O Canada! (Part I): Investing in the World's Soundest Banking System

Includes: BMO, BNS, CM, RY, TD
by: Joseph L. Shaefer

“BBDP” is a term I used in my first book. It stands for “Basic, Boring, Dull and Profitable.” And in investing for the long term, it forms the foundation of our investing pyramid. No fireworks. No "up 30% one week, down 25% the next", leaving you worse off than when you started.

The US economy – and stock market – has been filled with fireworks, not just in this most recent year but ever since the abolition of Glass-Steagall, the chicanery in dot-com IPOs, the artificial inflation in home prices thanks to Greenspan’s interest rate reductions to prevent the normal contraction in the economy after the dot-bomb went off, and the current and former administration’s decision to seek the guilty (Wall Street bankers and brokerages) and punish the innocent (American taxpayers.)

Most of the world’s stock markets move in rough parity with U.S. markets. But I believe, while there will probably not be an economic decoupling with Canada (I certainly hope not – this is one of the best good-deals-for-both-sides in the world), there is likely to be a market decoupling as investors learn about the quality of the companies north of the 49th Parallel.

(That term, often used as a proxy for the US – Canadian border, is actually a misnomer. More than 70% of Canada’s population reside south of the 49th parallel, including those in Toronto, Montreal and Ottawa. However many of the natural resources and virtually all of the “frontier” resources still lie north of that line…)

While US bankers and brokerages were engaged in a headlong rush to get through the door marked “Stupid Banking” at the same time, their Canadian counterparts were protecting investor deposits, eschewing sub-prime mortgages and derivatives, and being regulated by regulators who actually believe their job is to protect depositors and the national economy rather than provide themselves with contacts so they can get a cushy high-paying job as soon as they leave government.

As a result, in its just-released (in September) Global Competitiveness Report, the World Economic Forum, for the second year in a row, named Canada as having the world’s soundest banking system. And the IMF noted that Canadian regulators follow best practices in supervising financial institutions, and actually enforce their regulations – with nobody “too big to fail.” (Unlike the US, where some 90-95% of all off-books derivative exposure is still concentrated (and growing?) between J.P. Morgan (NYSE:JPM), Goldman Sachs (NYSE:GS), Bank of America (NYSE:BAC), and Citigroup (NYSE:C).)

The five largest banks in Canada are, in order of size, Royal Bank of Canada (NYSE:RY), Toronto Dominion (NYSE:TD), Bank of Montreal (NYSE:BMO), Bank of Nova Scotia (NYSE:BNS), and Canadian Imperial Bank of Commerce (NYSE:CM). And these are no small fry! On the 2009 Forbes Global 2000 list, RY is number 68 in the world, just ahead of Cisco (NASDAQ:CSCO); TD is number 111, just ahead of Apple (NASDAQ:AAPL); BNS is number 120, one ranking behind Boeing (NYSE:BA) and 3 ahead of Merck (NYSE:MRK); BMO is number 200, beating out General Dynamics (NYSE:GD), Union Pacific (NYSE:UNP) and Deere (NYSE:DE); and even the tiniest of the big 5, CM is ranked at number 585 in the world, ahead of Northrop (NYSE:NOC) and US Steel (NYSE:X). The fact that Canada has a population of just 33 million hasn’t hampered these banks' international growth one whit!

Remember, these are not just “Canadian banks”, but financial services firms that have offices worldwide as well as mutual funds, insurance, credit cards, and stock brokerage subsidiaries. In fact, you may well recognize one or more of these firms’ US subsidiaries.

Royal Bank serves seventeen million clients and has 80,000 employees around the world. When I was a young Schwab branch manager in Fort Lauderdale in the late 1970s I banked with one of the 400+ branches of RBC Bank, their US subsidiary, and have seen that familiar name scattered across many countries in the Caribbean, while on dive trips there. They have operations in 50 countries and, as a result of American bankers hitting the “Stupid” button, are expanding their presence in the US, as well. They acquired 39 branches of AmSouth Bank in Alabama in 2007 and 100% of Alabama National Bancorporation in 2008.

Toronto-Dominion has over 74,000 employees and an equal seventeen million clients worldwide. It owns TD Bank in the US, 30% of discount brokerage TD Ameritrade, all of TD Asset Management, TD mutual funds, as well as TD Waterhouse wealth management.

