I Bought Royal Bank Of Canada For The Grade 'A' Retirement Portfolio, Here's Why

Summary

• The "Grade 'A' Retirement Portfolio" basis and criteria is introduced.
• We review the business of the first entrant into the portfolio, Royal Bank of Canada.
• We grade RY based on the portfolio criteria and make a purchase.

Grade A Retirement Portfolio

In this article, I introduce a portfolio concept for the equity allocation of a very conservative retired investor. The portfolio is designed to have a higher yield and lower volatility than market averages. It will contain companies with an S&P credit rating of A- or better. The income from the portfolio should grow faster than inflation. This will be called the Grade A Retirement Portfolio. While total return is a secondary concern, the portfolio will not overpay. Finally, I will introduce the first company admitted to the portfolio.

Portfolio basis and concept

What should I look for in a portfolio that provides an income for a retiree? The first thing that comes to mind is a decent yield. How high does the yield need to be? To know this let’s take a look at an average American retired couple. To begin our analysis, let’s say our couple wants a total annual income of $70,000 or about $5,850 monthly. According to Social Security Administration cost of living adjustment fact sheet that reviews the changes in social security for 2019, the average monthly social security benefit for an aged couple when both receive benefits is $2,448.

Source: Social Security Administration

That leaves $3,400 monthly or $40,825 annually left for the portfolio to generate. For a portfolio of $1 million, the yield will need to be about 4.1%.

That yield, at least right now, is higher than we can get with any type of Treasury investment. Our couple will take on more risk to get the yield needed by investing in stocks. Stocks are riskier than Treasuries, however there are some things we can do to minimize the risk.

Of course, the cost of a loaf of bread and a gallon of milk and most other things go up over time. So, in addition to the required yield, I would want the income to increase each year by at least 2%, and preferably 3% or more to keep up with inflation. So, we are looking for stocks that increase dividends over time.

I would want to invest in financially sound companies. It makes no sense to invest in a company that has a high yield, if it has a debt load or other obligations that make it likely that the dividend will be frozen or cut. It is often a double whammy when a dividend is cut because along with reduced income, the share price usually suffers a steep decline. While it is possible to thoroughly analyze each company’s balance sheet, I like to use credit rating and dividend history to gauge the likelihood that dividends will continue to be paid as well as grow.

I want to know how the company performs during recessions. I take a look back at the great recession and the declines of 2000-2001 to see how the company did with earnings and dividends during those downturns. In addition to the historical look, the payout ratio is a more current assessment of dividend stability. I can look at this to make sure the dividend is well covered in case economic forces reduce earnings.

Finally, most retirees, myself included would prefer to collect this income with less volatility than the overall market. Stocks that grow dividends tend to be less volatile than the overall market. The Vanguard Dividend Appreciation ETF (VIG) can be used as a proxy for stocks with rising dividends. The VIG has a beta of 0.87 which is lower and less volatile than the 1.0 of the S&P 500. So, investing in stocks with growing dividends should reduce volatility. Just the same, we will check each stock considered for the portfolio for volatility.

To get a list of candidates for the portfolio, I set up a screen in Fast Graphs with the following inputs.

1. S&P credit rating of A- or better.
2. Current dividend yield of 2.9% or higher.
3. Market capitalization of $5 billion or more.

The results of this screen were subjected to further evaluations.

1. Dividend growth, recession performance and payout ratio
2. Volatility
3. Relative valuation

The First Admission To The Portfolio

The first company selected for the portfolio is Royal Bank of Canada (NYSE:RY).

The Company

Royal Bank is Canada’s largest bank by market capitalization and one of the leading financial services companies in North America. Royal Bank of Canada operates in five business segments:

• Personal & Commercial Banking operates in Canada and the US providing banking and lending services as well as self-directed investment services on the personal side and cash management, lending, lending and leasing on the commercial side. Credit cards are offered in both personal and commercial iterations.
• Wealth Management provides advice-based financial solutions as well as estate and trust services for high net worth clients.
• Capital Markets provides corporate financial services such as debt and equity originations, mergers and acquisitions etc. This unit also has a trading desk.
• Insurance offers life, disability, long-term care, home and auto insurance products as well as annuities.
• Investor & Treasury Services provides custodial, transfer, liquidity and other services to manage investor risks. The unit also launches ETFs.

The company has a holistic approach to all business segments. The strategy involves creating an exceptional client experience through innovation. One such initiative is RBC Ventures. This unit acts like a small agile company but with the backing of a large bank. They have created mobile apps that help organize daily life. They have an app to help keep track of vehicle maintenance. Another for tenants and landlords to send and receive payments.

One app helps newcomers to Canada receive guidance on all phases of the move. Yet another to help track spending. There is one to help manage, maintain and improve one’s home. There is even one that will send a notification to your phone to remind you it’s trash day. The plan is to convert app users into bank clients. The goal is to attract 5 million users over the next five years and turn 10% of them into banking relationships.

Ventures also invests in small companies. They don’t stop at investing though, they can help entrepreneurs grow their businesses through commercial arrangements. So, the small startup can have nearly the reach of the big bank. Of course, RBC benefits from both investing the capital and any commercial relationships entered into with the startups.

