By Dan Werner
We think Canadian banks will continue to benefit from their home country's structurally attractive banking market. However, we think current multiples of 2-3 times tangible book value offer investors little margin of safety. Furthermore, we see dark clouds forming on the horizon and think there is a reasonable likelihood of slower growth and higher loan losses in the near future.
Canadian banks have historically traded at high premiums, and five of the six that we cover carry wide economic moat ratings because we think they benefit from structural, sustainable competitive advantages. As a group, the major Canadian banks have outearned their cost of equity for the past decade, and we see no reason for that trend to reverse.
The six largest Canadian banks have extensive commercial and retail operations and large domestic branch networks. Together, they serve 92% of Canada's banking as measured by total assets. Since banks benefit from scale, we believe it is unlikely that new entrants pose a meaningful threat. Morningstar recently identified efficient scale as a new source of economic moat. In the case of the Canadian banks, efficient scale describes a market of limited size that is efficiently served by a small handful of competitors.
Since 1998, Canadian banks have been prohibited from acquiring each other. At that time, the Canadian finance minister rejected proposed mergers between Royal Bank and Bank of Montreal as well as Canadian Imperial Bank of Commerce and Toronto-Dominion Bank. The government concluded that the mergers would result in too much concentration of economic power, reduce competition, and reduce the government's flexibility in addressing future concerns. Furthermore, under the Investment Canada Act, the aggregate holdings of non-Canadian residents and their associates may not exceed 25% of all shares unless reviewed by the government. This law effectively prohibits the sale of any of Canada's domestic banking giants to a competitor outside Canada. Foreign banks can operate in Canada, but they must be separately incorporated and capitalized. With the restrictions on any domestic combinations or foreign acquisitions of any of these banks, the top six banks remain well entrenched.
One reason banks have generally garnered at least a narrow moat is high customer switching costs. It is usually difficult for a retail customer to switch deposit accounts from one bank to another. Corporate customers are often similarly sticky because the lending relationship is bundled with other services, which can make it difficult to compare pricing.
In Canada, customer stickiness is especially pronounced in mortgage lending. Most Canadians typically borrow for a much shorter period, and banks impose large prepayment penalties to discourage borrowers from prepaying their mortgages before they are due. When a mortgage borrower reaches the end of the loan term, he or she typically receives an invitation from the bank with renewal terms. Given a bank's history with a customer, it is usually easier for customers to stay with their original bank to renew their home loans. Furthermore, Canadian banks typically match each other's mortgage terms so it is not advantageous to move on the basis of rates. This oligopolistic pricing has the effect of limiting movement of home borrowers between banks.
There are a number of differences between the regulation of Canadian and U.S. home financing. In general, these regulatory differences discourage excessive risk taking by Canadian banks, and therefore allow them to earn higher returns on capital than U.S. banks. The Canadian national housing agency does not guarantee or purchase high-risk or securitized loans, unlike Fannie Mae and Freddie Mac in the U.S. If a borrower in Canada is unable to make a 20% down payment, he or she must purchase mortgage insurance through the Canada Mortgage and Housing Corporation. Also, mortgage interest is not tax-deductible in Canada. We think this takes away an implicit subsidy to purchase more-expensive housing that the homeowner may not be able to afford. Finally, the home lender in Canada generally has full recourse to the borrower should the borrower fail to make a payment.
With Canadian residential mortgages constituting 40% of total loans in loan portfolios, the reduced risk in these loans can be seen in lower delinquency rates compared with the U.S. As the financial crisis began to develop, the delinquency rate for Canadian mortgages has remained consistently lower. The six Canadian banks we cover reported gross impaired loans (typically loans that are 90 days in arrears) as a percentage of total loans ranging from 0.63% to 1.33% as of year-end 2011. Overall, from a credit perspective, the Canadian banks weathered the financial crisis impressively.
Earnings Are Likely to Come Under Pressure
We think Canadian banks' bottom lines will come under pressure in the next few years. We expect the flattening of the yield curve will put pressure on net interest margins. Furthermore, a number of factors could lead to slower loan growth and damp earnings growth.
For some of the Canadian banks, loan growth has averaged nearly 10% over the past five years. We think the slower macroeconomic environment along with historically high consumer debt levels will slow loan growth. More recently, investment banking revenue has come under pressure, given the recent turmoil in world markets. While the Canadian banks have little direct exposure to Europe, their trading revenue has not been immune to recent events.
Since the early 1990s, the Bank of Canada has kept interest rates low, which has fueled a credit boom. As in the U.S., the Canadian yield curve has flattened over the past year. Canadian consumers' limited ability to prepay their mortgages has cushioned the impact on banks for now. But we think that if these low rates continue, net interest margins will be hurt.
