It is pretty difficult these days to find income producing investments with a decent yield (e.g. >3%) and with the potential for growth of income and principal. Long bond yields have pretty much bottomed out and, I believe, bonds are likely to be under increasing price pressure going forward. Many equities are priced on the rich side of valuations. My portfolios are already well stocked with equity REITs, midstream MLPs, telecommunications and with a dash of utilities. Where is an investor to find a reasonable return at a reasonable risk? North of the US border, several Canadian banks provide the opportunity for a respectable dividend, capital appreciation, and a possible exchange rate play for US investors. The Canadian banks offer this investment opportunity with a risk profile generally lower than their US bank counterparts.
Why Canadian Banks?
With all the banking names in the United States, why focus on Canadian banks for potential investments? The first consideration is stability and credit worthiness. Moody's Investors Services ranks Canada's banking system number 1 in the world for financial strength and safety. The World Economic Forum has dubbed Canada's banking system the best in the world for seven years running. During the 2009 global financial crisis no Canadian bank failed or required a bailout. A quick review of the fraction of non-performing loans for the banks in the European Union (EU), the US, and for Canada tells us that Canada's banking system is in better shape. The EU banks fraction of non-performing loans is 5.6%. The US banking system is better situated with about 3% of loans non-performing. Canada's banks non-performing loan fraction is a very low 0.6%, a factor five times lower than in the US.
Canada's banks typically pay a higher dividend than do their US counterparts and they have been doing so for a very long time. For example, the Bank of Nova Scotia (NYSE: BNS) has a flawless record of paying dividends every year since 1832. Only the Bank of Montreal (NYSE: BMO) can top that with a track record extending back to 1829. Toronto-Dominion Bank (NYSE: TD) is not far behind having paid dividends since 1857. Dividends are important to the Canadian investors and to the Canadian banks paying them. I like that.
Finally, if you are going to invest outside of the US, there is some comfort in investing in Canadian equities. While Canada is not the US, it is also not all that different in its business culture, laws, regulations, and values.
Narrowing the Field
In the first rendition of this article, I screened the 5 largest Canadian banks looking at 10-year compound annual growth rates of revenue, EBITDA, EPS, dividends paid, and the most recent dividend payout ratio. The list includes the previously mentioned banks BMO, BNS, and TD as well as the Royal Bank of Canada (NYSE: RY) and the Canadian Imperial Bank of Commerce (NYSE: CM). I used GuruFocus for the data as it has a good user interface with the ability to display many financial metrics in chart form. An updated summary (from the first article) of the basic screening data is provided below.
Based on the screening in the previous article as well as this update, I selected BNS, RY, and TD for further analysis. BNS, RY, and TD have consistently grown revenue, EBITDA, EPS and dividends paid out to investors by solid margins compared to BMO and CM. Canadian oil producers are in no better shape than those in the US. I thought it prudent to look at the loan book exposure to crude oil production and production related companies. This proved very enlightening, as I found that TD had the lowest exposure at about 1%, RY also low at 1.6%, BNS rather high at about 10%. Unfortunately, many of the producers in Canada have fairly high costs for crude production and some defaults and loan restructuring are expected with Canada's oil producers. While BNS's overall performance has been on par with RY and TD, BNS has significantly higher exposure to the risk of oil and gas loan defaults if the price of crude stays below about $50/barrel. I dropped BNS from further consideration for this reason. The remaining two banks, RY and TD are discussed in more detail below.
Royal Bank of Canada
RY is Canada's largest bank by market capitalization at $78B in US dollars, the 6th largest in North America, and is ranked 18th globally. RY has offices in Canada, the US and in 38 other countries with a total of 79,000 employees serving more than 16 million clients.
Over the last 10 years, RY has managed to achieve healthy growth of its revenue, EPS, and dividend payments while maintaining a conservative dividend payout ratio. These metrics are shown in the updated charts below. Readers will note that the dip in EPS and the spike in the dividend payout ratio was due to the impact of the 2009 financial crisis. The bank quickly recovered its EPS.
RY maintains a Common Equity Tier 1 of 10.1% well exceeding the Basel III accord requirement of 6% and carries an AA-credit rating from Standard and Poor's. RY's cash flow remains strong and RY just recently raised its quarterly dividend to $0.81 CDN from $0.79 CDN continuing its history of rewarding its shareholders. As of Monday, February 29, RY's annual dividend yield is a healthy 4.74%.
