U.S. Banks Present Better Investment Opportunities Than Canadian Peers

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 |  Includes: BAC, BMO, BNS, C, CM, RY, TD
by: Alicia Damley, CFA

Given the performance of Canadian banks to date and the underlying fundamentals, there are better opportunities in the U.S. banking sector than in Canada. Priced currently at mid-teen P/Es, valuation metrics already reflect these fundamentals. Buying these stocks was a clear cut decision beginning in 2008 when constraints of the Canadian regulatory framework and a focus on traditional banking services paid off handsomely.

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Here’s why to look elsewhere first. Conservative, staid, even boring, have been common descriptors for Canadian banks. Focused on providing customer-centric, on balance sheet loans and mortgages, the banks were far removed from the exotic CDO and CDS products. The sector is stable and best described as an oligopoly, with the top five banks accounting for 85% of the system's total assets. Each of the top five banks boasts a nationwide branch network, in a country that spans five thousand miles and a population of 33 million. A 2010 fiscal year-end snapshot for the top five banks below shows strong returns and core Tier 1 ratios, deposit-funded balance sheets and average cost management. Despite their proximity to and presence in the U.S., constrained by the regulatory framework, the banking system’s exposure to the recent financial crisis was manageable. With the exception of CIBC (NYSE:CM), all generated solid profits in 2008 and 2009.

Summary of Top 5 Canadian Banks

as of Oct 31, 2010

(billions CAD)

Royal Bank of Canada (NYSE:RY)

TD Bank (NYSE:TD)

Scotiabank (NYSE:BNS)

Bank of Montreal (NYSE:BMO)

CIBC (CM)

Total assets

726.2

619.5

526.7

411.6

352.0

Loans

292.2

272.2

291.8

176.6

184.6

RWA

260.5

199.9

215.0

161.2

106.7

Deposits

433.0

430.0

361.7

249.3

246.7

Avg s/h equity

33.3

36.6

22.4

18.0

11.9

Core Tier 1 ratio

9.8%

13.9%

9.6%

13.6%

9.9%

Total revenue

28.3

19.6

15.5

12.2

12.1

Net income

5.2

4.6

4.2

2.8

2.5

RoE

15.7%

12.7%

19.0%

15.6%

20.6%

RoA

0.72%

0.75%

0.80%

0.68%

0.70%

RoRWA

2.01%

2.32%

1.97%

1.74%

2.30%

Loan/Deposits

67.5%

63.3%

80.7%

70.9%

74.8%

Efficiency ratio

50.8%

62.2%

52.8%

62.2%

58.1%

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Source: Bank Annual Reports

Regulatory oversight of the banking system limits the sector’s activities to traditional banking services while maintaining high capital thresholds. Growth has been driven by economic trends, immigration and limited unprofitable competitive behavior tendencies. In the last two decades, the banks have leveraged their national networks to enter brokerage, insurance and investment fund services, expanding their models to full universal banks. Given the sector concentration, in-market mergers are unlikely. Dominating the domestic market and following the success of a proven traditional banking model, the banks turned their expansion plans outward, primarily to the U.S. Today, all have operations in the U.S. with Scotiabank’s expansion penetrating further into the Caribbean and South America. Continued expansion through acquisition in the U.S. can be a driver for future growth, but the success of the model in the fragmented U.S. banking market is yet to be confirmed and may prove costly. TD Bank is the furthest ahead in this strategy.

For new investments today, the question is whether the sector’s performance will continue unabated. Understanding some of the key factors which have led to the differentiated bank stock price behavior is important. The Canadian economy, closely tied to the U.S., is now increasingly underpinned by global commodities. Like other commodity driven economies, the currency has continued to strengthen. Loan growth has tracked the broader economy. Canada already enjoys high credit penetration and any incremental credit penetration is supported primarily by immigration – which like the U.S. is the main driver of Canada’s population growth. Credit risk continues to remain benign, supported equally by solid credit underwriting competence and a strong economy, presently a virtuous circle. Historically, banks have been owned broadly across the domestic market, viewed as a source of stable dividend income, a trend that remains unchanged.

With markets showing sustained commodity demand and pricing trends, Canadian interest rates began moving up in Jun 2010. The sector’s mid-teen RoEs are in-line with return expectations for developed market banks (see here). Given the similar decisions of regulators in developed markets, dividend payouts are unlikely to rise out of step with other country regulators. The Canadian banks do provide a financial proxy for the commodity cycle, but not especially strong opportunities independent of it. Look to recovering U.S. bank names including Citigroup (NYSE:C) and Bank of America (NYSE:BAC) or emerging market banks including Bank Central Asia, Bank Rakyat, State Bank of India and Axis Bank for better options.

Disclosure: I am long BAC, C, RY. Additional disclosure: Long BBCA.IJ (Bank Central Asia).