Which Is The Best Canadian Bank?
Summary
- Canadian banks have outperformed the stock market over the past 15 years.
- They show a very solid dividend growth history.
- Considering the economic slowdown, oil price slump, and Canadian housing situation, there are still good opportunities to be enjoyed investing in Canadian banks.
The financial industry in Canada is fascinating; banks were long time blamed for not taking enough risk and for a lack of interesting returns for investors regardless of their steady dividend payouts. This was prior to 2008. Then they showed the world that Canadian banking laws were made for their own good and had protected the market from greed. While financial sectors across the world were collapsing, Canadian banks showed their strength of balance sheet and the six biggest banks even posted profits during this turmoil.
Now that these clouds are long gone, a new storm is approaching the Canadian market. The oil price slump has pushed the economy close to recession territory, the Bank of Canada dropped its rate accordingly and banks have smaller margins to play with. Canadians are keeping up their high levels of indebtedness and the housing market is overheating. Are Canadian banks still a must in your portfolio? If you are to buy one today, which one is the best pick considering all uncertainties?
Here's an overview of the 5 biggest banks in Canada:
TD Bank (TD)
Source: Ycharts
Based out of Toronto, Ontario, Canada, TD is becoming increasingly multi-national. The four main divisions of the company are Canadian Personal and Commercial Banking, Wealth management, Wholesale Banking (securities), and U.S. Personal and Commercial Banking. TD has about $1 trillion dollars in assets under management (Source: TD Investor Relations).
On top of being a leader in Canada, TD is also the most productive Canadian Bank (e.g., more earnings relative to its risk-weighted assets). Its earnings volatility is lower than its peers due to less exposure to capital markets. Finally, TD has deployed a very lean structure into its branches which benefit greatly from their expansion in Quebec and the US. TD Bank is now known as "America's Most Convenient Bank." TD has recently beat analysts' estimates once again. Their lean structure gives them one of the best customer service scores across Canada.
While RBC (RY) relies greatly on capital markets, TD's business model is closer to the traditional banking model. It shows an important book of mortgages in overheated housing markets such as Toronto, Calgary and Vancouver.
While the Canadian market might be a weight to carry for a few years, TD is also the best positioned of the Canadian banks to benefit from an interest rate increase in the US. The most recent quarter was disappointing in the US due to hedging strategy losses and lower than expected non-interest revenues (securities sold). However, hedging losses are not part of a repeating business model.
When an economic slowdown is around the corner, you want a solid bank that manages its business efficiently. Over the past years, TD has built a strong loan portfolio which should help them avoid negative surprises if and when the bubble bursts.
Valuation
I will use a two stage dividend discount model (DDM) to evaluate each bank. This includes a discount rate that will be the same for the 5 banks (9%).
Calculated Intrinsic Value OUTPUT 15-Cell Matrix | |||
Discount Rate (Horizontal) | |||
Margin of Safety | 8.00% | 9.00% | 10.00% |
20% Premium | $93.19 | $69.68 | $55.58 |
10% Premium | $85.43 | $63.87 | $50.94 |
Intrinsic Value | $77.66 | $58.06 | $46.31 |
10% Discount | $69.89 | $52.26 | $41.68 |
20% Discount | $62.13 | $46.45 | $37.05 |
Source: Dividend Toolkit by The Dividend Monk
I have used a very pessimistic dividend growth rate with 6% for the next 10 years and 5% after. The past 5 years dividend growth rate stands at 8.57%. Since I think all Canadian banks will go through a tougher economic environment, I would rather be more pessimistic with my valuation. Nonetheless, TD is still trading at discount.
Royal Bank (RY)
Source: Ycharts
Royal Bank provides various financial services to individuals as well as commercial and institutional clients. Their services range from regular banking, investments, insurance, brokerage, mortgages, loans, etc.
I consider RY as a very interesting play as its capital market and wealth management sectors provide a strong and consistent revenue stream aside from traditional banking. They do an awesome job generating strong profits from capital markets and their wealth management division generates revenues from over 15 million clients. They recently purchased City National, a private and commercial bank for wealthy clients based in Los Angeles.
