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3 Big Reasons to Avoid Royal Bank of Canada and 1 Stock to Buy Instead

The Canadian banks have had a fantastic couple of years and Royal Bank of Canada (TSX: RY)(NYSE: RY) stands out more recently as the one to beat. But scratch below the surface of the recent earnings report and you will see some red lights are going off.

For new investors looking to add a bank stock to their portfolios, Royal Bank might not be the wisest choice right now.

Here are three reasons why I think investors should avoid Royal Bank of Canada and why The Bank of Nova Scotia (TSX: BNS)(NYSE: BNS) is a better choice given the current outlook for the sector.

1. High-risk earnings

The capital markets group at Royal Bank stole the show in the company’s latest quarterly report. Earnings in the division rose by 66% to a record level of $641 million and represented roughly 27% of Royal Bank’s profits.

By all accounts, it was a blowout quarter.

Every bank has a capital markets group and the wholesale side of the business is an important part of the overall earnings picture. However, the revenue stream can be extremely volatile. Fees from mergers, acquisitions, equity offerings, and bond issues can dry up very quickly.

As capital markets earnings continue to represent a bigger part of the profit pie, Royal’s shareholders are being exposed to a greater level of risk.

2. Exposure to Canadian retail debt

All of the Canadian banks are sitting on a significant amount of mortgage exposure. Low interest rates have sent Canadians on a house-buying binge, and as prices continue to climb to record levels, the risk of a meltdown grows greater each year. Interest rates will have to rise at some point, and when they do, some property owners are not going to be able to make the payments at the higher levels. If too many people get into trouble too quickly, the snowball effect could be very ugly.

In a July report, Morningstar analyst Dan Werner said Royal Bank would be one of the banks hardest hit by a significant drop in house prices due to the size of its residential loans exposure relative to its tangible common equity position. Werner expects the peak-to-trough drop in Canadian house prices to come in at 30%.

3. Lower financial stability

During the last quarter, Royal Bank’s Basel III common equity Tier 1 (CET1) ratio dropped to 9.5%. The ratio is an indication of the bank’s financial strength. The number is still acceptable but is heading in the wrong direction.

Why buy The Bank of Nova Scotia instead?

The Bank of Nova Scotia offers long-term investors a lower-risk option at the moment. The company’s exposure to the Canadian housing market is also high but the risk profile of the portfolio is lower. The Bank of Nova Scotia reported its CET1 ratio rose in the last quarter to 10.9%, meaning it is extremely well capitalized.

The Bank of Nova Scotia also receives a large portion of its earning from its Latin American operations. Not only does this diversify the income stream, it also means the longer-term growth potential for the bank is very appealing as this region continues to develop.

Regarding capital appreciation and dividend growth, The Bank of Nova Scotia has a fantastic track record. The company has paid a dividend every year since 1883 and the stock has increased more than 85% in the past 10 years.

Royal Bank will probably continue to perform very well in the near term but I think the lower overall risk offered by The Bank of Nova Scotia makes it a smarter place to invest right now.

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Canadian banks are considered must-have investments. After all, they're very stable, well-capitalized, and face limited competition. That said, there are concerns for the banks and their investors. In this FREE report, we cover everything you need to know about Canada's Big 5 -- whether you're already an investor or are considering buying shares. Simply click here to receive your special FREE report, “What Every Bank Shareholder MUST Know."

Fool contributor Andrew Walker has no position in any stocks mentioned.

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