You think these are hick bankers? While Citi and Wachovia (NASDAQ:WB) and B of A and – shall we go on? drove their banks into the dirt, TD was making moves like this: in 1999, TD spun off 42 million shares of TD Waterhouse in an IPO, with shares priced at $24 (USD) per share, earning $1.01 billion USD. In 2001, in the bear following the dot-bomb, TD bought back that minority stake for $9 USD per share. That would be 42 million times $15, or a $630 million positive cash flow to own the same company at the bottom of the bear, just before the housing bubble sent all stocks roaring ahead again. And they didn’t touch a risky derivative to do it. Some hicks.

The Bank of Nova Scotia also runs banking operations well beyond Canada’s borders, though it chooses emerging markets for its investments. The most recent of these is the agreement to buy 100% of Banco del Desarrollo, Chile's seventh largest bank for just over (US) $1 billion. Like the other smart Canadian bankers, BNS has been a ready buyer for US assets at fire sale prices as US firms over-reached. To pay for their billion-dollar-plus mortgage fiasco, E-Trade (NASDAQ:ETFC) sold its Canadian division to Scotiabank for just over (US) $400 million, a great coup for BNS.

Bank of Montreal, Canada's oldest bank, also owns the Harris Bank, which I remember fondly from my days in Chicago, as well BMO Nesbitt Burns, a full commission investment firm, wealth manager Harris Investor Services, and super-wealth manager BMO Harris Private Banking. Not to be outdone in the buy-when-others-are-selling department, this year BMO bought AIG’s Canadian life insurance business for less than (US) $30 million, making them the second-biggest life insurer among Canadian banks.

Finally, Canadian Imperial Bank of Commerce, operating in the United States, the Caribbean, Asia and the UK, serves more than eleven million clients and has more than 40,000 employees worldwide. Their most recent coup was to buy Barclays’ (NYSE:BCS) 43.7% stake in First Caribbean International Bank. It helps to have cash when others are desperate to sell…

It also helps to be intelligently and ethically managed. While US bankers and brokers are repaying TARP money solely so they can give themselves massive bonuses at year-end, in Canada RY is changing the way its investment bankers and traders are paid -- in order to make its risk management even tighter. Instead of being rewarded for making brainless bets with depositors’ money – even if it works out in the short term – RY is giving a greater percentage of pay on a deferred basis, after the positions are closed, which gives bankers and traders an incentive to police themselves and to have their own skin – in the form of increased pay if they’ve make the best decision for the bank – in the game.

Even though I and our clients own many more natural resource, energy, metals and mining, and agricultural firms in Canada, I think the financial sector must provide the foundation for future growth. No company can generate 100% of its capital expansion needs internally.

When you’re building a $3 billion natural gas pipeline from the wilds of Alberta to the wilds of Chicago you’d better have a sound banking system that can evaluate your project, make informed risk decisions, and – most importantly – have the money to lend to you rather than having squandered it spinning roulette wheels that hit or miss in milliseconds. That’s why I recommend these five banks for your consideration before moving on to the rest of the fine Canadian companies.

Worldwide demand for infrastructure, materials, energy, and agriculture play to Canada’s great strengths. The US has such companies, as well. The difference is, our bankers have shot themselves in various essential body parts and placed their heads in others, while Canada has a strong banking system in place, ready to finance expansion.

  • RY sells for 22 times trailing earnings (12 times estimated forward earnings) and yields 3.6%.
  • TD sells for 21 times trailing earnings (12 times estimated forward earnings) and yields 3.7%.
  • BNS sells for 17 times trailing earnings (12 times estimated forward earnings) and yields 4.2%.
  • BMO sells for 17 times trailing earnings (12 times estimated forward earnings) and yields 5.4%.
  • And CM sells for 28 times trailing earnings (11 times estimated forward earnings) and yields 5.5%.

I like TD and BNS the best. Your mileage may vary. If you decide to buy, please note that if US financials decline – and how can they not as the true state of their off-balance sheet derivatives exposure begins to leak out – Canadian banks will probably decline in step. You might want to buy some now and, if I’m correct, buy more on the pullback. Unlike their US brethren, the pullback will be purely on sentiment, not on balance sheets.

Don’t just take my word for this. I cited a study from the World Bank (available here) when I advocated investing not in the BRICs but in the nations that provide what the BRICs need to fuel their growth.

That study ranked Canada the 8th-easiest country in the world in which to do business, (The US ranked 4th.) Now comes a new Forbes study that ranks Canada 3rd in the world among the “Best Countries to Do Business” (to the US’s #2, although I’m not sure we can continue to rank the US this highly if we continue to pursue our policies of embracing statist, centralized big government at a time when the rest of the world is going the other direction…)

Up next: Canadian Energy, Agriculture, Metals and Basic Resources.

Full Disclosure: Long TD and BNS.

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