While the Canadian debt ratio is still a concern, RY diversifies its revenue sources away from mortgages and commercial loans. However, keep in mind that the capital markets business brings higher volatility.
Valuation
Calculated Intrinsic Value OUTPUT 15-Cell Matrix | |||
Discount Rate (Horizontal) | |||
Margin of Safety | 8.00% | 9.00% | 10.00% |
20% Premium | $140.70 | $105.20 | $83.91 |
10% Premium | $128.98 | $96.43 | $76.92 |
Intrinsic Value | $117.25 | $87.66 | $69.92 |
10% Discount | $105.53 | $78.90 | $62.93 |
20% Discount | $93.80 | $70.13 | $55.94 |
Source: Dividend Toolkit by The Dividend Monk
Since both RY and TD show similar dividend growth payments in the past (8.57% for TD vs. 7.26% for RY), I have used the same 6% for 10 years and then 5% to assess a fair value to RY. Then again, it seems that RY is trading close to a 10% discount. So far, both banks seem to be trading at attractive values.
CIBC (CM)
Source: Ycharts
Strong from a base of 11+ million clients with over 1,100 branches and 44,000 employees, CM is well established as a P&C (Personal & Commercial) bank across Canada. 65% of its revenue is coming from retail and business banking and 27% from wholesale banking. This doesn't leave much room for wealth management (14%) and they are not really a player in capital markets.
CIBC would rather focus on the fundamentals of a Canadian Bank; personal and commercial clients. This enables a less volatile revenue stream and an easy-to-understand business model. Between you, me and the wall; do you really know how RY and NA are able to generate so much from capital markets? There is a big black box there that CM did not jump into. We saw how well those black boxes worked back in 2008…
CIBC focuses on its clients as a traditional banker. Its strategy is based on improving client service, making it more flexible and more user-friendly. (How much paperwork do you have to sign each time you want to do business with a bank?)
On the other hand, its main advantage of keeping things simple might play against the bank in the years to come. We don't expect much growth in both personal and commercial banking in Canada for the upcoming years. In fact, we are much closer to a declining market if oil prices stay low. The housing market won't be able to support another economic slowdown and risky mortgages may eventually default back into the banks' hands. This is where having other types of income streams could come in handy. Unfortunately, I think CM will probably have to wait on the sideline for a few years if this situation ever happens. In the meantime, the dividend payment will be enough to keep many investors waiting patiently.
Valuation
Calculated Intrinsic Value OUTPUT 15-Cell Matrix | |||
Discount Rate (Horizontal) | |||
Margin of Safety | 8.00% | 9.00% | 10.00% |
20% Premium | $140.72 | $112.41 | $93.54 |
10% Premium | $128.99 | $103.04 | $85.74 |
Intrinsic Value | $117.27 | $93.67 | $77.95 |
10% Discount | $105.54 | $84.30 | $70.15 |
20% Discount | $93.81 | $74.94 | $62.36 |
Source: Dividend Toolkit by The Dividend Monk
CIBC was not as generous as RY and TD in term of dividend growth over the past as its 5-year dividend growth rate was *only* 4.57%. I have used a 4.50% dividend growth rate for the next 10 years and dropped it to 4% afterward. I'm trying to use the most pessimistic dividend growth rate for each bank to see if they show a good entry point right now or not. According to my valuation, CM seems to be trading at its fair value.
ScotiaBank (BNS)
Source: Ycharts
Bank of Nova Scotia, also called ScotiaBank, is the third-largest bank in Canada in terms of asset base. It provides various financial services to individuals as well as commercial and institutional clients. Their services range from regular banking, investments, insurance, brokerage, mortgages, loans, etc. BNS is the most "international" Canadian bank serving a total of 21 million clients spread across 55 countries.
BNS is also highly invested in commodities, which hasn't been a plus so far in 2015. Its total loan exposure in the oil & gas industry is up to $15.5 billion (source Scotiabank investor presentation). Now that the situation of the barrel of oil has stabilized, we will see which companies may default on their loans in this new environment.