The reader should note that all of the above data is based on financials reported in US dollars and is therefore impacted by the exchange rate between the Canadian dollar and the US dollar. As an example, the dividends per share chart above shows the annual dividend paid in US dollars at $2.38 based on the current exchange rate. The annual dividend paid in Canadian dollars is $3.12 TTM. This does have implications in understanding the charts above. While the charts show that revenue, EPS, and dividends have all turned and headed south over the last several quarters, that result is true only in US dollars due to the recent strength of the US dollar compared to the Canadian dollar. The bottom line is that the reader needs to factor in the impact of the exchange rate to fully appreciate the charts above. I searched for a website that provided similar data in Canadian currency, but was unable to find a comparable website with data in Canadian currency.
This financial summary, while brief, indicates that RY is healthy and growing. For a more complete picture of RY's financials, the reader should spend some time on the GuruFocus web page and browse through the most recent investor presentation on the RY website.
TD is the 5th largest bank in North America by total assets and the 7th largest as measured by market capitalization (about $75B). TD has 2471 offices and branch locations across North America with 81,352 employees.
Like RY, TD has performed well over the last 10 years with growing revenue, earnings, and its dividend payout. The chart below shows the 10-year charts of these 3 metrics as well as the dividend payout ratio over those 10 years.
Like RY, TD maintains a solid Common Equity Tier 1 ratio of 10% and a credit rating of AA- from S&P. It looks like there might be a bit of competition between the two banks. TD's cash flow remains strong and TD also just recently raised its quarterly dividend to $0.55 CDN from $0.51 CDN continuing its history of rewarding its shareholders. As of Monday, February 29, TD's annual dividend yield is a solid 3.78%.
As is the case with RY, the charts above for TD also need to be considered in light of the changes in the Canadian dollar to US dollar exchange rate. Once the exchange rate is factored in, the revenue, EPS, and annual dividend paid show continued growth through 2015.
This summary of TD financials is brief. The reader is encouraged to spend some time on GuruFocus and the TD website for more detail on TD's financials. TD has an investor presentation on their website that provides much more detail.
Potential Risks to Investors
Investments that are a "sure thing" seldom come along; I've yet to find one in 30+ years. Investors should look at the possible risks of any potential investment. There may be other risks I've not identified, but the following paragraphs summarize the risks I've considered.
Most economists define a recession as two consecutive quarters of economic contraction. In Q1 2015, Canada's GDP contracted 0.2% and contracted again by 0.1% in Q2. So, technically, Canada experienced a mild recession in 2015. The GDP estimates for the third quarter are positive and the initial GDP readings for the first two months of Q3 show that Canada's economy is growing again. There is a potential risk that Canada's economy could slip back into recession putting a crimp on loan and deposit growth for the Canadian banks. I see this as very low risk for a couple reasons. First, Canada is our largest trading partner and Canada's economy is tied pretty closely to that of the US. While not growing leaps and bounds, the US economy is growing slowly but steadily and I believe it is unlikely that Canada's economy would suffer while the US economy continued to grow. Secondly, the recession that Canada experienced was very mild and caused very little economic dislocation. Outside of mining and the crude production sectors, few Canadians were affected by the most recent recession. When I've asked my Canadian friends and colleagues about the impact of this recent downturn in GDP, the answer I generally get is "What recession?".
I've already touched on the potential impact of low oil and natural gas prices on the loan books for both RY and TD. These two banks both have very low exposure to the oil and gas industry. If OPEC continues to flood the market with crude in pursuit of expanding their market share, there could be some defaults in the Canadian oil and gas sector. This would be a concern for banks with large loan exposure to the oil and gas sector (e.g. BNS) but RY and TD are fairly well insulated with oil and gas sector loan exposure at 1.6% and 1% respectively.
Some people have expressed concern over a potential housing bubble in Canada, particularly in the larger metro areas of Toronto and Vancouver. Housing prices in both locations have definitely been on a tear lately and slowed down only a little during Canada's most recent mild recession. There are a couple of important mitigating factors that Canada's housing market has over the US that makes it less likely that we will see any significant defaults out of the Canadian housing sector. Canada has more conservative requirements for mortgage loan qualification for owner-occupied homes, for home equity loans, and for investment/rental properties. The Canadian Housing and Mortgage Corporation (CHMC) requires mortgage insurance on all loans up to $500,000 CDN where the loan value is more than 80% of the property value. For mortgage loans over $500,000 CDN the down payment required to forego mortgage insurance was a little more relaxed at 20% of the first $500,000 CDN plus 5% of the amount over $500,000 CDN. The new liberal government in Canada recently tightened further the mortgage lending requirements for home mortgages over $500,000 CDN by raising the required down payment for amounts over $500,000 CDN to 10%.
