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Bank of Montreal vs. Royal Bank of Canada: Which Is the Best Investment?

The financial sector is finally catching its breath a bit after the big run, and new investors are now looking for attractive entry points in the Canadian banks. Let’s take a look at Bank of Montreal (TSX: BMO)(NYSE: BMO) and Royal Bank of Canada (TSX: RY)(NYSE: RY) to see if either might be a good choice in the current environment.

Bank of Montreal

The economic recovery in the U.S. is very important for Bank of Montreal. Thirty years ago, BMO bought Chicago-based Harris Bank and has slowly built a solid business in the Midwest. In 2011, BMO decided to bet big on the U.S. recovery, and spent $4.1 billion for Marshall and Ilsley Corp., based in Wisconsin. The size of the deal was significant, and some analysts questioned the move given the state of the U.S. economy at the time. Three years later, it looks like the investment was a smart one. BMO Harris Bank contributed $147 million to Bank of Montreal’s Q3 2014 earnings. Specifically, loans in the commercial banking unit increased by 18% compared to Q3 2013.

Bill Downe, BMO’s CEO, told analysts on the quarterly conference call the bank is seeing stronger revenue trends in the U.S. operations despite the extended low interest rate environment. BMO’s investment in the Midwest is largely a play on the rebound in U.S. manufacturing.

BMO is also expanding its wealth management division. In May 2014, BMO completed the $1.3 billion purchase of U.K.-based F&C Asset Management. The F&C deal positions BMO well for a European recovery.

Here in Canada, the housing market is a hot-topic for investors in all the Canadian banks. At the end of Q3 2014, BMO had $91.7 billion of residential mortgages on its books. Insured mortgages represented 64% of the portfolio and the loan-to-value ratio of the uninsured component was 58%.

BMO finished Q3 with a Basel III Tier 1 Capital (CET1) ratio of 9.6%. The stock trades at 12.7 times earnings and has a dividend yield of 3.8%.

Royal Bank of Canada

Contrary to Bank of Montreal, Royal Bank exited the U.S. retail market in 2011. The company used the $3.6 billion it received from the sale to build up its wealth management and capital markets divisions.

Today, Canada’s largest bank is firing on all cylinders and enjoying record profits. The capital markets unit accounted for 27% of Royal Bank’s Q3 2014 earnings, and the $641 million earned by the group was 66% higher than the same period in 2013. Wealth management profits were also strong, with a 22% year-over-year gain for the quarter.

On the retail side of the business, Royal Bank had $189 billion of Canadian residential mortgages outstanding at the end of the third quarter. Insured mortgages represented 39% of the portfolio and the larger, uninsured component had a loan-to-value ratio of 55%.

Royal’s CET1 ratio was 9.5% at the end of Q3. The stock trades at 13.7 times earnings and the dividend yield is 3.8%.

The bottom line

As long as the good times continue to roll in the capital markets group, things will be fine at Royal Bank. The fact that 61% of Royal’s mortgage portfolio is uninsured could be an issue in the next few years. At Bank of Montreal, roughly two-thirds of the mortgage holdings are insured, making BMO somewhat less susceptible to a sharp housing correction. Bank of Montreal’s stock is less expensive, the company’s U.S. operations are slowly improving, and the move to bolster its wealth management business should be a long-term positive.

The pullback in the banks might not be finished yet, but I would lean toward Bank of Montreal when the market resumes its upward trend.

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

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