Value Investing

The Big 6 Canadian Banks – Investment Woth The Risk? An In-Depth Analysis

Charles retired in his mid 50s in May 2016 from a career in Canadian banking. He relies exclusively on income from rental properties and a dividend income stream from a portfolio he amassed over several years.

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Note: All dollar values are reflected in Canadian dollars.

The following Big 6 financial institutions in Canada released their Q1 2018 results in late February/early March 2018.

  • The Royal Bank of Canada (TSX: RY) (NYSE: RY)
  • The Toronto-Dominion Bank (TSX: TD) (NYSE: TD)
  • The Bank of Nova Scotia (TSX: BNS) (NYSE: BNS)
  • The Bank of Montreal (TSX: BMO) (NYSE: BMO)
  • The Canadian Imperial Bank of Commerce (TSX: CM) (NYSE: CM)
  • The National Bank of Canada (TSX: NA)

Given this, I thought it would be an opportune time to review their results and to provide my opinion on which banks might be worthwhile additions to your investment portfolio.

Before delving into a high level overview of each bank, however, I feel I would be remiss if I did not touch upon some of the external factors these banks must contend with. As a result, this article is somewhat lengthy but I am of the opinion it is important to draw these factors to your attention so you can include them in your investment decision making process.

Table of Contents

Thsi article begins with a broad discussion of various factors that will impact the future performance of the Canadian banks before analyzing each company in detail. You can skip to any individual topic below:

Canadian Real Estate Market

Certain geographic regions within Canada have experienced dramatic increases in real estate values in recent years. In the Vancouver area, for example, real estate values have surged as money from Chinese investors seeking a safe haven for their money has poured into British Columbia real estate.

The rapid rise in real estate values was so extreme that long-time residents, in some cases, could no longer afford to live in homes in which they had resided for years since property taxes had escalated to levels they could no longer afford. Additional details on steps the British Columbia government has taken to cool Metro Vancouver’s overheated real estate market can be found here, here, and most recently, here and here.

Vancouver is not the only major urban area in Canada which has experienced a surge in real estate values. The Greater Toronto Area (GTA) has also experienced an unprecedented rise in real estate values. Measures introduced to cool the GTA housing market now appear to be taking effect as recently reported here and here.

It is not as if the problem of soaring real estate values is restricted to the Vancouver and Toronto areas. Montreal has recently been experiencing a surge in real estate values!

Why am I addressing the real estate market conditions in 3 of Canada’s largest metropolitan areas? Because we all know what happened to the financial sector in the US when the housing bubble burst! Let’s face it, it was a mess! In fact, CoreLogic has indicated that American households lost $16 trillion in net worth because of the housing and credit crisis in the late 2000s.

While US home prices have slowly recovered to an average of ~1% higher than at the peak of the national housing market in 2006, home prices in Connecticut, Nevada, Mississippi, West Virginia, Alabama, Delaware, Virginia, New Mexico, Rhode Island, Illinois, Florida, New Jersey, Arizona, and Maryland are still lower than where they were at the market peak. Imagine if you are a homeowner who bought at the market top and survived the crash. Almost a decade later you could very well sell at a loss had you bought at the market peak. This doesn’t even take into consideration the time value of money.

This is why anyone looking to invest in the Big 6 should take into consideration not only the attractive dividends and dividend growth but also the potential risks to which these banks are exposed. If a real estate market meltdown were to occur, would the major Canadian financial institutions be on the ropes?

In my opinion, the answer is ‘No’.

The Big 6 could certainly take a significant hit if there was a major economic downturn and real estate values nosedived. These banks, however, manage their real estate book far more prudently than their US counterparts did prior to the Financial Crisis. A significant reason for this is that the Big 6 hold on their books the mortgages they fund. When you know you’re going to retain an asset on your books you are more apt to make sound and prudent decisions.

Prior to the Financial Crisis, some US lenders tossed caution to the wind. They were securitizing billions of dollars of mortgages which meant they were unloading the risk to investors who were willing to acquire these securities. Since risk was being offloaded, lenders had little incentive to ensure mortgages were of good quality.

You also have to remember that the loan-to-value (LTV) ratio of the uninsured residential mortgage portfolio at the Big 6 is typically far lower than that of their US counterparts prior to the Financial Crisis. Impaired mortgage and home equity line of credit (HELOC) delinquencies and write-offs have been extremely low in Canada over the last several years. Personal loan delinquency levels are also well under control.

Secondly, the credit rating of borrowers to whom uninsured mortgages have been extended appears to be acceptable. I recognize it is entirely possible for a borrower with an acceptable credit rating to suddenly default on their obligations but for the most part, credit ratings will erode over time if a borrower begins to experience cash flow issues. This should, therefore, give banks time to address potential problems before they manifest themselves into write-offs.

Thirdly, loan to value levels in Canada are, for the most part, reasonable. In reviewing the Q1 2018 results for the Big 6, the average loan to value ratios on real estate in 1) Canada, 2) Vancouver only, and 3) Toronto only, appear to provide the banks with ample protection. I say ‘appear to provide’ because in the early 1990s I witnessed what happens to real estate values in an economic downturn.

What typically happens when a borrower is in financial distress is that the property pledged as security needs to be liquidated at the same time as countless other borrowers are trying to sell their property; it comes down to the simple law of supply and demand. A homeowner could find themselves in a predicament where their property remains listed for months unless they dramatically lower their asking price!

In addition, if a borrower is in financial distress, there is a strong possibility that the mortgage payments are not the only payments in arrears. Property taxes, and other payments are most likely also in arrears; certain payments rank in priority to mortgage payments when a property is liquidated.

Furthermore, if the borrower is uncooperative, the lender could incur significant legal fees in order to recover any loan advances. To complicate matters, you also have borrowers who will wilfully damage their property out of spite even though their actions will not improve their predicament.

As you can imagine, a loan to value ratio in the mid-60s or lower may certainly be required in many cases for the lender to recover principal, interest and legal fees AFTER other obligations which rank in priority are satisfied.

