O Canada! (Part I): Investing in the World's Soundest Banking System

“BBDP” is a term I used in my first book. It stands for “Basic, Boring, Dull and Profitable.” And in investing for the long term, it forms the foundation of our investing pyramid. No fireworks. No "up 30% one week, down 25% the next", leaving you worse off than when you started.

The US economy – and stock market – has been filled with fireworks, not just in this most recent year but ever since the abolition of Glass-Steagall, the chicanery in dot-com IPOs, the artificial inflation in home prices thanks to Greenspan’s interest rate reductions to prevent the normal contraction in the economy after the dot-bomb went off, and the current and former administration’s decision to seek the guilty (Wall Street bankers and brokerages) and punish the innocent (American taxpayers.)

Most of the world’s stock markets move in rough parity with U.S. markets. But I believe, while there will probably not be an economic decoupling with Canada (I certainly hope not – this is one of the best good-deals-for-both-sides in the world), there is likely to be a market decoupling as investors learn about the quality of the companies north of the 49th Parallel.

(That term, often used as a proxy for the US – Canadian border, is actually a misnomer. More than 70% of Canada’s population reside south of the 49th parallel, including those in Toronto, Montreal and Ottawa. However many of the natural resources and virtually all of the “frontier” resources still lie north of that line…)

While US bankers and brokerages were engaged in a headlong rush to get through the door marked “Stupid Banking” at the same time, their Canadian counterparts were protecting investor deposits, eschewing sub-prime mortgages and derivatives, and being regulated by regulators who actually believe their job is to protect depositors and the national economy rather than provide themselves with contacts so they can get a cushy high-paying job as soon as they leave government.

As a result, in its just-released (in September) Global Competitiveness Report, the World Economic Forum, for the second year in a row, named Canada as having the world’s soundest banking system. And the IMF noted that Canadian regulators follow best practices in supervising financial institutions, and actually enforce their regulations – with nobody “too big to fail.” (Unlike the US, where some 90-95% of all off-books derivative exposure is still concentrated (and growing?) between J.P. Morgan (JPM), Goldman Sachs (GS), Bank of America (BAC), and Citigroup (C).)

The five largest banks in Canada are, in order of size, Royal Bank of Canada (RY), Toronto Dominion (TD), Bank of Montreal (BMO), Bank of Nova Scotia (BNS), and Canadian Imperial Bank of Commerce (CM). And these are no small fry! On the 2009 Forbes Global 2000 list, RY is number 68 in the world, just ahead of Cisco (CSCO); TD is number 111, just ahead of Apple (AAPL); BNS is number 120, one ranking behind Boeing (BA) and 3 ahead of Merck (MRK); BMO is number 200, beating out General Dynamics (GD), Union Pacific (UNP) and Deere (DE); and even the tiniest of the big 5, CM is ranked at number 585 in the world, ahead of Northrop (NOC) and US Steel (X). The fact that Canada has a population of just 33 million hasn’t hampered these banks' international growth one whit!

Remember, these are not just “Canadian banks”, but financial services firms that have offices worldwide as well as mutual funds, insurance, credit cards, and stock brokerage subsidiaries. In fact, you may well recognize one or more of these firms’ US subsidiaries.

Royal Bank serves seventeen million clients and has 80,000 employees around the world. When I was a young Schwab branch manager in Fort Lauderdale in the late 1970s I banked with one of the 400+ branches of RBC Bank, their US subsidiary, and have seen that familiar name scattered across many countries in the Caribbean, while on dive trips there. They have operations in 50 countries and, as a result of American bankers hitting the “Stupid” button, are expanding their presence in the US, as well. They acquired 39 branches of AmSouth Bank in Alabama in 2007 and 100% of Alabama National Bancorporation in 2008.

Toronto-Dominion has over 74,000 employees and an equal seventeen million clients worldwide. It owns TD Bank in the US, 30% of discount brokerage TD Ameritrade, all of TD Asset Management, TD mutual funds, as well as TD Waterhouse wealth management.