This results in more initial owner equity in mortgaged properties. Additionally, mortgage interest is not tax deductible in Canada so owners have more incentive to pay off mortgage loans and no incentive to over-mortgage their property. This results in a lower probability of a homeowner defaulting and walking away from their mortgaged property. If a homeowner does walk away from their mortgage, mortgage lenders in Canada generally have full recourse to collect on the mortgage loan from the borrowers assets and future earnings. For the interested reader, this linked article provides a bit more color and detail on the differences between the US and Canadian mortgage lending requirements.
The charts below provide a clear picture of the effect of Canada's tighter mortgage qualifications and tax treatment of mortgage interest.
Even through one of the worst global financial crises in 2009, Canada's mortgage delinquencies barely registered any impact. During the height of the 2009 financial crisis, mortgage defaults in the US topped out at about 5% of all mortgage loans and at 20% in the subprime mortgage market. In Canada, mortgage loans also soared all the way up to 0.45% of all mortgage loans; a factor of 11 times less than in the US. My take away on this is that while the housing bubble is a concern for continued healthy home sales and continued strong growth in owner-occupied homes in Canada, the risk of significant impact to Canada's banking system due to mortgage default risk is relatively low.
The last potential risk I've considered is the exchange rate risk. Today, the Canadian dollar is weak compared to the US dollar. This has had a couple of impacts that should be considered by US investors looking to invest in Canadian companies. Canadian companies pay dividends in Canadian dollars. The strong US dollar has made those Canadian dividends worthless to us on the southern side of the border. However, the strong dollar has also lowered the share price of Canadian companies for US investors. Today, our strong US dollar buys us more equity or shares of Canadian companies. So, is this a risk or a benefit?
If a US investor bought shares of RY and TD today and the US dollar continues to strengthen relative to the Canadian dollar, the dividends paid in Canadian dollars would be worth less and the principal value of the investment could also drop. However, if the Canadian dollar strengthens relative to the US dollar, those Canadian dollar-denominated dividends will be worth more and the price of the equity would likely rise in US dollar terms. To take a look at a graphical representation of this I've included the two charts below.
From these two charts one can see the impact of the strong dollar on the value of the dividends paid to US investors. While both TD and RY have continued to increase dividends paid out, the value to US investors in 2015 and beginning of 2016 actually fell. This is due to the strong US dollar and the current exchange rate where $1 Canadian is worth only $0.74 US. Those US investors that bought into RY and TD in 2014 are probably not pleased with the impact from the strong US dollar.
However, for those US investors that are considering an investment today, the reward potential has improved due to the rise in the value of the US dollar. The US dollar strength relative to the Canadian dollar has been higher in the past 10 years, but not by very much. The chart below shows the value of the Canadian dollar versus the US dollar over the last 10 years. We are close to a 10-year peak in the value of the US dollar.
The question each investor has to answer to determine if the exchange rate issue is a risk or a benefit is..."Which way will future exchange rates go?" Will the dollar continue to strengthen relative to the Canadian dollar or will it weaken? As a result of the US Federal Reserve Open Market Committee (FOMC) finally figuring out that the global and US economies, while growing, are not sufficiently robust to warrant a series of interest rate increases, the upward pressure on the US dollar valuation against the Canadian dollar has recently dropped. In the longer term, I believe the Canadian dollar will strengthen relative to the greenback. So, long term, I believe the exchange rate will work in my favor as a US investor in RY and TD.
The Canadian banking sector is strong, healthy, and conservatively managed. Of the big five Canadian banks, I believe RY and TD stand out as having better investment potential and the lowest risk of impact from oil and gas sector loans. Both RY and TD have shown the ability to grow revenue, EPS and their dividend payments while maintaining a conservative payout ratio. While past performance is not a guarantee of future performance, it is a good indication that the company is being managed well. Finally, I believe the potential risks of investment in RY and TD to be low and, at least in the longer term, the exchange rate will work in favor of US investors.
I've already initiated a small position in both RY and TD and I have a couple of cash secured PUTs hoping to pick up a few more shares on the cheap. I'll be watching for an opportunistic dip in the valuations as well to pick up additional shares.
This article was written by
Disclosure: I am/we are long RY, TD. 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.