Royal Bank Of Canada: Minor Risks, Major Returns, & Mean Reversion?

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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.

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 a low price-to-earnings ratio of just 12.0.  For comparison, the S&P 500’s price-to-earnings ratio is around 25.

Ask yourself, does Royal Bank of Canada deserve a price-to-earnings ratio of less than half of the S&P 500’s, given the company’s competitive advantage, long dividend history, and growth prospects?

Banks have historically traded for lower price-to-earnings ratio than the overall market.  Still, Royal Bank of Canada’s valuation multiple has not taken part in the market’s valuation multiple rise.  The company has traded for an average price-to-earnings ratio of around 0.67x that of the S&P 500’s over the last 5 years.  This implies a fair price-to-earnings ratio of 16.7 at current prices.

Royal Bank of Canada ranks very well using The 8 Rules of Dividend Investing.  The company is currently ranked as a buy.

Consecutive Years of Dividend Increases:  Royal Bank of Canada has paid steady or increasing dividends (in Canadian dollars) every year since 1943.  The company easily meets the requirement of 25+ years of steady or rising dividends needed to be in the Sure Dividend database.

Why it matters: The Dividend Aristocrats (stocks with 25-plus years of rising dividends) have outperformed the S&P 500 over the last 10 years by 2.88 percentage points per year.
Source: S&P Factsheet

Dividend Yield:  Royal Bank of Canada’s 4.1% dividend yield ranks 20th out of 186 dividend stocks with 25+ years of steady or rising dividends.

Why it Matters: Stocks with higher dividend yields have historically outperformed stocks with lower dividend yields. The highest-yielding quintile of stocks outperformed the lowest-yielding quintile by 2.2 percentage points per year from 1928 to 2013.
Source: Dividends: A Review of Historical Returns

Payout Ratio:  Royal Bank of Canada’s reasonable payout ratio of 48% is the 77th lowest out of 186 dividend stocks with 25+ years of steady or rising dividends.  The company’s payout ratio gives it plenty of room to pay steady or rising dividends even if earnings contract.

Why it Matters: High-yield, low-payout ratio stocks outperformed high-yield, high-payout ratio stocks by 8.2 percentage points per year from 1990 to 2006.
Source: High Yield, Low Payout by Barefoot, Patel, & Yao, page 3

Long-Term Growth Rate:  Royal Bank of Canada’s expected earnings-per-share growth rate of 8.4% ranks it at 68 out of 186.  Higher growth rates mean faster growing dividends (and more capital gains, all other things equal) for investors.

Why it Matters: Growing dividend stocks have outperformed stocks with unchanging dividends from 1972 through 2015.
Source: An Economic Perspective on Dividends

Long-Term Volatility:  Royal Bank of Canada has a 10 year historical average stock price standard deviation of 24.6%.  The company’s relatively low stock price standard deviation is ranked 57 out of 186.

Why it Matters: The S&P Low Volatility index outperformed the S&P 500 by 2 percentage points per year for the 20-year period ending September 30th, 2011.
Source: Low & Slow Could Win the Race

Final Thoughts

Royal Bank of Canada ranks very well using The 8 Rules of Dividend Investing.  The company is a buy based on the Sure Dividend methodology.

United States investors should be aware of possible 15% dividend tax withholding from Canada.  Due to a tax treaty between the United States and Canada, this withholding can be waived for qualified retirement accounts like 401Ks and IRAs.

Royal Bank of Canada’s valuation is very reasonable given its solid expected growth and long history of success.  The company is not without risks, but has a favorable risk/reward paradigm.

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