Expect the Bullish Run in Canadian Banks to Continue

At the end of March I wrote the article Looking for A Few Good Banks, focusing on Canadian and Australian banks. Just after writing it I took a position in one of the two recommended banks, Toronto-Dominion (TD) through its ADR listed in New York. Since that time, TD has been on a path straight up, gaining 60% in a little over two months. It is true that the equity markets, particularly in financials have rebounded significantly in those two months. The KBW Bank Index in the U.S. is up about 45% during that same time as distressed U.S. banks recovered from end of the world scenario. However, the main premise for the investment in Canadian (and Australian) banks was they never were distressed. The secondary premise was diversification out of the U.S. dollar.

The goal here truly is a long term investment and not simply a trade to exit quickly, but the run up had me to take another look at TD and its peers to see how much the price move might have been warranted.

‘ADRs’ of Canadian Banks benefit from a strong Canadian dollar. The first point in looking at Canadian bank stocks is to differentiate between the stocks as seen in Canada versus as seen from the U.S. For the most part Canadian stocks are not technically ADRs – American Depository Receipts, but for all practical purposes they act like ADRs being listed in U.S. dollars in New York. As with ADRs, dual listed, Canadian stocks are tracking a security that is denominated Canadian dollars and will rise and fall with the exchange rate. Thus they give Americans effective currency diversification even though your purchase and holding remain in U.S. dollars.

While TD, RY and other Canadian banks have seen their share prices increase in Toronto, the appreciation as seen in New York has been enhanced by the strengthening Canadian dollar, commonly referred to as the ‘Loonie’. The Loonie has appreciated 13.5% relative to the U.S. dollar from the close of markets on March 30^th (when I posted my article) through last Friday.

This was expected and was part of the original investment thesis in looking at non-U.S. banks. As the financial world moves further from the bleak period that followed the collapse of Lehman Brothers last fall, investors are beginning to take risk again. This is reversing the trend to safe haven assets like the U.S. Treasuries and other dollar denominated assets. The Loonie is not alone in this appreciation as the Euro, Australian dollar (the ‘Aussie’) and other currencies have seen similar moves since March. No longer flocking to the safety of the U.S., investors are fretting about the stability of the U.S. dollar in the presence of all that issuance of government debt. Currencies with links to commodities like the Loonie and the Aussie are in particular favor.

I don’t pretend to know the direction of the Loonie, the Euro, or the Aussie from here. The point of currency diversification is to serve as a hedge against further U.S. dollar weakness, placing investments both in and out of home currency denominated assets. Folks that want to truly bet on the direction of a currency can more easily do that in the foreign exchange market which is not my area of expertise.

Canadian banks have been up across the board. The easiest way to take out the currency affect is to simply look at the Canadian banks as listed on the Toronto Stock Exchange (TSX). As you can see from the chart above, Toronto-Dominion has had some company in its share price run up. The strongest stock over these last 2+ months has been Bank of Montreal (BMO).

All five banks reported fiscal second quarter earnings and saw run ups ahead of the announcements. In the case of TD, BMO, and BNS, strong price gains continued after the release of earnings. CIBC (CM), one of two to report a loss, remains the most troubled institution as a much hoped-for return to profitability did not materialize. The other to report a loss was Royal Bank of Canada (RY) on a C$1 billion goodwill impairment charge which had been disclosed back in April.

Bank of Nova Scotia had the strongest report purely based on the bottom line but some worry that the company is not being conservative enough and putting bad loans behind them.

Net Interest Income is up strongly, particularly at TD & RY. The latest results only reinforced my conviction that Toronto-Dominion and Royal Bank of Canada have underlying banking businesses that continue to strengthen. As the yield curve has steepened in the past few months, global banks are given a big gift. The ability to borrow short and lend long, particularly on a stable deposit base, is the most basic, lowest risk form of banking.

The chart above shows that TD and RY have increased their net interest income 77% and 58% respectively over the last two years. While most global banks have seen their revenues and profits drop precipitously from the banking boom period of 2007. BMO, BNS, and CM have increased the NII over that period at a much slower rate, 11%, 11%, and 18% respectively.

Of course net interest income is simply a revenue source and does not directly equate to profitability. It is combined with ‘other income’ which includes fees, trading revenue, and investment banking income to form the total revenue. Then comes overhead expenses, write-offs, and other charges.

A bank that is truly a bank will augment their interest income with other income in a stable way. CIBC, for example, looks more like a Wall Street investment bank with declining income from interest (up 18% in two years but has declined for the last two quarters) and a highly volatile trading/other income that includes significant losses. Interest income is offset by all sorts of charges and does not fall to the bottom line.

Looking at the results of the five banks as a whole, it is clear that the banking sector in Canada is improving, justifying an average increase in share price by one-third. This combined with an almost 15% move in the Canadian dollar versus the U.S. dollar has given U.S. investors a combined return of almost 50% since the end of March. It is hard to argue that Canadian banks are “cheap” anymore but the improving fundamentals do support the run up to date. With yields that range from 3.3% (TD) to 5.1% (BMO & CM), they do represent a fairly safe income play with growth potential.

Canadian banks have had a strong run in share price, outpacing the broader market and the banking sector in the U.S. over the past two months. The results of the five major Canadian banks were not uniformly stellar. However, these results reinforce the premise that Canadian banks, particularly TD and RY, represent a low risk way to invest in a banking sector that can be very healthy if not inhibited by other activities like proprietary trading. As for me, I will continue to hold my TD shares for the foreseeable future.

Disclosure: The author has a long position in Toronto-Dominion (TD) as discussed in the article.

Comments

[bbowen7:]

Over the long term, the Canadian banks age generally more conservative - not a bad thing.

As a technical nuance (for amateurs like me), Canadian stocks (like most ADRs) have a tax withheld from the dividends, and thus are best held outside of IRAs where a tax credit can be taken.

Jun 09 01:15 PM

[enegola:]

I have followed Canadian Banks for the last 5 months. They have done well. I did not invest. Is this the right time to invest? Should I go "all in?"

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Jul 28 03:59 PM