Fortunately, a sizable portion of the real estate secured mortgage portfolio at the Big 6 banks is insured. Some readers may be unfamiliar with Mortgage Default Insurance in Canada so I provide the following quick overview.

There are three mortgage default insurance providers in Canada.

  • Canada Mortgage and Housing Corporation (CMHC);
  • Genworth Financial;
  • Canada Guaranty.

Mortgage default insurance is mandatory in Canada for down payments between 5% (the minimum in Canada) and 19.99%. It protects lenders in the event a borrower defaults on their mortgage obligation.

The homebuyer’s cost of mortgage default insurance varies. While the cost can be quite substantial, this insurance allows Canadians, who might not otherwise be able to purchase homes, access to the Canadian real estate market. Were it not for this insurance, it is most probable that mortgage rates would be higher as the risk of default would increase. The reason lenders are able to offer lower mortgage rates when mortgages are protected by mortgage default insurance is because the risk of default is passed along to the mortgage insurer.

Here are some requirements that must be satisfied so as to qualify for mortgage default insurance:

  • 25 years is the maximum amortization for insured mortgages;
  • Where the purchase price is between $500,000 and $999,999, a higher down payment is required. The minimum down payment is 5% of the first $500,000, and 10% of the remaining amount;
  • Mortgage default insurance is not available on homes purchased for more than $1 million so a borrower must come up with a 20% down payment on homes in excess of this value.

The Big 6 are typically conservative when it comes to extending mortgages or other types of loan advances. As a result, there is a segment of the Canadian population which will not qualify for credit from the Big 6. This is where the alternative lenders come into play. The larger lenders in this space were thriving until more stringent mortgage rules came into play.

Despite the larger lenders having experienced challenges because of these new rules, there are other non-traditional mortgage lenders willing to extend mortgages under somewhat lenient conditions. Here is a video for a non-traditional lender in Toronto. You decide whether you would borrow from this individual!

The old adage ‘If it is too good to be true then it probably is’ should be heeded. While there may be benefits to going with these non-traditional lenders, the risks are in the fine print. It is vital to know the payment schedule, fees and penalties that you could incur by not following the rules as these fees and penalties can be extremely steep.

The question now arises as to what happens to the Big 6 if ‘higher risk’ borrowers who have availed themselves of the services of non-traditional mortgage lenders start defaulting en masse. While mass defaults could certainly negatively impact real estate values I think the risks are minimal.

Back in late 2016, The Canadian Imperial Bank of Commerce issued a report stating that the proportion of mortgages extended by lenders other than the banks and credit unions comprised ~2.2% of the market versus ~0.8% in 2008-2009 and that these other lenders had seen their market share grow by ~25%/year.

Even if lenders other than the banks and credit unions now comprised ~5% of the market, I do not envision that 100% of those mortgages would default. As a result, I think the fall-out from a surge in defaults on mortgages extended by non-traditional lenders might have some negative impact on real estate values but I don’t think we would experience a 35%+ correction in real estate values across the board.

The Introduction of Tighter Mortgage Regulation in Canada

In an effort to reinforce a strong and prudent regulatory regime for residential mortgage underwriting in Canada, the Office of the Superintendent of Financial Institutions Canada (OSFI) introduced Guideline B-20 − Residential Mortgage Underwriting Practices and Procedures which took effect January 1, 2018.

Under the new guidelines, there is a new minimum qualifying rate for uninsured mortgages, more stringent expectations around LTV frameworks and limits, and restrictions to transactions designed to circumvent those LTV limits.

In the case of insured residential mortgages, OSFI expects all federally-regulated financial institutions to meet mortgage insurers’ requirements in regard to debt serviceability.  Where uninsured residential mortgages are to be extended, all federally-regulated financial institutions should contemplate current and future conditions as they consider qualifying rates and make appropriate judgments.  At a minimum, the qualifying rate for all uninsured mortgages should be the greater of the contractual mortgage rate plus 2% or the five-year benchmark rate published by the Bank of Canada.

A detailed explanation of the recently implemented Residential Mortgage Underwriting Practices and Procedures can be found here.

In addition to the banks wanting to ensure that their real estate secured book of business is of high quality, you also have OSFI wanting to ensure the Canadian financial institutions remain financially sound. The banks and OSFI certainly do not want what occurred in the US to occur in Canada!

Earlier in this article I wrote about inflated real estate values in some of Canada’s major urban areas and the concern this had raised with regulators. It now appears that interest rate increases and tougher mortgage guidelines are starting to have some impact on real estate values judging from recent reports (see here).

The Heavily Indebted Canadian Consumer

One has to question whether the Big 6 will continue to experience the same level of growth in Canada as in recent years. The average Canadian consumer is already stretched thin and many homeowners have been using their homes as piggy banks. It is also quite concerning that the younger generations are not averse to taking on debt. Since many have likely not experienced a major economic downturn subsequent to leaving home and setting off on their own, it is not surprising that some think the ‘good times’ will go on in perpetuity.

The consensus is that the Bank of Canada will announce at least 2 – 3 increases in 2018. While this will likely result in an increase in loan spreads I strongly suspect there will be an uptick in personal loan and mortgage defaults.

Technology Improvements

The Big 6 spend a considerable amount on technology. A few years ago I remember BNS’s CEO and members of the Board met with executives at several high tech companies to learn how technological advancements were going to change the banking industry. How things have progressed in such a short time span!

BMO recently announced a major initiative and prior to my retirement in 2016, BNS had launched Rapid Labs; the transcript of BNS’s President and CEO’s remarks to students at Ivey Business School, Western University in which he discussed this initiative can be found here.

While the use of blockchain technology is at the forefront of investors’ minds, there are other technological improvements that are being made to make the bank more efficient and to protect the banks and clients from cyber crime.

For obvious reasons, the banks will not disclose specifics as to all the technological improvements that are in the works. I can assure you, however, that the Big 6 are collectively spending billions on technology every year.

Readers must remember that many of the systems the banks have been using for years rely on COBOL and FORTRAN. The use of these program languages is unlikely to go on in perpetuity but at the same time, the banks cannot simply flip a switch and transition to newer program languages. Switching platforms is fraught with risk and considerable testing is required. You can, therefore, expect the Big 6 to be in a position where substantial investments will need to be made indefinitely.

