Which Canadian Bank Is The Best Investment?

| About: Royal Bank (RY)

Summary

Royal Bank of Canada is the largest Canadian bank by market cap.

The bank is diversified into Canada, America, and some developed markets.

It holds the best position in several metrics, and is trading at fair value at this time.

This is the third in a series of articles on Canadian banks. Feel free to read the other 2 here and here.

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The Royal Bank of Canada (NYSE: RY) is the largest Canadian bank by market capitalization, at ~$94 billion as listed on the NYSE. It were incorporated in 1869 as a regional bank, and has since grown to serve customers in Canada, the US, and 37 other countries. The bank's dividend streak is impressive, having paid steady or increasing dividends every year since 1943. It froze its dividend for 2 years through the financial crisis, and has increased it every year since 2010. RY's business segments are highlighted below:

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Source: Investor Presentation

RY may be a global bank, but it still generates the lion's share (no pun intended) of its revenue at home in Canada. The bank is growing well in the US, including its recent acquisition of City National Bank, and it has an international segment comprising 17% of the business. RY carries a 10.3% Tier 1 Common Equity Capital Ratio, well above the 6% Basel III requirement, and in line with peers. This ratio is an important liquidity score that attempts to quantify a bank's ability to withstand stress. RY is well known for being a conservative and safe investment, primarily due to its performance through the Great Recession. Along with the other large Canadian banks, it was a relative safe harbor during a very rough time for financial stocks.

Loan Portfolio

The table above shows the loans/assets and loans/deposits ratios of RY and its 2 largest Canadian competitors, The Bank of Nova Scotia (NYSE: BNS) and Toronto-Dominion Bank (NYSE: TD), as well as the Warren Buffett favorite Wells Fargo (NYSE: WFC). These ratios represent liquidity as well as the risk profile of a bank. Banks willing to hold more loans versus their total assets or deposits shows their tolerance for risk. These numbers can definitely be too high, but they can also be too low, showing a bank isn't driving the earnings growth it could. RY holds the lowest (most conservative) of both of these ratios by a sizable margin.

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Source: Investor Presentation

RY, like its competitor TD, carries a significant amount of loans in the real estate market. Home prices have been careening upwards in Canada (specifically in Toronto and Vancouver) to what are considered unsustainable levels. There is a widely held perception that this represents a bubble, and that any number of catalysts will cause the housing market to tank, causing distress for both these big mortgage banks. However, my take is that both of these banks are conservative, wide-moat businesses, and they will make it through a drop in their housing market just like they have made it through recessions and stock market crashes in the past.

Source: Investor Presentation

These graphs show the difference in the average Canadian homeowner versus an American one. The % of equity in their houses is much higher, and they have held a lower delinquency rate through the recent past. A lot of this has to do with more stringent regulations on mortgages in Canada. There are more requirements in regard to down payments, mortgage insurance and LTV (loan amount to house appraisal value). This makes a disaster less likely to occur, and RY is extremely conservative in nature.

Growth

RY's City National Bank acquisition closed late last year. This is expected to bolt-on and add to RY's footprint in America. It brings in over ~C$412 billion in client-managed assets, swelling RY's wealth management and capital markets businesses. The company plans on leveraging CNB's positioning in the highest net worth locations in America to cross-sell RY products. This will give RY an additional growth opportunity in America, with access to a whole new client base. A bank this size has a huge amount of products to offer, and RY can use the customers it is gaining from CNB and future acquisitions to grow its revenues.

Management has targeted a goal of 7%+ EPS growth over the next 5 years. Over the past 5 years, they have achieved a rate of ~12%. With the situation possibly brewing in Canada's housing market, it's possible that the company will achieve lower rates due to an increase in defaults going forward. However, 7% seems likely, and this would yield a total return of ~11%+ for investors.

Financials

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RY carries the highest ROE by a substantial margin. The bank has targeted 18%+ going forward, and it has achieved that number in the past. One thing that should help it reach that goal is the buyback program I will detail later in the article. Significant increases in net income over the past several years have set RY apart from its main competitors in this regard.

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Again, RY is the best of the 3 banks in ROA. This metric shows the ability of a bank to leverage its assets into earnings. This is another key profitability metric in RY's favor.

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It has the worst net interest margin of the 3 banks. This metric is largely driven by interest rates. When interest rates do begin rising again - which they will at some point - banks will benefit, with their margins increasing.

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RY has driven a good amount of FCF growth over the last several years. It is behind TD, which is an absolute FCF machine, but it's enough to service the ~C$7.4 billion in long-term debt the bank is currently carrying, and still increase its dividend. RY has targeted a 40-50% payout ratio, and it is currently at 46.40%. This means investors should expect the DGR to stabilize somewhere around the earnings growth rate going forward, which is expected to be ~7%+.

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RY announced in May a plan to buy back up to 20 million of its shares. This would almost take the company back to its 2015 share count. I am happy with this move, because the company has used share issuances in acquisitions. When these shares aren't repurchased, the net result is a dilution of shareholders' equity on top of the fact that it increases the burden of dividend payments every quarter. RY leads the pack on diluting its share count the least since 2007. If the bank continues to fund a buyback program with FCF (not debt), that will continue to drive shareholder gains, especially at these low valuations.

Valuation

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Source: F.A.S.T. Graphs

In this zoomed out version of RY's valuation, the bank appears undervalued compared to its long-term average P/E ratio of 12.6X. This includes a severe drop during the financial crisis.

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Looking at its valuation from a closer perspective, RY is trading right around its normal P/E ratio since the financial crisis of 12X. The 4% yield is in line with its average yield over the period, as well.

Conclusion

It seems that all 3 of the major Canadian banks are trading around fair value. They offer something different to everyone, with BNS carrying a large presence in the emerging markets, TD solely focused on Canada and the US, and RY holding an international segment in the developed markets. I don't think investors would go wrong buying any of the three and holding for a long time. I like RY's plan to buy back some of the shares that it has diluted over the last decade, and its ROE/ROA metrics. However, I am a big fan of BNS's growth prospects, and I believe the bank has the opportunity for the largest gains going forward. TD has the best credit rating of the 3 and seems to be taking market share well in North America. I think that, barring a change, I will be investing in BNS and watching all 3 for any weakness to open a position.

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Financial statistics were sourced from Morningstar, with the charts and tables created by the author, unless otherwise stated. This article is for informational purposes only and represents the author's own opinions. It is not a formal recommendation to buy or sell any stock. Please do your own due diligence and/or consult a financial professional prior to making investment decisions.

Disclosure: I/we have no positions in any stocks mentioned, but may initiate a long position in BNS, TD, RY over the next 72 hours.

I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.