You think these are hick bankers? While Citi and Wachovia (WB) and B of A and – shall we go on? drove their banks into the dirt, TD was making moves like this: in 1999, TD spun off 42 million shares of TD Waterhouse in an IPO, with shares priced at $24 (USD) per share, earning $1.01 billion USD. In 2001, in the bear following the dot-bomb, TD bought back that minority stake for $9 USD per share. That would be 42 million times $15, or a $630 million positive cash flow to own the same company at the bottom of the bear, just before the housing bubble sent all stocks roaring ahead again. And they didn’t touch a risky derivative to do it. Some hicks.

The Bank of Nova Scotia also runs banking operations well beyond Canada’s borders, though it chooses emerging markets for its investments. The most recent of these is the agreement to buy 100% of Banco del Desarrollo, Chile's seventh largest bank for just over (US) $1 billion. Like the other smart Canadian bankers, BNS has been a ready buyer for US assets at fire sale prices as US firms over-reached. To pay for their billion-dollar-plus mortgage fiasco, E-Trade (ETFC) sold its Canadian division to Scotiabank for just over (US) $400 million, a great coup for BNS.

Bank of Montreal, Canada's oldest bank, also owns the Harris Bank, which I remember fondly from my days in Chicago, as well BMO Nesbitt Burns, a full commission investment firm, wealth manager Harris Investor Services, and super-wealth manager BMO Harris Private Banking. Not to be outdone in the buy-when-others-are-selling department, this year BMO bought AIG’s Canadian life insurance business for less than (US) $30 million, making them the second-biggest life insurer among Canadian banks.

Finally, Canadian Imperial Bank of Commerce, operating in the United States, the Caribbean, Asia and the UK, serves more than eleven million clients and has more than 40,000 employees worldwide. Their most recent coup was to buy Barclays’ (BCS) 43.7% stake in First Caribbean International Bank. It helps to have cash when others are desperate to sell…

It also helps to be intelligently and ethically managed. While US bankers and brokers are repaying TARP money solely so they can give themselves massive bonuses at year-end, in Canada RY is changing the way its investment bankers and traders are paid -- in order to make its risk management even tighter. Instead of being rewarded for making brainless bets with depositors’ money – even if it works out in the short term – RY is giving a greater percentage of pay on a deferred basis, after the positions are closed, which gives bankers and traders an incentive to police themselves and to have their own skin – in the form of increased pay if they’ve make the best decision for the bank – in the game.

Even though I and our clients own many more natural resource, energy, metals and mining, and agricultural firms in Canada, I think the financial sector must provide the foundation for future growth. No company can generate 100% of its capital expansion needs internally.

When you’re building a $3 billion natural gas pipeline from the wilds of Alberta to the wilds of Chicago you’d better have a sound banking system that can evaluate your project, make informed risk decisions, and – most importantly – have the money to lend to you rather than having squandered it spinning roulette wheels that hit or miss in milliseconds. That’s why I recommend these five banks for your consideration before moving on to the rest of the fine Canadian companies.

Worldwide demand for infrastructure, materials, energy, and agriculture play to Canada’s great strengths. The US has such companies, as well. The difference is, our bankers have shot themselves in various essential body parts and placed their heads in others, while Canada has a strong banking system in place, ready to finance expansion.

• RY sells for 22 times trailing earnings (12 times estimated forward earnings) and yields 3.6%.
• TD sells for 21 times trailing earnings (12 times estimated forward earnings) and yields 3.7%.
• BNS sells for 17 times trailing earnings (12 times estimated forward earnings) and yields 4.2%.
• BMO sells for 17 times trailing earnings (12 times estimated forward earnings) and yields 5.4%.
• And CM sells for 28 times trailing earnings (11 times estimated forward earnings) and yields 5.5%.

I like TD and BNS the best. Your mileage may vary. If you decide to buy, please note that if US financials decline – and how can they not as the true state of their off-balance sheet derivatives exposure begins to leak out – Canadian banks will probably decline in step. You might want to buy some now and, if I’m correct, buy more on the pullback. Unlike their US brethren, the pullback will be purely on sentiment, not on balance sheets.

Don’t just take my word for this. I cited a study from the World Bank (available here) when I advocated investing not in the BRICs but in the nations that provide what the BRICs need to fuel their growth.

