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Canadian Banks: Are Investor Expectations Getting Ahead of Fundamentals?

Heading into 2014, Canadian banks are faced with a challenging environment.   But yet, after the last few years of record breaking performance against all odds, it feels like these stocks will never falter.  The funny thing about the market is, it’s precisely at moments like these that we should be most concerned.  While bank stocks have come under a bit of pressure of late after reporting year end results, are investors’ expectations still too high?

Revenue Growth Slowing

The Canadian banks are experiencing an environment of slowing revenue growth.  This can be seen as an inflection point, leading to a period whereby earnings growth will not come as easy in the coming years.  In fiscal 2013, Royal Bank’s (TSX: RY) revenue increased 3.7%.  This compares to 2012 revenue growth of 7.7% and 2011 revenue growth of 6%.   Similarly, revenue growth of 6.7% at TD (TSX: TD) in fiscal 2013 was also slower than the double digit growth of prior years.

Net Interest Margins are Declining

The net interest margin is calculated as (interest income less interest paid) divided by average customer loans, and is a key profitability metric for the banks.  Royal Bank’s net interest margin was 2.7% in the latest quarter, a decrease of 7 basis points sequentially and 6 basis points year over year.   Bank of Montreal (TSX: BMO) also saw a deterioration in its net interest margin, which fell 8 basis points sequentially and 14 basis points year over year.

….. So Looking for Efficiencies to Drive Growth

To combat these trends, the banks are shifting gear and focusing more on cost savings and efficiencies that can be squeezed out of the business.  Royal Bank announced that it would cut 1,129 full time jobs, or 1.5% of its work force.  Bank of Nova Scotia (TSX: BNS) has also talked about trimming and cost cutting after a slightly disappointing quarter that saw the bank’s international segment struggle with narrowing interest margins and an 18% increase in loan loss provisions.

Mortgage and Personal Loans Growth Coming to an End?

While the housing market continuing its run, even though mortgage rates continue to edge higher, and the consumer remains heavily indebted, it’s inevitable that mortgage and loan growth will slow at some point in the near future.  At TD, personal and commercial banking earnings increased 13%, with a corresponding revenue increase of only 3%.  Similarly, Royal Bank experienced a slower growth environment in mortgages in its latest quarter.  And while at Bank of Nova Scotia, residential mortgages increased 5% and personal loans and credit cards increased 10%, investors should expect this to moderate.

New Platform in Banking

A new age of digital and mobile banking platforms is coming to the banking industry and shifting the way customers do business.  This is changing the way that the banks interact with their customers, and the banks must invest in these new technologies in order to maintain their relationships.  Mobile banking is growing in popularity and the banks that adjust to this new way of interacting with their clients will have an advantage as we head into the next few years.  Royal Bank is offering credit card payments through the RBC Secure Cloud as well as debit transactions but this is still in the testing phase and roll out has been slow.

Bottom Line

The Canadian banks will be facing some headwinds in the near future and given that investors do not appear to be pricing in these risks, the stocks may be in for a hit in the coming year.  But for investors who would like to continue to receive healthy and reliable dividends, the bank stocks are a good place to be invested.  Just don’t expect much in the way of near-term capital appreciation.

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Fool contributor Karen Thomas does not own shares in any of the companies mentioned.  The Motley Fool does not own shares in any of the companies mentioned.

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