To keep reading, enter your email address or login below.
If I were to put together a list of the finest companies in Canada, Royal Bank of Canada (TSX:RY)(NYSE:RY) would be near the top. Heck, there’s a case for making it the number one choice.
The company has been paying dividends annually for nearly 150 years, starting in 1870. Let that sink in for a minute. Through the Great Depression, two world wars, hyperinflation, and countless other events that brought many great companies to their knees, Royal Bank not only survived, but thrived.
Royal Bank is the kind of stock that has made countless Canadians rich. All you needed to do was buy it, tuck it away for a few decades, and it would inevitably grow. Sure, there would be bumps along the way, but nobody could argue with the long-term results.
But is now the best time to be doing that? Perhaps not. Here are three reasons why you might want to think twice before adding Royal Bank to your portfolio today.
By far the biggest risk to Royal Bank is the Canadian housing market.
You’ve all heard the arguments about why the market is overheated. Metrics like the price-to-income ratio and the price-to-rent ratio are the highest they’ve ever been. Landlords across the country are content with locking in yields of 3-4%, happy to break even on the rent, while pocketing the inevitable appreciation. And who hasn’t heard a bidding war story from the streets of Toronto or Vancouver? These are all things that signal a possibly overheated market.
While I have confidence in Royal Bank’s management to deal with the inevitable downturn, it will still affect the stock. Yes, many mortgages are covered by default insurance, but there are still thousands of lines of credit and debt consolidation loans that aren’t. Plus, a sustained decline in housing will put millions of homeowners in a negative equity position, greatly reducing their financial flexibility. That’s not good news to a company that does a lot of lending against real estate. It’s hard to borrow against collateral that’s falling in value.
I’m convinced Royal Bank will emerge from any real estate crash practically unscathed. But the stock will still get hurt when the downturn happens.
Upon first glance, it doesn’t appear that Royal Bank has much exposure to the energy market. It’s total energy loan book is a little less than $10 billion, or about 2.2% of its total loan portfolio. Very manageable, at least on the surface.
But when you dig deeper, things are a little less rosy. Energy companies collectively have $22 billion in untapped credit from the bank, credit that will start to be utilized if we see weak crude prices persist over the next six months. Weakness in energy has a way of affecting the whole economy, especially in places like Alberta and Saskatchewan. We’re already seeing energy layoffs affect the housing market in Alberta. If the situation gets worse; there’s far more than a $9.6 billion portfolio of energy loans at risk.
An expensive acquisition
In January Royal Bank agreed to acquire City National Corp for $5.4 billion, or $93.80 per City National share. Royal Bank shares immediately sold off 3% on the news.
Investors were mostly concerned with the price paid. City National earned $4.25 per share in 2014, which means Royal Bank paid more than 21 times earnings for its new subsidiary. That’s expensive, especially considering Royal Bank shares trade at just 12.8 times 2014’s earnings.
Royal Bank is issuing more than 40 million shares to help pay for the transaction, which are worth about $3.2 billion at today’s price. Even for Canada’s largest bank, that’s a fair amount of dilution.
I don’t want to suggest that Royal Bank is a poor company. There’s a lot still going for it, and if I held shares, I don’t think I’d sell them. But after the 10% run up in the stock, I’d advocate being patient before buying shares.
How about the other bank shares?
Royal Bank makes up just one of the so-called "big five." How do prospects look for its peers?
In this FREE report, we cover everything you need to know about Canada's big five—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 Nelson Smith has no position in any stocks mentioned.