With the four largest Canadian banks having reported their quarterly earnings for the three-month period ended April 30, investors may start considering Canadian banks as an alternative to their peers in the U.S., especially when looking at earnings adjusted for risk. Canadian banks have provided outstanding earnings growth and many have the potential to increase dividends, even when facing the stricter requirements of Basel III. On the other side of the border, investors are left concerned about the risk management practices and capital adequacy of American banks, and they simply are not seeing the same earnings growth as bank management is distracted more with regulatory compliance and putting out fires than it is concerned with growing the business.
We will take a look at the six largest Canadian banks, as well as their American peer group, in terms of market capitalization and attempt to understand whether there is value to be found in Canadian banks, or whether American banks offer higher return potential when adjusted for their less risk-adverse strategies.
First, some quick numbers on the Canadian banks:
Royal Bank of Canada (RY)
The Royal Bank of Canada posted earnings below analyst expectations in the second quarter, with earnings of US$1.15/diluted share. This excludes the loss on the RBC Dexia acquisition. Excluding the loss shows continuing operations at RBC are up 4.5% from the same period last year.
RBC is the largest Canadian bank, with a market capitalization of US$70.8 billion.
Forward P/E: 9.9x
Trailing P/E: 11.3x
Return on Equity: 18.71%
Dividend Yield: 4.6%
Payout Ratio: 51.5%
Tier 1 Capital Ratio: 13.2%
2011 vs. 2010 EPS Growth: 24.1%
Toronto-Dominion Bank (TD)
Toronto-Dominion is perhaps the flavor of the week in terms of Canadian banking stocks, as many Americans are most familiar with this institution due to its large U.S. presence. TD has shown extremely strong EPS growth as investments in heavily discounted U.S. banks have begun to show favorable returns. For investors trying to diversify their financials portfolio away from the United States, TD may not be the best choice as it is heavily invested south of the border. After TD's 2008 acquisition of Commerce Bancorp, TD has more U.S. branches than ones located in Canada.
TD has the lowest payout ratio of any of the top six Canadian banks, and therefore could be judged as in the best position to raise its dividend. That said, Canadian banks seem to be reluctant to allow their Tier 1 capital to decline below 12%, and therefore TD will need to find ways to increase that ratio prior to implementing an increased dividend.
Forward P/E: 10.0x
Trailing P/E: 11.8x
Return on Equity: 15.1%
Dividend Yield: 3.7%
Payout Ratio: 43.8%
Tier 1 Capital Ratio: 12.0%
2011 vs. 2010 EPS Growth: 18.2%
Bank of Nova Scotia (BNS)
The Bank of Nova Scotia, or ScotiaBank, is Canada's most internationally diversified bank. That has served it well in certain emerging markets, although that has also left it with some questionable acquisitions in its history. ScotiaBank has an attractive current payout ratio and solid EPS growth.
ScotiaBank announced in its Q2 financial statements that it has entered into an agreement with H&R REIT, a Canadian real-estate investment trust, to sell its Toronto head office for over $1.2 billion. This will free up additional capital for its Tier 1 ratio, as the head office was an asset with no value for the purposes of determining capital requirements.
Forward P/E: 10.2x
Trailing P/E: 11.0x
Return on Equity: 20.2%
Dividend Yield: 4.5%
Payout Ratio: 48.8%
Tier 1 Capital Ratio: 12.2%
2011 vs. 2010 EPS Growth: 18.6%
Bank of Montreal (BMO)
The Bank of Montreal is Canada's fourth largest bank with a market capitalization of US$34.2 billion. The Bank of Montreal had the lowest earnings growth in 2011, after leading the Big Five in growth in the prior year. Whether this is a onetime blip on the radar as growth slows after a strong year or whether it is a sustained trend is yet to be seen.
The Bank of Montreal also has significant U.S. exposure, though not quite to the extent of Toronto-Dominion. U.S. based earnings represented just over 18% of BMO's total income in Q2 2012.
Forward P/E: 9.2x
Trailing P/E: 10.2x
Return on Equity: 15.3%
Dividend Yield: 5.2%
Payout Ratio: 52.6%
Tier 1 Capital Ratio: 12.0%
2011 vs. 2010 EPS Growth: 10.0%
Canadian Imperial Bank of Commerce (CM)
Canadian Imperial Bank of Commerce is the only remaining one of the Big Five banks that has not yet posted its Q2 numbers. While many investors may remember the CIBC that got caught up in risky trading strategies and was sued as part of the Enron debacle, the current CIBC has the highest Tier 1 capital ratio of any of the Canadian banks. It's slightly lower-than-average EPS growth may be attributable to a lower risk stance; however, the firm trades on a highly attractive forward price to earnings multiple. That said, there is little room for current dividend growth with a nearly 55% payout ratio.