NAFTA Renegotiations

If the U.S. withdraws from NAFTA, I strongly suspect the Big 6 will experience negative repercussions because their Commercial and Corporate clients will be negatively impacted.

Canada’s trade with the U.S. is not going to stop but it will get more expensive. NAFTA, and its predecessor the Canada-U.S. Free Trade Agreement (CUSFTA), eliminated tariffs on most products traded between Canada and the U.S., with a few exceptions. Scrapping these deals will bring back higher World Trade Organization (WTO) tariff schedules.

The more barriers to trade, the more difficult it can be for exporters. Were the U.S. to leave NAFTA, there would undoubtedly be some job losses, but it is hard to predict to what extent. NAFTA has been in place for over 20 years and the Canadian and US economies are closely integrated; we rely on trade with each other in the sophisticated supply chains that have been developed. Any increase in tariffs faced by Canadian exporters would likely be passed on to the American consumer and vice versa.

At this stage I think it is premature to determine to what extent the banks will be impacted if NAFTA is scrapped or modified. If the renegotiation of NAFTA results in the US deciding to exit NAFTA, however, I strongly suspect Canada will need to further diversify trade with countries across the Pacific (Trans-Pacific Partnership and the Pacific Alliance trade bloc).

Impact of the Tax Cuts and Jobs Act (TCJ)

In each of the company analyses I have recently written on my site I have touched upon the impact of the TCJ. I would, therefore, be remiss if I did not briefly touch on this subject matter in this post.

The recently passed corporate tax cut will affect the Big 6 and those with more business in the US will be impacted to a greater extent. The banks will experience one-time hits to their earnings but the 14% cut to the tax rate, 35% reduced to 21%, reduces the value of deferred tax assets. The banks, however, have indicated they will all ultimately benefit from the lower tax rate.

I provide the following in the event you are unfamiliar with the impact of the TCJ.

The purpose of the new TCJ is to lower the U.S. tax rate to 21% thus putting rates in the U.S. more in line with other nations. The U.S. corporate tax rate of 35% was the highest among the 35 countries that are members of the Organization for Economic Co-operation and Development (OECD). If a significant proportion of a company’s business is outside the U.S., however, the effective tax rate would very likely be lower on a global basis.

The TCJ effectively eliminates the worldwide system and puts the U.S. on a modified territorial system; US companies are now on more equal footing with global competition.

The U.S. was one of a handful of OECD members that featured a worldwide tax system. This meant that if a US based company repatriated funds to the US (ie. the transfer of money earned by foreign subsidiary operations to the US), it would have been required to pay the difference between the tax imposed at the 35% U.S. tax rate and the taxes already paid in the foreign country in which the income was earned. In general, the foreign taxes were much lower than in the US.

US companies which operated under the worldwide system were at a disadvantage relative to companies in the vast majority of countries which operate under a territorial tax system. The territorial tax system allows companies to pay taxes on income where it is generated and to repatriate those earnings without incurring further tax. This is far more efficient and provides greater cash management flexibility since business decisions are less impacted by tax considerations.

Under the TCJ, if a company repatriates funds held overseas, it will incur a repatriation tax on historical foreign earnings which was being reinvested or held for overseas investment. The company will record a one-time, non-cash charge which will be recognized from an accounting standpoint but the TCJ stipulates this amount only needs to be paid over an 8 year period.

Since a company has 8 years in which to pay the tax bill faced on the repatriation of overseas cash and investments, the payment of this tax bill will negatively net cash for several years. In most cases, however, companies have indicated that over the long-term the net outcome of the new TCJ will be positive.

Credit Ratings

You can certainly spend time conducting a detailed review of each bank`s current and historical capital adequacy ratios. For the purposes at hand, however, I will follow my standard practice of reviewing the credit ratings assigned by the various ratings agencies.

Under each of the Big 6 reviews which follow, I include a `Credit Ratings` section in which I provide a link to the bank’s website where the most current credit ratings are reported. The following chart can be used to determine each bank’s probability of default.

Canadian Banks

IFRS 9: New Accounting Standard For Canadian Companies

IFRS 9 replaces IAS 39, Financial Instruments – Recognition and Measurement and generally is effective for years beginning on or after January 1, 2018. IFRS 9 was developed in three phases, dealing separately with the classification and measurement of financial assets, impairment and hedging.

The reason for its development was to respond to criticisms that IAS 39 is too complex, inconsistent with the way entities manage their businesses and risks, and defers the recognition of credit losses on loans and receivables until too late in the credit cycle. The International Accounting Standards Board (IASB) had always intended to reconsider IAS 39, but the Financial Crisis made this a priority.

As part of the adoption of IFRS 9, the banks must recognize provision for credit losses related to both impaired (stage 3) and non-impaired (stages 1 and 2) loans in their respective strategic business units.

I am certainly not an expert in the field of accounting nor is this the venue in which to even attempt to address the impact the new standards will have on the members of the financial industry. Suffice it to say, banks will incur additional costs in order to comply with IFRS 9. On the flip side, the changes in reporting brought about by the implementation of IFRS 9 should address a criticism of the impairment model used during the Financial Crisis wherein companies were able to delay the recognition of asset impairments. Now, the new model requires recognition of full lifetime losses more quickly. This should be far more beneficial for the investment community.

Big 6 Analysis

Having covered the issues that impact the Big 6 I will now turn to a brief analysis of each bank.

The Royal Bank of Canada (TSX: RY) (NYSE: RY)

Overview

RY is a one of the largest banks in the world based on market capitalization. It employs 80,000 people in Canada, the US, and 35 other countries and has a customer base in excess of 16 million clients.

RY operates 5 business segments:

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

RY - 5 Business SegmentsRY - Sustainable Growth

Source: RY 2017 Annual Report

A quick overview of RY can be found here.

In December 2016, RY completed the sale of Moneris Solutions, Inc. (Moneris USA) from Moneris Solutions Corporation (Moneris) to Vantiv, Inc. (NYSE: VNTV) for $0.425B. Moneris USA was the U.S. subsidiary of Moneris, a joint investment between BMO and RY.