If you combine this factor with the global Latin America economic slowdown, BNS doesn't seem to be in a position to offer much growth to investors. For example, BNS was down 8% in January 2015 because of its exposure to emerging markets. Dividend payments are never at risk with Canadian banks, but I'd like to hope for more than just a quarterly payment from my investment.
However, if you are a patient investor, entering in BNS at the moment might be very good timing. Since there are many clouds over BNS, the stock price should be cheap. We will have a better idea using the Dividend Discount Model:
Valuation
Calculated Intrinsic Value OUTPUT 15-Cell Matrix | |||
Discount Rate (Horizontal) | |||
Margin of Safety | 8.00% | 9.00% | 10.00% |
20% Premium | $119.15 | $89.22 | $71.27 |
10% Premium | $109.22 | $81.78 | $65.33 |
Intrinsic Value | $99.29 | $74.35 | $59.39 |
10% Discount | $89.36 | $66.91 | $53.45 |
20% Discount | $79.43 | $59.48 | $47.51 |
Source: Dividend Toolkit by The Dividend Monk
I used a 5.50% dividend growth and dropped it to 5% after 10 years. Over the past 5 years, BNS dividend payments grew by 5.57% annually. BNS is currently trading at a small discount.
BMO (BMO)
Source: Ycharts
BMO shows a great balance in revenue sources between Personal & Commercial Banking (38% of net income), Wealth Management (21%) and Capital Markets (24%). BMO surprises the market by showing consistent growth in the lending business considering the global Canadian housing market. It's a good thing for now, but may be a source of concern in the future.
Since the purchase of Harris Bank, a Chicago-based private bank, in 1984, BMO has built a strong expertise in wealth management and a great entry point to the US market. In the 2000s all other Canadian banks started their project of creating a "private banking" division to best serve high net worth clients.
For the future, BMO can count on US growth opportunities similar to TD's situation. Their latest quarterly results in the US were disappointing, but strong capital market revenues and wealth management profit increases smooth out the overall financial result. BMO has not materialized the full potential of its US platform yet as management faces stronger than expected headwinds to position the bank in the US.
BMO is a smaller player than BNS, TD and RY, and this is probably why many analysts think it is trading at a discount.
Valuation
Calculated Intrinsic Value OUTPUT 15-Cell Matrix | |||
Discount Rate (Horizontal) | |||
Margin of Safety | 8.00% | 9.00% | 10.00% |
20% Premium | $106.60 | $85.15 | $70.86 |
10% Premium | $97.71 | $78.05 | $64.95 |
Intrinsic Value | $88.83 | $70.96 | $59.05 |
10% Discount | $79.95 | $63.86 | $53.14 |
20% Discount | $71.06 | $56.77 | $47.24 |
Source: Dividend Toolkit by The Dividend Monk
BMO past dividend growth is highly disappointing. We are talking about only 2% annually over the past 5 years. However, the bank is now in a much better shape and increased its dividend twice in 2014 and recently increased it again. This is why I'm using a 4.5% dividend growth rate for the first 10 years and then dropping it to 4.00%. With this valuation, the stock is trading at a small premium. It's not the right time to buy BMO… unless you are looking for a higher dividend yield (4.42%). Even then, CM is a better option for income-seeking investors.
Conclusion
As you can see, even though the six banks evolve in the same market, they are not using the same strategy and are not priced equally. At Dividend Stocks Rock; we use 7 investing principles to determine if a stock should be part of our portfolio or not. Not all banks are part of our portfolio for this reason.
I would position the five banks in this order:
#1 Royal Bank - for its 10% discounted price and its ability to generate higher growth from capital markets.
#2 TD Bank - for its small discounted price and its well-managed loan portfolio.
#3 Scotia Bank - for its small discounted price and long-term opportunities in commodities and emerging markets.
#4 CIBC - fairly valued, client-oriented, solid bank.
#5 BMO - slightly overvalued, still struggling to find its place in the Canadian market among other banks.
Disclaimer: I do not hold shares of the big 5 Canadian Banks
This article was written by
Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within 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.