That study ranked Canada the 8th-easiest country in the world in which to do business, (The US ranked 4th.) Now comes a new Forbes study that ranks Canada 3rd in the world among the “Best Countries to Do Business” (to the US’s #2, although I’m not sure we can continue to rank the US this highly if we continue to pursue our policies of embracing statist, centralized big government at a time when the rest of the world is going the other direction…)

Up next: Canadian Energy, Agriculture, Metals and Basic Resources.

Full Disclosure: Long TD and BNS.

The Fine Print: As Registered Investment Advisors, we see it as our responsibility to advise the following: We do not know your personal financial situation, so the information contained in this communiqué represents the opinions of the staff of Stanford Wealth Management, and should not be construed as personalized investment advice.

Also, past performance is no guarantee of future results, rather an obvious statement if you review the records of many alleged gurus, but important nonetheless –our Investors Edge ® Growth and Value Portfolio has beaten the S&P 500 for 10 years running but there is no guarantee that we will continue to do so.

It should not be assumed that investing in any securities we are investing in will always be profitable. We take our research seriously, we do our best to get it right, and we “eat our own cooking,” but we could be wrong, hence our full disclosure as to whether we own or are buying the investments we write about.

Comments

[sieraromero:]

American style capitalism is destroying our great country in the name of greed and short term profits. Long term profits don't even factor in on most of their business models because that doesn't affect their bonuses. Bankers, CEO's and their cronie boards of directors are destroying our country! He was right about them paying back the TARP money. It is not to strengthen their respective balance sheets. It is so that they may continue to give themselves further outlandish BONUSES. They figure the American taxpayers will bail them out again in order to protect the country's financial position. We can't again,and our country will suffer greatly when the next shoe drops.

Oct 05 08:36 AM

[David Van K...:]

Good article, informative and well-written. It just so happens that I am currently doing my stage-1 filtering of companies for "The Top 40 Dividend Stocks for 2010," and all 5 Canadian banks you mentioned passed the first stage. They won't all make the final list, but they have all the fine qualities you mentioned. And you described well the difference in philosophy in Canadian banking, both at the bank and regulator level.

You also make a good observation that the Canadian banks may fall "in sympathy" if there is a pullback in American banks. That happened in 2008. The one with which I am most familiar, RY, pulled back just about as much as the American banks. But investors figured out the differences, RY recovered at warp speed, and now I have a nice capital gain in RY, in addition to the sound dividend.

I look forward to your next article.

Oct 05 08:49 AM

[Michael D.:]

I think 'Hicks' is a term used more appropriately (selectively) to those south of the 49th parallel.

Oct 05 08:53 AM

[Uncle Pie:]

When looking at Canada's financials, don't overlook Power Corp., trading symbol in the US is PWCDF. (despite the name, it's NOT a utility). A financial conglomerate with interests in insurance, asset management and numerous stakes in various public and private companies in Canada and Europe. Very generous dividend policy and a total return to shareholders over the past 15 years of 14.5%...slightly in excess of Warren Buffet's Berkshire Hathaway's return of 14.1% over the same time period, according to a recent excellent article on the Bloomberg website which you can find if you do a search for "Demarais Buffet".
This writer owns shares of Power Corp., Power Financial, and RBC.

Oct 05 09:01 AM

[Ray Winter:]

It's interesting that the countries whose Banks have not been badly affected by the sub-prime catastrophe are all from the UK's Commonwealth countries, and they all followed the financial disciplines with which they were originally established. Canada, Australia and New Zealand have all escaped the problems of the US & Europe.

It would therefore seem that when the BIG BANG took place in the UK financial services industries during the 90's and the subsequent invasion by the US's financial communities to acquire traditional British financial institutions, they brought their attitudes with them to the detriment of financial prudence and respect for their investors and savers.

Oct 05 09:28 AM

[a. palmer jr.:]

I guess there comes a time when we, from the US, have to admit that despite all the hype and hoopla, are not the smartest people on the planet. At least financially we're not even runner up. We value our own assets above our country, and have been spoiled beyond belief. When we want something we just go out and buy it without thought of what the cost is or how it will affect our future. We buy things on credit that credit shouldn't even be extended for. Then when we, who have low wage jobs discover that the $350000 house that we shouldn't have bought in the first place and bought with little money down is only worth $175000 what do we do? We let it go back instead of biting the bullet and understanding that all investments involve risk. We make it someone else's problem too.
We as a people should learn to develop a little character rather than making dumb mistakes and wanting someone else to bail us out.