Moneris in Canada continues to be a joint venture between RY and BMO.

RY has benefited from the favourable macroeconomic environment with strong GDP growth, high employment and interest rate increases leading to low credit losses, strong demand for credit and stronger margins.

It has a highly focused strategy that targets high-growth client segments within its priority markets of Canada, the U.S., and select global financial centres.

RY, like all the other banks within the Big 6, is focused on transforming its physical network and in digitizing its operations to meet changing customer needs.

RY can now serve more commercial and high net worth clients after having successfully integrated City National in the US which it acquired in November 2015. As City National has deepened its presence in its core markets of California and New York City and has also expanded to Washington, D.C. and Minneapolis, it has been able to build on synergies with the Capital Markets business segment. RY’s U.S. capital markets business continues to grow and now accounts for more than half of overall Capital Markets earnings; Capital Markets has been ranked as one of the top 10 investment banks by fees for the last 5 years.

Q1 2018 Results and 2018 Outlook

On February 23, 2018, RY released its Q1 2018 results. The following are some of the takeaways from this presentation.

RY Q1 2018 ResultsRY - Strong Revenue Growth Offset by US Tax ReformRY - Items Impacting 2017 and 2018 Results

 

Source: RY Q1 2018 Presentation February 23, 2018

Credit Ratings

 RY’s credit ratings assigned by 4 different ratings agencies can be found here.

Valuation

RY reported diluted EPS of $7.56 for FY2017 versus $6.78 in FY2016. Management has targeted 7%+ growth in diluted EPS thus giving us projected diluted EPS for FY2018 of at least $8.09. With RY trading at ~$101 as at March 5, 2018 we get a forward PE of ~12.48.

Dividend, Dividend Yield, Dividend Payout Ratio, and Share Repurchases

RY’s dividend history can be found here and stock splits can be found here.

RY froze its annual dividend during the Financial Crisis but has subsequently been increasing its quarterly dividend a couple of times per year.

On February 23, 2018, RY announced a 3% increase to its previous $0.91 quarterly dividend commencing with the May 2018 dividend. I anticipate 2 quarterly dividend payments of ~$0.94 followed by 2 dividend payments of ~$0.97 (this would represent another 3% dividend increase). On this basis, the forward dividend would be ~$3.82 for a forward dividend yield of ~3.8% based on RY’s March 5, 2018 closing stock price of ~$101.

Based on my projected diluted EPS for FY2018 of at least $8.09 and my projected forward dividend of $3.82, I arrive at a ~47% dividend payout ratio which is within RY’s 40% – 50% targeted range.

The weighted average number of diluted shares outstanding (millions) in 2014 – 2017 amounted to 1,452; 1,450; 1,494; and 1,475. As at the end of Q1 2018 there were 1,459 outstanding.

In FY2017, RY returned a record $8.2B billion of capital in dividends and share buybacks and has outperformed its global peer group having delivered compound annual Total Shareholder Returns of 12% and 17% over 3 and 5 years.

You can read the details here of RY’s announcement in January 2018 about its specific share repurchase programs which is part of its normal course issuer bid.

Recommendation

RY is currently a bit expensive relative to the other members of the Big 6. When you invest in RY, however, you are investing in arguably the best bank of the group (TD is a close 2nd). You will, therefore, typically find that you pay up for RY’s quality.

RY warrants a position in the portfolio of investors who are willing to be patient and who have a long-term investment time horizon.

The Toronto-Dominion Bank (TSX: TD) (NYSE: TD)

Overview

TD was formed on February 1, 1955 through the amalgamation of The Bank of Toronto, chartered in 1855, and The Dominion Bank, chartered in 1869.

TD had $1.3T in assets on January 31, 2018 and ranks among the world’s leading online financial services firms, with approximately 12 million active online and mobile customers. It has more than 85,000 employees in offices around the world and it offers a full range of financial products and services more than 25 million customers worldwide.

TD consistently ranks in the Top 10 list of North American banks on the basis of Total Assets and Market Cap.

A quick overview of TD can be found here.

TD - SnapshotTD - Strategy

Source: TD Q4 2017 Investor Presentation – November 30, 2017

TD operates 3 Business Lines:

  • Canadian Retail including TD Canada Trust, Business Banking, TD Auto Finance (Canada), TD Wealth (Canada), TD Direct Investing and TD Insurance
  • U.S. Retail including TD Bank, America’s Most Convenient Bank, TD Auto Finance (U.S.), TD Wealth (U.S.) and TD’s investment in TD Ameritrade
  • Wholesale Banking including TD Securities

Similar to the other members of the Big 6, TD has grown through acquisition. You can view details of all acquisitions dating back to 1999 here.

TD - Strategic Evolution

Source: TD Q4 2017 Investor Presentation – November 30, 2017

As noted earlier in this article the Big 6 are spending heavily on technology. TD’s most recent acquisition is artificial intelligence start-up Layer 6 AI. Toronto-based Layer 6 AI, which launched in late 2016, uses AI in its platform to analyze various forms of data to learn and anticipate an individual customer’s needs.

This acquisition comes after TD announced in October 2017 an agreement with U.S.-based Kasisto to integrate its KAI Banking chatbot platform into the bank’s mobile app.

TD has:

  • multiple streams of income. It generates substantial earnings from its US Retail business line and the Wealth side of its Canadian Retail business line. Wholesale Banking is another area from which TD generates income but the magnitude is much smaller than the aforementioned business lines.
  • the most exposure to the US market of all its Canadian peers; its US branch network is larger than that in Canada. The projected increases in the Fed rate in 2018 and the recently introduced tax cuts will negatively impact results in the short-term but should positively impact TD in the long run.

TD’s current Group Head and Chief Risk Officer was my boss many years ago. He was an extremely astute and conservative banker at the time. I strongly suspect his risk management skills have only improved over the years otherwise he would not be in his current role. I am willing to bet my bottom dollar he is monitoring the bank’s risk exposure like a hawk.

Q1 2018 Results and 2018 Outlook

TD released its Q1 2018 earnings on March 1, 2018.