The next strategy is to accelerate growth in the US. RY operates US divisions of Capital Markets, Wealth Management, RBC bank and City National bank. In 2018, about 25% of RY’s 2018 revenue came from the US with deals such as the placement of $36 billion in debt for The Walt Disney Company (DIS) to acquire some assets from Twenty-First Century Fox (FOX) and playing a key role in the $11.5 billion bond offering for Vodafone (VOD). This in addition to increasing penetration into the personal banking and wealth management markets with RBC Global Asset Management.

Financially, RY is strong. The balance sheet is very strong, as evidenced by its S&P AA- credit rating. RY is also well-capitalized with a CET1 ratio of 11.5% which is very strong as the minimum for US banks in 2019 is 4.5%. Additionally, the ROE has averaged over 16% for the last ten years.

Business environment and risks

Morningstar rates RY as having a wide moat because:

“… it has superior market share in the advantageous Canadian banking environment, superior operating efficiency, and exposure to more moaty nonbank businesses. The bank has consistently operated with one of the best efficiency ratios in Canada, partially through superior operational execution, and partially due to the highest noninterest income proportion among the Canadian banks. The bank is also one of the two largest banks in Canada (along with Toronto Dominion) and has dominant market share in many categories, including number-one or number-two share in all key retail banking products. It is also one of the dominant investment banks in Canada and a top-15 player worldwide. Once you reach the scale and reputation required to source and execute deals, offerings, and advice that Royal Bank of Canada has, we believe the investment banking business becomes moatier. It also has the largest amount of assets under management and assets under administration among the Canadian banks, giving it the largest exposure to this higher-margin, fee-based business…” ¹

The Canadian banking environment is favorable to existing banks as regulations inhibit foreign competition because no more than 25% of bank shares can be owned by non-Canadians. Large national banks are also favored in the Canadian banking system due to exclusive federal chartering, which limits smaller, regional competition. Overall the regulatory environment allows for higher returns and reduced risk for the established large national banks such as RY.

Even with the track record and favorable business environment, there are risks with an investment in RY. There is a very large exposure to the Canadian real estate market. The real estate values in Canada are high and consumer debt levels have been rising. This combination increases the risk for RY, especially in the case of an economic downturn. If the banking capital requirements were increased, it would lower returns achieved by RY.

Let’s take a look at the requirements for this portfolio.

First the screens

RY easily meets the requirements of the screens

• Credit rating of A- or better. (AA-)
• Current yield greater than 2.9%. (3.8%)
• Market capitalization of at least $5 Billion. ($76 Billion)

RY passes the basic screens. This is a start, but further investigation needs to be done to see if it has a place in our conservative portfolio.

Dividend growth, recession performance and payout ratio

RY has a history of relatively very consistent growth of earnings and dividends with only a few down years on earnings in the last twenty. The FAST Graphs chart below shows this graphically. It is the Canadian version of the performance. For US investors, it has been a little choppier due to vacillating in the USD/CAD exchange rate. Both the blue and orange lines track earnings. The white lines track dividends.

Source: FAST Graphs

Dividend increases have not always been large and there was a $.03 CAD cut near the turn of the century and dividends held at $2.00 CAD during the great recession. The chart below shows the dividend CAGR for the 1, 2, 3, 5, and 10-year time frames for US investors. In Canadian dollars, it is much more consistent.

Source: Author with data from FAST Graphs

The payout ratio for 2018 is 45% and management's stated objective is to maintain it between 40% and 50%. This explains the freeze in during the great recession. The dividend was the same in 2008, 2009 and 2010. In 2009, the ratio was 71% as earnings suffered. In 2010, the ratio was 56% as earnings recovered slightly. In 2011, there was a small dividend increase and the ratio was 48%. The ratio has remained in the mid 40%s since 2011.

While this is not stellar dividend growth, performance is reliable enough for this conservative portfolio when considering the other criterion.

Volatility and valuation

According to Seeking Alpha, the 36 and 60-month beta for RY are both 0.73. RY has a beta that is appropriate for this portfolio.

For this portfolio, purchases need to be made at fair value or better. Here is the GrayBeard Retirement DCF calculations.

Source: Author

As I write this (2/3/2019), the price of RY is $76.54 US. The hybrid values listed of $79.92 and $85.61 are confirmed by the Morningstar fair value of $83¹. S&P Global gives it a fair value of $75² and a 12-month target of $86². While this is certainly not a “pound the table” buy, we can say with some confidence that RY is trading at fair or better value.

RY is admitted to the portfolio because:

• Its credit rating is AA-.
• Its yield is greater than 2.9%.
• Its market capitalization is greater than $5 billion.
• Its dividends have a track record of growth and are well covered.
• Its volatility is lower than the S&P 500.
• It is not overvalued.

Additionally, the company is conservatively financed, has a strategy for growth and capital to execute without deteriorating credit quality, and operates in a favorable business environment. Shares of RY were added to the GrayBeard High Yield account on 1/31/2019 at $76.10 /share.

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1. Morningstar Equity Report (RY) as of 11/28/2018.

2. CFRA Stock Report, RY, 1/26/2019.

Analyst’s Disclosure: I am/we are long RY. 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.