreign ownership in Canadian Banks is limited to 10%.
I own the Royal, BMO and the National Bank.

Feb 08 01:54 PM

[Nick Waddell:]

As Canadians we have been told a lot lately that we are surviving the downturn better than any other G8 nation. We should be careful of patting ourselves on the back too much. The US is still, by far, our largest trading partner. A prolonged downturn for the US means a prolonged downturn for Canada, our meager stimulus package notwithstanding.

Feb 08 02:46 PM

[Mr. Ed, Jr.:]

Why would anyone want to own any bank stocks in this environment ? Even good banks can get dragged under , and that they have not cut dividends (yet) does not seem to be a strong enough reason. Why get involved ?

Feb 08 03:05 PM

[Teutonic Kn...:]

Elaborating on Prudentinvestor's comment above, there are several concerns with the Canadian economy going forward, listed as follows:

1) Oil will likely stay low for the foreseeable future. At one time late in 2007 the Canadian Dollar traded above par against the U.S. Dollar because of oil. The meteoric rise of the oil sands prospect had since dimmed as the break-even mark for production is around $33. If oil hovers around $30 to $40 dollars for several years, oil sands would not be profitable.

2) The U.S. is of late hyping to going "Green". You saw the dramatic drop of unsolicited retail catalogs hitting your mailbox these days, and corporations are striving to improve their image in cutting back printing papers. Newspapers reading appear to be in continuing decline and so will demand for newsprint. These new trends do not bode well for Canada's timber industry.

3) As related by Prudentinvestor, mining a center-piece of the Canadian economy will be hit hard. Nortel was "squeezed" out to BK, and autos are under extreme pressure.

4) Mega Metropolis like Toronto and Vancouver traditionally act as magnets of Hong Kong immigrants, and those influx of capitals will be slowed as the global malaise sinks in. Of late, Toronto and Vancouver real estates attracted new investors from Mainland China, whose new found wealth and prosperity are taking a breathing null.

Consequently with less money around in private enterprise, and less revenues for the governments, the scope and depth of the downturn remains uncertain; consequently my view is that the banking industry will not see a spectacular rise in new business.

Feb 09 03:39 PM