As noted in the Impact of the Tax Cuts and Jobs Act (TCJ) section of this article, the Big 6 earnings will be negatively impacted in the short-term. This is exactly what happened to TD in that it reported earnings of $2.4B, a reduction of 7% primarily due to a one-time impact as a result of U.S. tax reform. Adjusted earnings, however, of $2.9B were up 15% compared with the same quarter last year, reflecting growth across all business segments.

TD - Q1 2018 HighlightsTD - Q1 2018 Overview

Source: TD Q1 2018 Quarterly results Presentation – March 1, 2018

Credit Ratings

TD’s credit ratings assigned by 4 different ratings agencies can be found here.

Valuation

In TD’s 2017 Annual Report, management indicated one of its financial objectives is to grow diluted EPS 7% to 10%.  In FY2017, TD reported diluted EPS of $5.50 versus $4.67 in FY2016. Based on management’s target growth range, I anticipate FY2018’s diluted EPS will fall in the range of $5.90 – $6.05. Based on TD’s March 5, 2018 closing price of ~$75.35 we get a forward diluted PE of ~12.45 – ~12.77.

Dividend, Dividend Yield, Dividend Payout Ratio, and Share Repurchases

TD’s dividend history can be found here and its stock split history can be found here.

Unlike some other members of the Big 6, TD only increases its dividend once a year. With the recent release of its Q1 2018 results, TD announced a $0.07/share dividend increase ($0.67/share from $0.60/share) for the quarter ending in April; this is an 11.7% increase.

The new annual dividend of $2.68 provides investors with a yield of ~3.56% based on the March 5, 2018 closing price of ~$75.35.

This new dividend also represents a dividend payout ratio of ~44% – ~45% using the projected FY2018 diluted EPS range of $5.90 – $6.05. These levels fall within management target dividend payout range of 40% – 50%.

The weighted average number of diluted shares outstanding (millions) in 2014 – 2017 amounted to 1,845; 1,854; 1,856; and 1,855. As at the end of Q1 2018 there were 1,846 outstanding.

You can read the details here of TD’s announcement in October 2017 about its intent to repurchase common shares through specific share repurchase programs in connection with an amended Normal Course Issuer Bid.

Recommendation

If my memory serves me correctly, TD was one of the smaller members of the Big 6 when I started my banking career in 1980. This changed dramatically when TD acquired CT Financial in 2000 and followed up that acquisition with its Banknorth Group and Commerce Bancorp US-based acquisitions in the first half of the 2000s.

TD also chose to focus heavily on Retail Banking and Wealth Management. This has produced impressive results over the years and has enabled TD to avoid some of the grief its larger North American peer group members experienced during the Financial Crisis.

TD is an extremely well-run bank and, like RY, it rarely goes on sale. You will pay up for TD but will be well rewarded if you are a patient investor with a long-term investment time horizon.

The Bank of Nova Scotia (TSX: BNS) (NYSE: BNS)

Overview

Prior to retiring in 2016 I was employed with BNS which was founded 185 years ago; it is actually older than Canada. It is Canada’s international bank and is a leading financial services provider in North America, Latin America, the Caribbean and Central America, and Asia-Pacific.

Unlike other members of the Big 6 which have decided to establish a physical presence in the US, BNS has chosen to focus on markets where real GDP growth is more robust (Mexico, Peru, Chile, and Colombia).

BNS - Focusing on Core Markets and OpportunitiesBNS - Economic Outlook in Key Markets

Source: BNS All-Bank Investor Day Presentation – February 1, 2018

BNS operates 3 Business Lines:

  • Canadian Banking
  • International Banking
  • Global Banking and Markets

BNS - Delivering On Our Medium Term Financial ObjectivesBNS - Consistent Financial Performance

Source: BNS All-Bank Investor Day Presentation – February 1, 2018

Earlier in this article I referenced the extent to which the Big 6 are investing in technology and operational improvements. This image supports that statement.

BNS - Technology and Operational Improvements

Source: BNS All-Bank Investor Day Presentation – February 1, 2018

Unfortunately, BNS’s website is grossly outdated when it comes to the reporting of its acquisition activity. The most recent acquisition activity reported on the bank’s website is for 2015; there have been a few acquisitions subsequent to 2015.

In 2017, for example, BNS announced that its offer to acquire a 68% interest in BBVA Chile (Chile’s 7th largest bank) from Banco Bilbao Vizcaya Argentaria’s (BBVA) had been accepted; BNS owned Chile’s 6th largest bank and this acquisition roughly doubles BNS’s market share in Chile to ~14%.

An even more recent acquisition was announced in mid-February 2018 with BNS’s intent to acquire Jarislowsky, Fraser Limited, one of Canada’s leading independent investment firms with more than $40B in assets under management on behalf of institutional and high net worth clients. The combination of Jarislowsky Fraser and BNS’s asset management business will create the 3rd largest Canadian active asset manager with $166B in assets under management (as of December 31, 2017). The transaction is expected to close in fiscal Q3 2018, subject to regulatory approvals.

BNS - Jarislowsky Fraser Acquisition

Source: BNS Q1 2018 Investor Presentation – February 27, 2018

Q1 2018 Results and 2018 Outlook

BNS released its Q1 2018 results on February 27, 2018.

BNS - Q1 2018 OverviewBNS - Q1 2018 Financial Performance

Source: BNS Q1 2018 Investor Presentation – February 27, 2018

Credit Ratings

BNS’s credit ratings assigned by 4 different rating agencies can be found here.

Valuation

BNS reported diluted EPS of $6.49 for FY2017 and has raised its medium-term EPS growth objective to 7%+. On this basis, I am estimating that BNS will generate diluted EPS for FY2018 of at least $6.94. With BNS trading at ~$79 as at March 5, 2018 we get a forward PE of ~11.4.

Dividend, Dividend Yield, Dividend Payout Ratio, and Share Repurchases

BNS’s dividend and stock split history can be found here.

BNS froze its annual dividend during the Financial Crisis but has subsequently been increasing its quarterly dividend a couple of times/year.

