Monday, November 02, 2009

Barron's Article on Canadian Banks

  
Barron's, Dimitra Defotis, 2 November 2009

A Canadian native likes to give this quiz to his u.s. friends: What's the most boring word in investing? Answer: "Canadian." How can you make it even more boring? Put the word "banks" behind it.

But boring can be beautiful, especially when trouble erupts.

Yes, the shares of banks in the Great White North were badly bruised during last year's global meltdown, but they deserved better. Thanks to strict regulation, Canada's banks don't make subprime loans, and a typical mortgage term is only five years, greatly moderating balance-sheet risk. The largest banks have a virtual monopoly, controlling their regional markets for residential mortgages, credit cards, retail deposits and brokerage services. With their stout balance sheets and conservative bent, Canada's banks look healthy. Indeed, a recent World Economic Forum report rated the Canadian banking system as the world's soundest. In comparison, Switzerland was No. 16. The U.S. limped in at No. 40, just behind Germany (at No. 39) and ahead of the U.K. (at No. 44).

This isn't to say that Canada's financial system weathered the 2007-2008 financial debacle unscathed. Combined, the five largest banks -- Royal Bank of Canada, Toronto-Dominion Bank, Bank of Nova Scotia, Canadian Imperial Bank of Commerce, Bank of Montréal, along with No. 6 National Bank of Canada -- have had more than $22 billion in write-downs in their securities and trading businesses since early 2007. But their American and European counterparts have fared far worse, and none of the Canadians has needed a government bailout. And now, RBC analyst André-Philippe Hardy argues, they are even less exposed to credit risk than in the past because loans make up 40% of assets, versus 45% in 2008 and 70% in the 1980s and 1990s.

Another positive: In Canada, when someone defaults on a mortgage, lenders have more recourse than do mortgage lenders in the U.S. What's more, RBC research views Canadian banks as well-insulated from some of the troubles to the south, even though they operate in the States. Through October 2008, the Canadians had only $16 billion in U.S. residential mortgages on their balance sheets -- a mere 3.5% of their total residential loans.

In some ways, anyone who invests in one of the five biggest Canadian banks -- all of which trade in both New York and Toronto -- pays a premium; in other ways, the stocks are bargains. Royal Bank of Canada, Toronto-Dominion and Bank of Nova Scotia are the group's most attractive members because they boast the most potential to boost profits through foreign growth. Each sells at more than two times book value, while some of their U.S. peers fetch less than book. But they all boast substantial dividends, rack up higher returns on assets and sell at lower multiples of current and expected earnings than their south-of-the-border rivals. The largest Canadian banks trade at an average of about 12 times estimated 2010 profits, compared with 13.7 times for JPMorgan Chase, 19.9 for Bank of America and 72 for Citigroup.

The northern banks are benefiting from a robust Canadian dollar that makes it easier to expand by buying foreign companies; operations abroad already account for about a third of their earnings. And they are being helped by the fact that Canada's recession has been somewhat milder than those in the U.S. or much of Europe.

"The next 12 months still look good," Rohit Sehgal, a money manager at Toronto's Goodman & Co. Investment Counsel, says of the Canadian banks, which he thinks should be helped by cost-cutting, a more favorable yield curve and a likely decline in nonperforming loans.

Based on normalized earnings projections, RBC estimates that TD and Scotiabank shares could rise more than 18% over the next year. Wall Street analysts see the pair climbing by a more modest 14% and 8%, respectively, and Royal Bank advancing by 10%. Add dividends, and the potential total returns look juicier.

Royal Bank of Canada, with a stock- market value of $70 billion, is Canada's titan. The bank also has the highest Tier 1 ratio -- a measure of capital ad- equacy -- at 12.9%. Royal Bank gets about a third of its earnings from the capital-markets division, which includes investment banking, trading and underwriting in the U.S. and Canada, and trading operations in London.

Dominic Grestoni, a money manager for Winnipeg-based I.G. Investment Management, says the bank is an accomplished asset manager and has had success selling mutual funds through its branches.

At its recent price of 51.81 (all the figures in this story are in U.S. dollars), Royal Bank is the group's most expensive member. But the stock historically has traded at a premium, and RBC's 15% return on equity is a bit above the group's average of 14%.

Analysts expect Royal Bank to earn $4.02 for its fiscal 2010 year, which ends next October, according to Thomson Reuters. That would be a decline of 3% from the $4.14 expected for fiscal 2009. (Twelve analysts surveyed by Bloomberg are looking for $4.35 next year.) Still, profit is expected to jump 18% in 2011, assuming the recession eases, global investment banking expands and U.S. operations recover. "Royal Bank globally [has] the opportunity to do better than the other banks," says money manager Sehgal. "You pay the highest multiple [see table on previous page] and get the lowest yield, but I am willing to do that because it ranks extremely well on any criteria."

Royal Bank's CEO, Gordon Nixon, tells Barron's that any large acquisition is likely to be in the company's wealth-management business, already the largest among its domestic peers. The bank has forked over $7 billion since 2000 to pick up U.S. retail banks, though its returns on acquisitions have been low. It has more than 430 branches in the States and, Nixon says, a U.S. acquisition is unlikely, "given balance-sheet weakness."

Toronto-Dominion Bank is likely to report only a slight increase in fiscal 2010 earnings, to $5.11 per share from the $5.07 expected for fiscal 2009, which ended in October. The company, which owns the TD Waterhouse and TD Ameritrade discount and online brokerages, has made a big push into the U.S., where it has more than 1,000 locations, about as many as it has at home.

Its Tier 1 ratio, at 11.2% as of the end of the third quarter, is in line with the average for U.S. competitors, and its return on equity, at 13.2%, is strong, but slightly below the average for the big Canadian banks. Since 2005, Toronto-Dominion has spent $20 billion on acquisitions, including Commerce Bancorp, whose U.S. branches are known for a high level of service.

Bank of Nova Scotia, in contrast, has been focused on Latin America in its global operations, which generate more than a third of its profits. Scotiabank, as it's known, has made retail-oriented acquisitions in the Caribbean, Mexico, Chile, Peru and other locales and is Canada's most international bank. The bank's return on equity, at 17.5%, is second only to National Bank's 20%. While its core business is retail banking, Scotiabank is expanding its wealth-management, brokerage and investment-banking operations. This year, it's likely to earn $3.30 a share. The figure should rise to $3.35 in 2010 and to $4.24 in 2011.

As for the other big banks, Canadian Imperial has made a foray into the Caribbean, while Bank of Montreal has expanded in Chicago and Milwaukee.

Grestoni, the I.G. Investment Management money manager, has made the three largest Canadian banks his largest holdings. He's sold some of his Bank of Montreal stake; he considers it a laggard in retail businesses, including mutual funds and wealth management. While the Montreal bank moved into the U.S. early, buying Harris Bank in Chicago more than a decade ago, and community banks also in the Chicago area, those operations struggled during the credit crisis.
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In sum, if the markets sell off, Canadian bank shares won't be immune. And if the global economy doesn't recover as strongly as analysts expect, 2011 profits might not be as robust as forecast. But, at the least, boring can help investors sleep better, especially when it pays a nice dividend.

The Bottom Line: Shares of Canada's three largest banks offer potential upside of 8% to 18% over the next 12 months. And that doesn't count the substantial dividends that they offer.
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