Oct 05 10:01 AM

[Vuke:]

That opportunity for learning is coming Arnold. The next few years are going to be exactly about that.

On Oct 05 10:01 AM a. palmer jr. wrote:

> ...........instead of biting the bullet and understanding that all investments involve risk. We make it someone else's problem too.

> We as a people should learn to develop a little character rather
> than making dumb mistakes and wanting someone else to bail us out.

Oct 05 10:16 AM

[Themoose:]

umm.. did you know the gov't of Canada took 60 billions dollars of mortgages off the Canadian Banks balance sheets? Didn't see any mention of that in your article? If you think your bankers are chum chum in the states our bankers and gov't are family. I guess it's best not to know what's really going on right?

Oct 05 10:25 AM

[MNCAN:]

Many people put Canada down by saying it is a socialist country. Until this year of global recession, Canada had operated at a budget surplus for the last 10 years, has a healthy banking system, is not bogged down year after year by a health care debate, and has gun control. It has its own problems, but they seem minor in comparison. Sure the taxes are higher, but you only get what you pay for. Call it what you will, if that is socialism, maybe it’s not so bad.

Oct 05 11:29 AM

[Joseph L. S...:]

Yes, I knew that. That’s a government guarantee for $60 billion worth of mortgages for EVERY Canadian bank in the country! But did YOU know that would be equal to what American taxpayers guaranteed for ONE bank – not to mention the $180 billion for AIG!

(From the Fed’s website: “The Federal Reserve Bank and the United States Treasury by May 2009 had increased the potential financial support to AIG, with the support of an investment of as much as $70 billion, a $60 billion credit line and <<< $52.5 billion to buy mortgage-based assets >>> owned or guaranteed by AIG, increasing the total amount available to as much as $182.5 billion.)

I decided, relative to the size of Canadian banks and the fact that, well after those guarantees were granted, the World Bank still ranks Canada the soundest banking regime of 186 countries in the world, this was too small a part of the Canadian banking story to sidetrack into.

I tell you what – I’ll by the three biggest Canadian banks and you can buy the three biggest US banks and we’ll compare notes in a year. Or two. Or ten!

Cheers and best wishes,
JS


On Oct 05 10:25 AM Themoose wrote:

> umm.. did you know the gov't of Canada took 60 billions dollars of
> mortgages off the Canadian Banks balance sheets? Didn't see any mention
> of that in your article? If you think your bankers are chum chum
> in the states our bankers and gov't are family. I guess it's best
> not to know what's really going on right?

Oct 05 08:39 PM

[eric attias:]

Come to think about it, it was probably the best way to inject liquidity in a sound banking system yet not immune to global economic turmoil.

Because Canada's housing market has not gone through the bubbles seen in other countries (the US, Spain, UK etc...), these mortgages are not expected to default and the Canadian Taxpayer will recover the funds in due time....


On Oct 05 10:25 AM Themoose wrote:

> umm.. did you know the gov't of Canada took 60 billions dollars of
> mortgages off the Canadian Banks balance sheets? Didn't see any mention
> of that in your article? If you think your bankers are chum chum
> in the states our bankers and gov't are family. I guess it's best
> not to know what's really going on right?

Oct 06 01:33 AM

[bob adamson:]

Good observation. The following elaborates on that point and other matters raised by the comments of others responding to this article.

Essentially Australia, New Zealand, and Canada adopted updated versions of the traditional Scottish banking model while the US investment banking sector and the UK's (including the Royal Bank of Scotland) are updated versions of the English banking model. Both models have their merits, caution and investing for the long term being two of the Scots’.

Australia, New Zealand, and Canada each faced and met serious economic challenges in the late 1980s and 1990s. Essentially the crises in Asia, Russia and especially South America almost triggered ones for us as well because we each were relatively small economies, had high debt/GNP ratios, were dependent on foreign trade for a significant portion of our economic growth and activity and were running large annual government deficits. In short, we were each easy potential targets for hedge fund currency speculators and, unlike the US and UK, were too small to ignore the situation and its underlying causes.