On February 27, 2018, BNS announced a $0.03 increase to its previous $0.79 quarterly dividend commencing with the April 2018 dividend. I anticipate 2 quarterly dividend payments of $0.82 followed by 2 dividend payments of ~$0.85 (this would represent another $0.03 dividend increase). On this basis, the forward dividend would be ~$3.34 for a forward dividend yield of ~4.2% based on BNS’s March 5, 2018 closing stock price of ~$79.

As previously noted, I project diluted EPS for FY2018 of at least $6.94. With a projected forward dividend of $3.34 we arrive at a ~48% dividend payout ratio which is within BNS’s 40% – 50% targeted range.

The weighted average number of diluted shares outstanding (millions) in 2014 – 2017 amounted to 1,222; 1,232; 1,226; and 1,223. As at the end of Q1 2018 there were 1,215 outstanding.

You can also expect BNS to repurchase shares with the ~$6.5B in excess capital the bank is expected to generate between now and 2020.

Recommendation

Many readers are likely familiar with BNS’s exposure in the Caribbean if they have traveled to that region. As a matter of interest, BNS was the bank used by rum runners who would make excursions to Jamaica. BNS, at one time, had a larger exposure in that region than in Canada!

Investors seeking exposure to geographic regions with an up and coming middle class would do well by investing in BNS. Senior management made a strategic decision several decades ago to focus on markets such as Mexico, Colombia, Chile, and Peru as opposed to the US. The rationale was that the US was overbanked. Management knew the risks of expanding in the Latin American countries was higher than if expansion were made in the US (Argentina was a disaster for BNS and senior bank employees had to flee the country) but the strategy has paid off handsomely.

The Bank of Montreal (TSX: BMO) (NYSE: BMO)

Overview

BMO was established in 1817. It provides a broad range of personal and commercial banking, wealth management and investment banking products and services to more than 12 million customers. It is the 8th largest bank in North America as measured by assets and is Canada’s 4th largest bank from a market cap perspective.

A quick overview of BMO can be found here.

The following are BMO’s Key Strategic Areas of Focus.

BMO - Key Strategic Areas of Focus

Source: BMO Financial Group Investor Presentation – February 27, 2018

It derives ~70% of its revenue from Canada where barriers to entry in the Canadian banking system are extremely high. Mergers amongst the major Canadian FIs are unlikely to happen anytime in the near future. In 1998 two large merger proposals were denied: RY with BMO and TD with CM. Furthermore, existing regulations prevent foreign competition; non-Canadian residents may not own more than 25% of the shares of a bank unless approved by the government.

The remaining ~25% of BMO’s revenue is derived from its US operations. It is interesting to note that BMO established a US presence in the US Midwest in 1984 when it acquired Harris Bank but it never rebranded its US operations with the BMO name until 2011 after acquiring Milwaukee based Marshall & Isley Corporation (M&I Bank) in December 2010. The lag in rebranding the US operations is in stark contrast to that of TD which wasted little time in renaming its US operations.

If you compare the progress BMO has made in the US with that of TD which entered the US market in a meaningful way only in the mid 2000s, you realize that the strategic vision may have been less than 20/20 at the top of the BMO house.

The Canadian banks will likely encounter some challenges domestically in 2018 as the Canadian consumer is stretched thin and the housing market in some major urban centres will likely experience some softening. Had BMO done anything of significance with the US segment of the bank between 1984 and 2010 (it has delivered 13% compound annual income growth over the last 2 years and strong operating leverage) the US operations would likely be generating in excess of the current 25% of total bank earnings.

BMO’s CEO has indicated the bank will continue to accelerate growth in its US segment. The plan is to build on the strength of its commercial banking operations and to accelerate growth and profitability in its personal banking, personal wealth, and asset management business lines.

Given the plans to accelerate growth in the US, I suspect BMO is on the hunt for acquisitions to complement its organic growth; becoming a meaningful player in the highly fragmented US market through organic growth is extremely difficult and time-consuming.

Acquisition opportunities for the right price and of the size of M&I Bank do not often arise. As such, “bolt on” acquisitions in the regions in which BMO already has operations is likely the best course of action as opposed to making a major acquisition. The challenge BMO faces is that acquisitions in the US are currently very expensive.

BMO has the second lowest relative exposure to the residential mortgage market amongst the Big 6 in Canada. In fact, BMO’s mortgage exposure in Q1 2018 dropped from that reported at the end of Q4 2017 by $300 million. The balances at RY, TD, BNS, and CM all increased slightly.

BMO has the largest amount of assets under management among the Canadian banks and the largest proportion of its revenue coming from wealth-management fees in its peer group; Canadian readers may be familiar with BMO’s ETFs. BMO, however, is competing against a formidable competitor in this space in the form of BlackRock which holds a ~50% market share of the Canadian ETF market. In addition, Vanguard entered the Canadian market in December 2011. While Vanguard currently has 33 ETFs with only $12.5B in assets under management, it is a formidable competitor that will undoubtedly grow its Canadian market share in due course.

Q1 2018 Results and 2018 Outlook

BMO released its Q1 2018 results on February 27, 2018.

BMO - Q1 2018 Financial HighlightsBMO - Q1 2018 Financial Highlights (cont'd)

Source: BMO Financial Group Investor Presentation – February 27, 2018

Credit Ratings

BMO’s credit ratings assigned by 4 different rating agencies can be found here.

Valuation

BMO reported diluted EPS of $7.92 for FY2017 and it targets 7% – 10% diluted EPS growth thus giving us projected diluted EPS of $8.47 – $8.71 for FY2018. With BMO trading at $96.64 as at March 5, 2018 we get a forward PE of ~11 – ~11.4.

Dividend, Dividend Yield, Dividend Payout Ratio, and Share Repurchases

BMO’s dividend history can be found here. Stock splits occurred March 14, 2001 (2 for 1 by way of a 100% stock dividend), March 20, 1993 (2 for 1) and June 23, 1967 (5 for 1).