Forward P/E: 8.6x
Trailing P/E: 10.2x
Return on Equity: 21.4%
Dividend Yield: 5.3%
Payout Ratio: 54.8%
Tier 1 Capital Ratio: 14.3%
2011 vs. 2010 EPS Growth: 16.3%
National Bank of Canada (OTCPK:NTIOF)
National Bank of Canada is not generally widely known of outside of Canada, but can be a very interesting play for Americans or other investors that are looking to diversify by purchasing highly "Canadian" assets. National Bank is traded on the Toronto Stock Exchange under the symbol "NA" and has a current market capitalization of C$11.6 billion.
National Bank's asset portfolio and revenue base is nearly strictly Canadian. All but 3% of revenues are from Canada, with 70% of revenues from the Province of Quebec alone (see pg. 19 of National Bank of Canada 2011 Annual Audit Financial Statements). While the Province of Quebec is certainly not the economic engine behind the Canadian economy currently, National Bank is working to diversify its business outside of Quebec and into more economically viable provinces such as Alberta and Saskatchewan. For investors looking for a truly diversified play away from U.S. assets, National Bank is certainly an interesting option.
With a payout ratio of only 43.7%, National Bank does have some capacity to consider a dividend increase in the near future. However, the forward P/E may suggest that this is already baked into the valuation.
Forward P/E: 9.6x
Trailing P/E: 10.5x
Return on Equity: 18.2%
Dividend Yield: 4.2%
Payout Ratio: 43.7%
Tier 1 Capital Ratio: 12.7%
2011 vs. 2010 EPS Growth: 12.0%
Do American Banks Provide More Value?
We will take a look at four U.S. banks of comparable market capitalization to the Canadian banks in order to compare their merits as investments. The four similarly sized banks in the United States are Citigroup (C), Bank of America (BAC), U.S. Bancorp (USB), and PNC Financial (PNC).
Considering that EPS growth is expected to be at an annualized rate of only approximately 13% based on consensus analyst estimates, it's hard to get excited about massive upside with Citigroup, especially with the dismal Tier 1 capital ratio in comparison to the Canadian firms. There is a lot of risk holding Citi currently, but we would not dispute that there is also some upside in excess of what is available holding Canadian financial institutions -- if everything goes right.
When compared to Canadian banks however, we believe there stronger potential for capital appreciation owning names such as CIBC, Toronto-Dominion, and National Bank without being kept awake at night by the $200 billion in toxic assets lingering on the balance sheet. Plus, Canadian firms will pay you a solid dividend while holding the stock, whereas Citi won't be doing so for some time.
As a trade, there may be some value in Citi, but as a core long-term portfolio holding it's best to look elsewhere for more appropriate risk-adjusted returns.
Forward P/E: 6.4x
Trailing P/E: 7.4x
Return on Equity: 6.1%
Dividend Yield: 0.2%
Payout Ratio: 1.1%
Tier 1 Capital Ratio: 4.9% (per latest Fed Stress Tests)
2011 vs. 2010 EPS Growth: 3.7%
Bank of America
While Bank of America is better capitalized than Citi, concerns still linger about its loan portfolio and what exactly those assets on the balance sheet are worth. With Tier 1 capital more in alignment with Canadian banks than Citi (though still significantly less), Bank of America seems to be a less risky choice than Citigroup. We still would not put Bank of America into the same investment class as the Canadian banks or the remaining two American banks discussed here, but we will show later that it at least offers an increased expected return based on analyst estimates considering its risk.