Thus in the 1990s Canada went through tough streamlining of national and provincial fiscal and monetary policies and social programs; think restraint on bank expansion and amalgamation, public pension reform, balanced federal and provincial budgets, Medicare cost containment etc. When the global real estate and derivative bubble began to burst in 2006/7, Canada therefore was affected less and was better able to respond internally.

Mention should be made concerning the residential and commercial property markets in Canada because the relative strength of these markets is a significant underpinning for the banking sector. While Canadian real property values did increase significantly in the early years of this decade, this was not induced or fueled by the secularized debt or derivatives market. Attempts by the banks to move in that direction (and to further relax consumer loan security requirements) were weak, discouraged by regulators and short lived – for the most part lenders lent to borrowers with the intention of holding the mortgage or other debt instrument to maturity or to a fixed date for renegotiation of terms. Further, residential mortgage interest is not generally a borrowers’ income tax deduction item in Canada so there was less incentive for risky borrowing or lending practices. Lastly, CMHC (Canada’s federal residential insurance agency) insisted throughout that the mortgages it insured be well covered by underlying property value and that borrowers have a reasonable capacity to meet their obligations.

While Canadian banks were therefore not hit when the bubbles in the US and UK burst, they were effected when international inter-bank and commercial credit markets subsequently froze last fall. However, because the Canada’s national government had run surpluses for the previous 12 years, already through CMHC was guaranteeing most Canadian residential mortgages and those mortgages were mostly sound, the government and the banks were able to enter into a mutually beneficial arrangement. The government bought a large portion of the banks’ residential mortgage holdings with the intention to hold these to maturity (a good investment). The banks gained the liquidity to continue business as usual including the provision of ready credit on reasonable terms to commercial and consumer customers.

In short, Canada and Canadian banks have been prudent, relatively lucky and are sound and benefiting from this. A note of caution though needs to be sounded though. While we have come through the current economic downturn relatively well, Canada and therefore Canada’s banks are not immune to the global economic contraction. Given our reliance on international (particularly US) trade, we are, in fact, more exposed to the negative effects of a long term downturn than many larger economies, including that of the US. Further, the value of the CAN$ has increased around 40% relative to the US$ over the past four years and this has reduced the competitiveness of many segments of Canada’s primary and secondary industry which, in turn, impacts the banks. Further, while foreign investors have benefited on their Canadian equity holdings in the recent past because of this currency appreciation, it is doubtful whether the CAN$ will rise above parity with the US$ for any sustained period (i.e. don’t count on gains in Canadian equities being further compounded by currency appreciation because the Canadian economy can not function adequately in the near term if the CAN$ appreciates further significantly). In conclusion, Canada and its banks are generally cautious because it is obvious that they would otherwise face unmanageable problems. Sometimes being a middle sized economy has its advantages in that the nature and extent of your economic challenges are not hidden and can not be ignored.

Some have observed that Canada is more ‘socialist’ than the US. I would put it differently. We tend to choose the middle way and are open to the adoption of measures that give a real prospect of working without undue concern where these measures fall in the right/left spectrum. We also tend at all times to look seriously at the experience of other countries.

Wikipedia has a fairly good entry comparing the US and Canadian economies, including taxes, at the following link:

en.wikipedia.org/wiki/...

Offsetting the higher Canadian taxes to some extent is the fact that residents neither pay premiums (a couple of Provinces charge premiums at low rates) nor make co-payments under the Provincial basic health insurance plans. Also, Provincial Vehicle insurance plans in many Provinces provide low cost vehicle related insurance at low premiums.


On Oct 06 01:33 AM eric attias wrote:

> Come to think about it, it was probably the best way to inject liquidity
> in a sound banking system yet not immune to global economic turmoil.
>
>
> Because Canada's housing market has not gone through the bubbles
> seen in other countries (the US, Spain, UK etc...), these mortgages
> are not expected to default and the Canadian Taxpayer will recover
> the funds in due time....

Oct 06 07:09 PM