BMO froze its annual dividend at $2.80 during 2008 – 2012 but following the Financial Crisis it has been increasing its quarterly dividend a couple of times/year. The May 28, 2018 $0.93 dividend will be the second time the dividend is disbursed at this level. I anticipate that BMO will announce an increase in May to its August dividend. A $0.03/quarter increase would be in keeping with recent increases.

On this basis, the forward dividend would be $3.78 which is calculated as $0.93 for the recent February dividend and the May dividend plus $0.96 for the August and November dividends. The $3.78 forward dividend represents a ~3.9% forward dividend yield based on BMO’s March 5, 2018 $96.64 closing stock price.

Management is committed to the medium-term objectives for EPS growth of 7% – 10% thus giving us a forward diluted EPS range of $8.47 – $8.71 for FY2018. With a projected forward dividend of $3.78 we arrive at a ~43.4% – ~44.6% dividend payout ratio which is within BMO’s 40% – 50% targeted range.

BMO recently announced its intent to repurchase up to 20 Million of its common shares. Further details can be found here.

The weighted average number of diluted shares outstanding (millions) in 2014 – 2017 amounted to 648.5; 651.9; 646.1 and 647.1. At the end of Q1 2018 there were 649.9 outstanding.

Recommendation

BMO is a nice to own bank but it seems to trip over itself every once in awhile. It entered the US market long before TD but never really made any headway. During the Financial Crisis it was able to bolster in US presence with the acquisition of M&I Bank.

You will pay less for BMO than RY and TD but there is a reason for that…it is not of the same quality as those two banks.

The Canadian Imperial Bank of Commerce (TSX: CM) (NYSE: CM)

Overview

CM, which celebrated its 150th year of serving clients in 2017, operates 4 Key Businesses

  • Canadian Personal and Small Business Banking
  • Canadian Commercial Banking and Wealth Management
  • U.S. Commercial Banking and Wealth Management
  • Capital Markets

A quick overview of CM can be found here.

CM Strong and Consistent Returns to Shareholders

CM Strategy Drives Consistent EPS and Dividend Growth

Source: Building a Relationship-Focused Bank – December 13, 2017 Investor Presentation

It is the major Canadian financial institution with the most exposure to the Canadian consumer and housing market; roughly 60% of its income is derived from Canadian personal and commercial banking versus peer levels between 30% – 50%. Senior management is keenly aware of the risks the bank faces, and therefore, steps are being taken to reduce the bank’s vulnerabilities. An example of this is CM’s acquisition of Chicago-based PrivateBancorp in June 2017 for ~CDN$5B; this bank has recently been rebranded CIBC Bank USA.

The final purchase price was well in excess of CM’s original intent to make an acquisition in the $1B – $2B range. Considering the bank it acquired has a relatively small presence in the US with only 34 offices in 12 states, it will certainly be an uphill battle to attain management’s stated objective of generating 25% of bank-wide profits from its new US division by 2024.

Given the ~5% annual diluted EPS growth target and the goal to generate ~25% of CM’s profits from its new US division within the next 7 – 10 years, I am of the opinion that another US acquisition will need to occur. Based on the US expansion experiences of TD, RY, and BMO, organic growth is not easy to achieve in the saturated US market. I think CM is well aware of this and this is why I strongly suspect CM will make further US acquisitions once it has had a chance to properly integrate its recent acquisition.

Q1 2018 Results and 2018 Outlook

CM released its Q1 2018 results on February 22, 2018.

CM Q1 2018 Highlights

Source: CM Q1 2018 Investor Presentation – February 22, 2018

Credit Rating

CM’s credit ratings assigned by 4 different rating agencies can be found here.

Valuation

CM reported diluted EPS of $11.24 for FY2017 and it targets 5%+ on average diluted EPS growth thus giving us projected diluted EPS of $11.80 for FY2018. With CM trading at $116.3 as at March 5, 2018 we get a forward PE of~9.86

Dividend, Dividend Yield, Dividend Payout Ratio, and Share Repurchases

CM’s dividend history can be found here. Stock splits occurred March 27, 1997 (2 for 1 by way of a 100% stock dividend), January 31, 1986 (2 for 1) and August 9, 1967 (5 for 1).

Looking at CM’s dividend history you will see that CM froze its dividend for 3 years @ $0.87/quarter during the Financial Crisis. Once dividend increases were reinstated in 2011, the pace at which dividend increases occurred accelerated although each dividend increase was inconsistent in value.

CM - Delivering Strong Returns

Source: Building a Relationship-Focused Bank – December 13, 2017 Investor Presentation

CM recently announced a $0.03/quarter dividend increase ($1.30 increased to $1.33). Based on the pattern of dividend increases in recent quarters, I envision CM will retain the $1.33 dividend for another quarter and will then announce another $0.03/quarter increase for the late October 2018 payment.

On this basis I calculate the forward dividend as being $5.38 (2 quarters @ $1.33 and 2 quarters @ $1.36). On the basis of a March 5, 2018 closing stock price of $116.3 we arrive at a forward dividend yield of ~4.6%.

CM reported diluted EPS of $11.24 for FY2017 and it targets 5%+ on average diluted EPS growth. On this basis, CM is projecting diluted EPS of $11.80 for FY2018. With a projected forward dividend of $5.38 we arrive at a ~46% dividend payout ratio which is within CM’s 40% – 50% targeted range.

The weighted average number of diluted shares outstanding (millions) in 2014 – 2017 amounted to 398.4; 397.8; 395.9 and 413.5. As at the end of Q1 2018 there were 442,852 outstanding. The significant increase in the number of shares outstanding is attributed to the issuance of shares to assist with the acquisition of PrivateBancorp.

As with the other members of the Big 6, CM also periodically repurchases shares.

Recommendation

Historically, CM used to step on a landmine every few years and as a result was typically viewed as a laggard within the Canadian banking community. New senior management is making efforts to change this perception as evidenced by CM’s recent entry into the US. CM certainly has a tough road ahead of itself in that it paid up for PrivateBancorp and it is somewhat late to the party.

While I am cautiously optimistic CM is on the right path there is a reason why it is not as richly valued as RY, TD, and BNS.

The National Bank of Canada (TSX: NA)

Overview

NA provides integrated financial services to consumers, small and medium-sized enterprises (SMEs) and large corporations in its domestic market while also offering specialized services internationally.

