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In a previous article 'The Outlook for Australia's Big Four Banks,' I outlined the risk profile for Australia's 'Big Four.' Bank stocks previously offered investors access to stable, quality earnings streams with high secure yields. This held true almost regardless of where (geographically) you were invested. Then came the Global Financial Crisis (GFC). The GFC revealed the weaknesses not only in individual banks' risk models, but also national regulatory oversight. Or as Warren Buffett bluntly put it: "You only find out who is swimming naked when the tide goes out."

Suddenly, Australian and Canadian banks with their strict regulatory oversight and conservative lending practices went from being the parochial cousins (for opposing deregulation and relaxing risk controls), to the poster children of fiscal responsibility. As of Dec 2011 - 3 years after the crisis began, only 11 banks worldwide still had an S&P rating of AA- or higher. Three were Canadian, four Australian.

S&P Rating

Rabobank Nederland

AA

BNP Paribas

AA-

Banco Santander

AA-

Nordea Bank AB

AA-

National Australia Bank

AA-

Commonwealth Bank of Australia

AA

Westpac Bank Corporation

AA-

Australia and New Zealand Banking Group Limited

AA-

Toronto-Dominion Bank

AA-

Royal Bank of Canada

AA-

Bank of Nova Scotia

AA-

Bank of Montreal

A+

The similarities between Australia's and Canada's banks are not trivial. Both their banking systems and wider economies have much in common:

  • Strict regulatory oversight preventing M&A between Australia's 'Big Four' and Canada's 'Big Six'
  • Conservative mortgage lending practices
  • Low exposure to EU Sovereign debt
  • Natural resource based economies
  • Strong commodity currencies
  • Low government debt to GDP levels
  • Heavy reliance on single trading partner (Canada-USA, Australia-China)

I believe the biggest difference between the Australian banks vs. Canadian is value. Australian banks right now offer great value. In this article I will attempt to contrast the differences to explain why the Australian banks - despite their similarities with Canada's, are a better buy.

Dividends through Crisis

Both countries' biggest banks continued to pay dividends through 2008-2009 - in sharp contrast to most other regions where bank dividends were either cut drastically or suspended altogether.

Australia (A$)

2008 Div.

2009 Div.

Differential(%)

Australia and New Zealand Bank

1.36

1.02

-25.00

Commonwealth Bank of Australia

2.66

2.27

-14.66

National Australia Bank

1.94

1.46

-24.74

Westpac

1.42

1.16

-18.31

Average

1.72

1.64

-20.68

Canada (C$)

2008 Div.

2009 Div.

Differential(%)

Royal Bank of Canada

2

2

0.00

Toronto-Dominion Bank

2.36

2.44

3.39

Bank of Nova Scotia

1.92

1.96

2.08

Bank of Montreal

2.8

2.8

0.00

Average

2.27

2.30

1.37

As the above table show, Australian banks cut their dividend by a higher margin than their Canadian peers in 2009, but have increased them by a higher margin since 2009. See below.

Australia (A$)

2009 Div.

2011 Div.

Differential(%)

Australia and New Zealand Bank

1.02

1.4

37.25

Commonwealth Bank of Australia

2.27

3.2

40.97

National Australia Bank

1.46

1.72

17.81

Westpac

1.16

1.56

34.48

Average

32.63

Canada (C$)

2009 Div.

2011 Div.

Differential(%)

Royal Bank of Canada

2

2.08

4.00

Toronto-Dominion Bank

2.44

2.61

6.97

Bank of Nova Scotia

1.96

2.05

4.59

Bank of Montreal

2.8

2.8

0.00

Average

3.89

Although Australia avoided a technical recession during 2008/2009, with bank earnings and dividends rebounding strongly, the market has not bid Australian bank stocks above 2007 levels.

Sydney (Closing Prices)

31/12/2007

17/02/2012

Gain/Loss

Australia and New Zealand Bank

28.23

21.57

-23.59

Commonwealth Bank of Australia

57.84

49.79

-13.92

National Australia Bank

36.73

22.77

-38.01

Westpac

27.48

20.18

-26.56

Average

-25.52

Toronto (Closing Prices)

31/12/2007

17/02/2012

Gain/Loss

Royal Bank of Canada

49.4

53.14

7.57

Toronto-Dominion Bank

67.12

78.54

17.01

Bank of Nova Scotia

48

53.59

11.65

Bank of Montreal

55.27

58.12

5.16

Average

10.35

Australia's 'Four Pillars' are currently trading at an average of 25% below their Dec 2007 levels. The Canadian banks are 10% above. A differential of 35%. While the banks down under have seen their wholesale funding costs rise with the EU debt crisis - squeezing margins, they have begun to pass the higher cost of borrowing on to the consumer. As of this month all four raised the standard variable rate they charge on mortgages. Given similar risk profiles and forecasts for both economies, higher funding costs alone do not justify the Australian bank's 35% discount to their Canadian peers. While it could be that Canadian banks are overvalued, given their modest P/E multiples I do not see them as overpriced.