Forward P/E: 9.2x
Trailing P/E: N/A
Return on Equity: -0.61%
Dividend Yield: 0.56%
Payout Ratio: N/A
Tier 1 Capital Ratio: 10.1% (per latest Fed Stress Tests)
2011 vs. 2010 EPS Growth: -98.9%
The first healthy bank to be considered south of the border in this article, U.S. Bancorp offers some attractive business aspects. First, it is growing returns rapidly, increasing EPS by 39.3% in 2011 and an incredible 78.4% in the previous year. While this pace is expected to slow to a more moderate 14.9% in 2012 and continuing at a similar rate beyond, this earnings growth is more in line with U.S. Bancorp's Canadian peers. However, the valuation is not cheap when it comes to this firm, and a premium is being paid for a return on equity that is below most of the Canadian banks. U.S. Bancorp has a more reasonable Tier 1 capital ratio than, say, Citigroup, but it still is a more risky capitalization than the Canadian banks -- and they simply are not earning excess returns to justify it.
If we were looking at U.S. financials in this market capitalization range, U.S. Bancorp would certainly be a strong contender. However, we still think that the Canadian firms offer better return on equity with lower risk capitalization and assets.
Forward P/E: 11.1x
Trailing P/E: 11.9x
Return on Equity: 16.5%
Dividend Yield: 2.5%
Payout Ratio: 29.9%
Tier 1 Capital Ratio: 10.9%
2011 vs. 2010 EPS Growth: 39.3%
PNC Financial is another U.S.-based financial that is in the same market capitalization range as the smaller Canadian banks. While PNC offers reasonably competitive price to earnings metrics, the ROE of the firm leaves a lot to be desired. Earnings growth has also been slower to materialize than U.S. Bancorp (and Canadian banks) and analysts expect this to continue at a lackluster approximately 6% pace over the coming years.
Forward P/E: 9.8x
Trailing P/E: 11.2x
Return on Equity: 8.9%
Dividend Yield: 2.6%
Payout Ratio: 28.9%
Tier 1 Capital Ratio: 9.3%
2011 vs. 2010 EPS Growth: 5.2%
Long-Term Consensus Estimates:
Here is a table of 2014 consensus earnings estimates for each of the financial institutions, multiplied by their current trailing P/E ratios to arrive at a simple potential valuation. (Canadian Bank EPS estimates are in Canadian dollars, then converted to U.S. dollars before applying the current U.S. P/E multiple. National Bank is calculated in all Canadian dollars as no reliable U.S.-based trading multiple can be determined):
Ticker 2014 Estimated EPS P/E Multiple Valuation Increase Annualized Return** 1 C $5.20 10.0x* $52.20 94.8% 27.3% 2 BAC $1.38 9.2x* $12.70 73.9% 21.8% 3 CM $8.47 10.2x $86.39 25.3% 12.5% 4 TD $8.44 11.8x $99.59 29.9% 12.2% 5 PNC $7.43 11.2x $83.21 33.6% 12.2% 6 NA $8.79 10.5x $92.30 26.1% 11.5% 7 RY $5.44 11.3x $61.47 23.9% 11.3% 8 USB $3.34 11.9x $39.75 28.1% 10.5% 9 BMO $6.03 10.2x $61.51 14.5% 9.0% 10 BNS $5.37 11.0x $59.07 16.1% 8.7%
* Used the forward P/E for BAC as TTM is negative, also using 10x as a multiple for C as it begins to return to normal operations.
** Dividends are assumed to continue at the same payout ratio and are re-invested
Primarily, Canadian banks primarily allow for American or international investors to diversify their exposure away from traditional finance markets of Europe and the United States. Most Canadian banks, excepting TD, have very little exposure to U.S. markets, with the majority of holdings in Canada.
The question then becomes what is the cost of this diversification. Am I losing substantial returns investing in CIBC over PNC Financial, for example? The answer, based on analyst estimates seems to be no. This de-risking through diversification (and through investing in banks with higher risk capital) does not seem to be expensive whatsoever.
Clearly, there is opportunity to make significantly higher returns investing in high risk financial institutions like Citigroup and Bank of America trading below book value, due to having billions in high toxic assets on their balance sheets. We don't dispute that. However, the best comparisons are healthy U.S. banks of similar to size to Canadian institutions, as these are the true alternatives that most investors will be considering for this segment of their portfolio.
In all, we don't recommend Americans sell all of their U.S. bank holdings and invest them in Canadian financial firms. U.S. banks still operate in a more lax regulatory environment and have more growth opportunities. However, we do recommend that both American and international investors consider investing in Canadian financial institutions as a way to diversify their country-pecific risk in the financial segments of their portfolios. We have highlighted here that this does not have to mean taking substantially lower returns in most cases; opportunities exist in Canada to at least match investment returns from similar institutions in the U.S.