Royal Bank Of Canada: Minor Risks, Major Returns, & Mean Reversion by Ben Reynolds,

Royal Bank of Canada (RY) may have slipped under the radar of many United States investors…  And that’s a shame.  The company is one of a handful of elite Canadian banks.

Many high quality dividend stocks today are trading at historically high valuation levels.  Low interest rates have pushed up stable businesses’ valuations.

Royal Bank of Canada is a high quality dividend growth stock.  The company has compounded both earnings-per-share and dividends at 10% a year over the last decade.

The company also has a high dividend yield of 4.1% – and a price-to-earnings ratio of just 12.

Royal Bank of Canada is the largest Canadian bank based on market cap.  The company has paid steady or increasing dividends every year since 1943.

Royal Bank of Canada operates in 5 segments:

  • Personal & Commercial Banking
  • Investor & Treasury Services
  • Wealth Management
  • Capital Markets
  • Insurance

The image below shows the company’s earnings by business segment and revenue by geography over the last twelve months.

Royal Bank Of Canada

Source:  Royal Bank of Canada Investor Presentation, slide 5

This article examines the compelling investment prospects of Royal Bank of Canada.  Keep reading to learn more about this high yielding dividend growth stock.

Royal Bank Of Canada – Current Events

Royal Bank of Canada released its 3rd quarter results on August 24th.  Adjusted earnings-per-share grew 3.6%.  The company also announced a 2.0% dividend increase.

The company’s CEO David McKay had this to say about the recent results:

“RBC had a record third quarter, delivering reported earnings of over $2.8 billion and $7.9 billion for the first nine months of the year, demonstrating the strength of our diversified business model and our disciplined risk and efficiency management. Our strong capital position enabled us to repurchase $292 million of common shares in the third quarter and I’m pleased to announce a 2% increase to our quarterly dividend.”

The company saw mediocre growth in its most recent quarter.  Growth lagged historical results and managements’ earnings-per-share growth expectations in the medium term of 7% a year.

Results were decent considering the poor economic climate in Canada.  Canada is a fairly resource dependent economy.  Low oil prices are affecting unemployment.  Canada’s current unemployment rate is 7.0%, versus 4.8% for the United States.

Risk Factors

There are 2 primary risk factors facing Royal Bank of Canada:

  • Dangerous real estate market in Canada
  • Low oil prices

Canada’s real estate market is overheated in its largest cities.  Banks suffered greatly during the Great Recession of 2007 to 2009 in the United States due to collapsing real estate prices.

There is fear surrounding Royal Bank of Canada regarding the potential for a Canadian housing crisis.  Condos in Canada’s largest cities are the most overpriced.  Condo mortgages make up just 2.7% of Royal Bank of Canada’s total loan portfolio, and 9.8% of total residential mortgage portfolio.

The Canadian residential mortgage business is less risky than the United States’ mortgage business in many ways.  Canadian’s have more equity in their houses versus United States residents.  Having more ‘skin in the game’ makes one less likely to default on their mortgage.  As a result, mortgage delinquency rates are much lower in Canada than in the United States.

Royal Bank Of Canada

Source:  Royal Bank of Canada Investor Presentation, slide 32

I find it unlikely that a Canadian housing crisis will permanently impair earnings at Royal Bank of Canada.  Obviously, deep housing declines would hurt earnings in the short-term, but the company is not overexposed to this risk.

The other looming risk factor for Royal Bank of Canada is low oil prices.  Low oil prices have slowed earnings growth, but the company continues to prosper despite this.  Oil & gas loans make up less than 2% of the company’s total loan portfolio, as the image below shows:

Royal Bank Of Canada

Source:  Royal Bank of Canada Investor Presentation, slide 40

Competitive Advantage & Recession Performance

Royal Bank of Canada’s 73 year streak of steady or rising dividends (in its local currency) is incredibly impressive.  It is clear evidence of a strong and durable competitive advantage.

The company’s durable competitive advantage comes from a mix of its size, trusted brand, and ability to invest capital into a wide variety of financial industries.

Royal Bank of Canada is the largest Canadian Bank based on its market cap.  It is also one of the 20 largest banks globally.  The company has over 16 million clients and 80,000 employees spread over 38 countries.

Royal Bank of Canada’s diverse operations give it another advantage.  It can deploy capital in the areas that have the highest expected returns.  This has helped Royal Bank of Canada maintain a return on equity of over 13% every year of the past decade.

The company’s diversification and strength within the financial industry remind me of Johnson & Johnson’s (JNJ) strength in the health care industry.  Royal Bank of Canada is in many ways the financial segment’s Johnson & Johnson.

Royal Bank of Canada performed well over the Great Recession of 2007 to 2009.  The company’s conservative policies and wide diversification served it well.  Royal Bank of Canada’s earnings-per-share through the Great Recession are shown below:

  • 2007 earnings-per-share of $4.19
  • 2008 earnings per share of $3.38
  • 2009 earnings per share of $3.28

The company would go on to reach new earnings-per-share highs by 2011.

Growth Prospects & Total Return

Banks make money by charging fees for services/penalties and by making loans with higher interest rate than the rate at which the bank borrows money from its depositors or other institutions.  The difference in interest rates is called net interest margin.

The higher the net interest margin, the better for banks.  Unfortunately for banks, net interest margins are near 30 year lows.

Royal Bank Of Canada

Source:  Federal Reserve Bank of St. Louis

Simple reversion to the mean in net interest margin will create rising profits for banks.  Buying banks now is like buying gold miners at 30 year low gold prices.

“Reversion to the mean is the iron rule of the financial markets.” — John Bogle

As a Canadian company, Royal Bank of Canada uses Canadian dollars.  United Stats investors will see better results from Royal Bank of Canada when the Canadian dollar appreciates versus the United States dollar – and worse results when the opposite occurs.

The United States dollar has appreciated significantly versus the Canadian dollar over the last several years.  Again, reversion to the mean will benefit Royal Bank of Canada investors living in the United States.

Royal Bank Of Canada

Source:  Google Finance

Royal Bank of Canada’s management is expecting 7% earnings-per-share growth over the medium term.  The company has compounded earnings-per-share at 10% a year over the last decade.  I expect the company to grow earnings-per-share at around 8.5% a year going forward.

This growth combined with the company’s current 4.1% dividend yield gives investors expected total returns of 12.6% a year at current prices.

Valuation & 8 Rules Rank

Royal Bank of Canada currently has

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