It operates in four business segments:

  • Personal and Commercial;
  • Wealth Management;
  • Financial Markets;
  • S. Specialty Finance and International

It offers a complete range of financial services that include banking and investment solutions for individuals and businesses, securities brokerage, insurance, and wealth management services.

NA is the leading bank in Quebec. It maintains branches in almost every province and through representative offices, subsidiaries, and partnerships it also operates in the United States, Europe and other parts of the world.

A quick overview of NA can be found here.

NA’s two main challenges are Revenue Growth and Technological Changes. 10% of the bank’s efforts are being directed toward targeted international expansion while the remaining 90% is being directed toward transformation and growth strategies.

The technological transformation consists of $0.35B invested annually over the past 3 years with investments to remain at the same level for the coming years and changes to processes and data. In addition, NA is investing in new ABMs, client relationship management tools, and digital features such as mobile cheque deposits and biometric identification.

NA is also collaborating with fintechs such as NestWealth and LendingClub and is pursuing niche/specialty markets such as Credigy and on the international front it has taken a majority stake in Cambodia’s ABA Bank and equity stakes in NSIA in Côte d’Ivoire, AfrAsia in Mauritius, and XacBank in Mongolia.

In FY2017 a new business segment was formed which is comprised of Credigy, NA’s Atlanta-based specialty consumer finance subsidiary, and NA’s emerging markets portfolio, notably ABA Bank in Cambodia. These subsidiaries delivered a combined 25% increase in net income in FY2017 and strong return on equity and this segment currently represents more than 8% of consolidated net income with the expectation this figure will grow to 10% over the next few years.

While NA has international expansion on its roadmap, a decision was made to extend the moratorium on major investments in emerging markets as NA operationalizes and consolidates existing activities.

Q1 2018 Results and 2018 Outlook

NA’s Q1 2018 results released on February 28, 2018 can be found here.

NA Q1 2018 HighlightsNA Q1 2018 Segment Snapshot

Source: NA – Analyst and Investor Q1 2018 Presentation – February 28, 2018

NA FY2018 Mid-Term Objectives

Source: NA – Analyst and Investor Q4 and FY2017 Presentation – December 1, 2017

Credit Ratings

NA’s credit ratings assigned by 4 different rating agencies can be found here.

Valuation

When management presented FY2017 results on December 1, 2017, it provided guidance with respect to FY2018. Growth of 5% – 10% in diluted EPS has been projected. Using FY2017’s diluted EPS of $5.45 we get a projected diluted EPS range of $5.72 – $6.00. With NA trading at ~$63 as at March 5, 2018 this represents a forward PE of ~10.5 – ~11.

Dividend, Dividend Yield, Dividend Payout Ratio, and Share Repurchases

NA’s dividend history can be found here. Stock splits (2 for 1) occurred February 13, 2014, and February 12, 1987.

Looking at NA’s dividend history you will see that NA froze its dividend during the Financial Crisis. Once dividend increases were reinstated in 2013, NA returned to the practice of increasing the common dividend twice a year.

NA - CAGR of Dividends

Source: 2017 AGM Presentation by President and CEO

An increase to NA’s $0.60 quarterly dividend will likely be announced in June 2018 if NA sticks with its practice of increasing its dividend $0.02 every two quarters. At the moment, however, NA’s $2.36 dividend (two quarters @ $0.58 and two @ $0.60) provides investors with a 3.75% dividend yield based on a ~$63 stock price.

The $2.36 dividend represents a ~39% – ~41.3% dividend payout ratio using a projected diluted EPS range of $5.72 – $6.00 for FY2018.

The weighted average number of common shares outstanding (millions) in 2014 – 2017 amounted to 331.1; 333.1; 339.9 and 344.7. As at the end of Q1 2018 there were 345.5 outstanding.

Periodically, NA will repurchase (and here) its shares much like the other members of the Big 6.

Recommendation

While NA has certainly rewarded investors over the years, it operates in a land of giants. In its 2017 Annual Report, the 2nd paragraph in the ‘Message from the President and CEO’ referenced the bank’s record Net Income of $2B. It certainly is difficult to get excited about that achievement when it is significantly less than Net Income results of the larger members of its Canadian peer group.

NA’s international expansion in Côte d’Ivoire, Mauritius, and Mongolia does not appeal to me. If I am seeking a bank with exposure to international regions with far greater growth potential I would be inclined to invest in BNS.

In my opinion, NA would be the last of the Big 6 in which I would make an investment.

Final Thoughts

Why an investor would invest in speculative stocks or would be inclined to chase yield before taking positions in the major Canadian financial institutions is beyond me. I recognize the Big 6 are not immune to economic downturns but their growth potential bodes well for long-term investors; these banks have a track record of rewarding patient shareholders.

They are certainly not on sale at the moment but acquiring shares in stages (with backing up the truck and loading up on shares when there is a major correction) is a great way to create long-term wealth. You will be rewarded with regular dividend increases and share buybacks. In addition, investors with a long-term investment time horizon have the opportunity to generate capital gains from shares in the Big 6 since because they typically generate profits year after year.

Personally, my order of preference in which I would accumulate positions in these banks is as follows: RY, TD, BNS, CM, BMO, and NA. I have held positions in the first 5 for years. I have never taken a position in NA for no other reason than I would prefer to invest in RY and TD. Nothing against NA…just my personal preference.

On a final note, it is amazing how the accumulation of shares in these banks over a prolonged period can generate dividend income which will eventually offset some of your monthly living expenses. That is a great feeling!

If you practice a little patience and keep acquiring shares in these banks you will, one day, find that the quarterly dividends cover some of the expenses associated with your child’s/children’s education. That is an even greater feeling!

Practice even more patience and one day you may find yourself in a position where you can take a ‘Well Day’….as in ‘Well, I just don’t want to work anymore’. Now THAT is….NIRVANA!

Thanks for reading!

Thanks for reading this article. Please send any feedback, corrections, or questions to support@suredividend.com.

Article by Charles Fournier, Sure Dividend


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