Not So Dependant

Australia's economy is less dependent on a single trading partner than Canada. In 2011, roughly 75% of all Canadian exports went to the US, whereas China accounts for about 22% of all Australian exports. India, South Korea, and Japan make up another 30%. Apart from Japan, these countries have seen significantly higher GDP growth than the US during the period 2007-2011. China alone has averaged 10% growth since 2007. It could be that post crisis the market has re-priced risk, but given record after tax profits of A$ 24 billion from the 'big four' in 2011 - a 44% increase over 2007 earnings, Australian bank stock prices would be expected to be above 2007 levels - not 25% below. The hope seems to be with Canada, and the fear with Australia. Just rumours of a slowdown in China are enough to cast a shadow over Australia's economic outlook these days. But even though the US economic recovery is showing signs of real traction, the OECD predict that US GDP growth at 2-3% in 2012. China is forecast to grow by 8%, India by 7%.

Diverging Ways

Household debt in both Canada and Australia is running at around 150% of personal incomes. Frothy Australian housing markets have slowed considerably though, with mortgage lending growth under 6% in 2011 - the lowest level in more than 20 years. Things are different in Canada. With near record low mortgage rates, the overheated real estate market shows no signs of cooling in 2012 - although individual banks have already tightened mortgage lending criteria in response to warnings from the Bank of Canada.

The two countries are also at different stages in the interest rate cycle. Australia started raising rates already back in 2009 - hiking 8 times since. Currently they stand at 4.25%. Canada's at 1%. The market had expected a more hawkish tone from Bank of Canada governor Mark Carney when interest rates were left on hold back in October. It was the ninth consecutive time that the central bank had decided to hold the rate. Europe's debt crisis which he described as "barely contained," was seen as the main driver for keeping rates steady. The current market consensus is that the Bank of Canada will now keep rates unchanged until the start of 2013. However, if the EU debt crisis is resolved more swiftly than expected, or US growth accelerates, rates in Canada might rise faster than anticipated. A hard landing in Canadian real estate would see mortgage lending fall sharply. Despite Canadian bank's extensive operations in the US, increases at their US affiliates would not be enough to offset a sharp slowdown in domestic lending. An EU debt crisis resolution would also see the Australian bank's wholesale funding costs fall. We could then see roles reverse. The hope might then be with Australia, and the fear with Canada.

Australia Pays Better

The average current yield of the 'big four' is over 7%.

Payout ratio

Current Yield

Div. Growth- 5yr

EPS Growth -
5 yr

P/E

Australia and New Zealand Bank

65.34

6.6

2.29

0.48

10.58

Commonwealth Bank of Australia

78.32

6.52

7.39

5.44

11.64

National Australia Bank

75.85

7.6

0.59

-2.43

9.78

Westpac

67.35

7.72

6.1

6.18

9.1

Average

71.72

7.11

4.09

2.42

10.28

-

Payout ratio

Current Yield

Div. Growth- 5yr

EPS Growth - 5yr

P/E

Royal Bank of Canada

46.61

3.96

7.63

3.73

12.08

Toronto-Dominion Bank

40.57

3.39

2.72

5.44

12.3

Bank of Nova Scotia

44.36

3.88

0.59

5.52

11.32

Bank of Montreal

54.13

4.75

4.38

0.74

11.13

Average

46.42

4.00

3.83

3.86

11.71

Note the average payout ratio of 71.72% for Australia's big four. Recent dividend growth has not come at the expense of increasing the payout ratio. The payout ratio across all companies in the ASX200 has averaged 63% for the 5 year period 2006-2011. Historically, Australian banks simply pay more of their earning to shareholders than the Canadians. The 4 Canadian bank payouts average 46.4%. It is the difference in payout ratios, plus the lower market valuation that explains why the' big four' current yields are a massive 311 basis points higher than the Canadian four. EPS and dividend growth are roughly aligned between both countries banks for the previous 5 years.

Conclusion

If you want three very simple reasons to buy Australian banks over Canada's they are:

1. Average 7% yield. Over 3% more than Canada's

2. Compared to 2007 levels Australian banks trading at 35% discount to Canadians.

3. Payout ratio of 71% vs. 46% for Canada. Australian banks payout on average 25% more of their income to stock holders.

Because of the similarities, I have used Canada and its four biggest banks purely as a comparative. All 8 banks trade on low earnings multiples, and you could do a lot worse than invest in the Canadian banks. But for the income investor, Australia's big four currently offer better value.

The Small Print

There is currency risk with dividends paid in either Australian and Canadian dollars. If these commodity currencies revert partially or fully to their historic mean, income streams could be worth 15-30% less in US dollar terms. I am not aware of any Australian Bank Sector ETF - hedged or unhedged. All 8 banks mentioned here have an ADR listing:

Australia & New Zealand Bank - (OTCPK:ANZBY)

Comm. Bank of Australia - (OTCPK:CMWAY)

National Bank of Australia - (OTCPK:NABZY)

Westpac - (NYSE:WBK)

Royal Bank of Canada - (NYSE:RY)

Toronto-Dominion Bank - (NYSE:TD)

Bank of Nova Scotia - (NYSE:BNS)

Bank of Montreal - (NYSE:BMO)

Liquidity is much higher in the Canadians. Trading direct on the ASX is recommended for the Australian banks as bid/ask spreads in the ADR's can be high. Custodian fees for holding Australian equities are usually low. All four Australian Banks pay their dividends '100% Franked.' This means that all corporation taxes have been paid, and the dividend can be paid out free of all withholding taxes, making them ideal for retirement accounts. Canadian dividends are subject to a 15% withholding for foreign investors.

Source: With 7% Yield, Australian Big 4 Banks Offer Better Value Than Canada's Big 4