These low rates are starting to be reflected in the Canadian banks' net interest margins. Flatter yield curves generally negatively affect revenue for banks as they decrease the differential between banks' lower short-term borrowing rates and higher longer-term lending rates. With the yield curve at historic low levels, there is little room for banks to earn yield on loans or fixed income.
About two thirds of Canadian banks' loans are in either home mortgages or personal loans (which usually include home equity lines). While some of the Canadian banks had nearly double-digit loan growth over the past five years, we expect that growth to slow in the near term as the demand for credit declines in a slower economic environment.
In part because of low interest rates, Canada has experienced its own housing boom; the home ownership rate has risen to 69%, similar to the U.S. at the peak of the housing bubble. We think the growth of household debt/disposable income for Canadians is unsustainable, which will result in lower loan growth for the banks.
However, the increasing debt levels do not seem to correspond to the same excessive levels of home price appreciation as experienced in the U.S. The increase in Canadian housing prices was modest relative to the increase in the U.S. Nevertheless, some of the increased debt of the Canadian consumer has been used to fund the purchase of residential real estate. We think there will be downward pressure on prices when the Canadian consumer decides (or is forced) to deleverage.
Although debt levels have increased significantly, Canadian debt service ratios (debt payments/disposable income) have remained fairly stable. Canadian consumers have benefited from a period of low interest rates, which helps keep the debt service ratio low. But given the short-term nature (typically five years) of Canadian mortgages, we believe that in the longer term as interest rates rise, the Canadian debt service ratio will increase as more mortgage loans reprice over the next five years at rates we expect to be higher. Along with historically high debt levels, we think higher debt service ratios will also serve as a long-term damper on loan growth.
Diversification May Actually Increase Risk
Over the past year, we have watched the Canadian banks make various acquisitions in order to increase revenue, especially in their fee-based businesses. With all of this acquisition activity, particularly in asset management, we think there is an increased risk that banks will destroy shareholder value by overpaying for assets. For example, the soundness of Bank of Montreal's acquisition of M&I Bank in Wisconsin appears to depend on the favorable resolution of problem assets it acquired in the deal. As with most of the asset-management acquisitions, we think this deal further depends on the acquired advisors staying with the new company and not leaving for another firm. While Canadian banks' foreign bank acquisitions offer access to markets with much higher GDP growth, there is increased credit risk, given the higher nonperforming loan levels at these target institutions. We do not think stock market prices fully incorporate this risk. Bank of Nova Scotia's price tag of 3 times tangible book value for its majority stake of Colombia's Banco Colpatria is quite high, given the risk. While acquisitions are small compared with the large size of the Canadian banks, we are concerned about the impact of multiple deals upon shareholder value.
Capital Allocation Is a Key Differentiator
If we had to pick our favorite Canadian bank, it would be Toronto-Dominion (TD). We like its strong internal growth in Canada and the Northeast U.S. along with its increasing return on capital in the U.S. We would also steer investors toward Royal Bank of Canada (RY), as we think it presents a unique value opportunity with its higher dividend yield and its plans to sell its relatively small presence in the Southeast U.S. However, with the divestiture not scheduled to be completed until March 2012, there may be some noise in the next few earnings periods. Canadian bank investors looking for more international exposure should consider Bank of Nova Scotia (BNS), which offers more exposure to high GDP growth countries in Asia and Central and South America. However, we remain wary of the credit risks in those countries, given the bank's higher nonperforming loan levels there relative to its native Canada.
We're less enthusiastic about Bank of Montreal (BMO), Canadian Imperial Bank of Commerce (CM), and National Bank of Canada (OTCPK:NTIOF). Bank of Montreal is integrating its acquisition of M&I Bank in the U.S., and we think it will take a long time to resolve M&I's problem assets. We think Canadian Imperial Bank of Commerce will be most affected by any slowdown in the Canadian economy, given its exposure to the domestic consumer. While National Bank of Canada's base in Quebec has generated excess capital, we are concerned about its expansion of wealth management through acquisition, as the bank could easily spend too much on these deals.
Most of the companies we cover are fairly valued, but all have reasonable dividend yields. Canadian banks remain among the safest in world, in our opinion. However, we think various domestic and international factors will make it difficult for the banks to replicate the increase in their stock prices of the past two years. Instead, we think the banks face headwinds that will make it difficult to repeat their past operating performance. While we favor some banks over others as investments, we think the next few years will present challenges to improve upon their past profitability.
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