Canadian bank stock earnings have proven to be a mixed bag, as evidenced by the recent quarterly report from Canada’s largest bank, the Royal Bank of Canada (TSX: RY).
On one hand, RBC showed promising growth as profits increased across multiple divisions by $295 million to $3.9 billion.
However, the quarter also revealed some concerns, such as a rising headcount expense, an increase in provisions for credit losses, and a commitment to cutting up to 2% of its workforce in the coming quarter.
Expenses and bad loans have increased, and there’s a backdrop of job cuts and wage inflation that’s affecting the bottom line.
For these reasons, I tend to steer clear of investing in individual stocks, even those that are as seemingly solid and large as RBC. The complexities of the banking sector, especially amid a shifting economic landscape, can add layers of risk that many investors may not be comfortable with.
So, what’s the alternative? Here’s what I would personally buy instead.
Diversification is the name of the game
Rather than delving into the usual spiel about the benefits of diversification, let’s explore some hypothetical “what-if” scenarios that could impact investors solely holding RBC stock.
- Dividend Cut: Imagine a future economic downturn that severely impairs RBC’s cash flow. Under such strain, one of the first things to go could be the dividend payouts, a key reason many investors hold RBC stock in the first place.
- Regulatory Issues: U.S. regulators are already pressing banks to set aside more cash to guard against risks. If new stringent regulations were to be imposed, especially those affecting international operations, RBC could see a hit on its profitability and stock value.
- Increased Provisions for Credit Losses: With interest rates skyrocketing, the possibility of more loans going bad increases. If RBC has to set aside even more money for potential credit losses, that’s less money for operations and dividends, impacting both the bank’s performance and investor sentiment.
While RBC is undoubtedly a strong institution, these scenarios are far from impossible, and they could seriously dent the returns for investors who are solely vested in RBC stock.
The only effective antidote against such “what-if” pitfalls is diversification. Don’t just stop at RBC; consider diversifying your portfolio by including its competitors. Doing so can help balance out the idiosyncratic risks tied to one institution.
What I would invest in instead
If you’re wondering how best to achieve this diversification without having to pick and choose individual stocks, I have the perfect exchange-traded fund (ETF) for the role: the BMO Equal Weight Banks Index ETF (TSX:ZEB)
ZEB currently holds all six of the big Canadian bank stocks in equal proportions – in addition to RBC, the ETF also holds Toronto-Dominion Bank, Bank of Nova Scotia, Bank of Montreal, Canadian Imperial Bank of Commerce, and National Bank of Canada.
By investing in ZEB, you change your investment thesis from betting on RBC outperforming in perpetuity to the Canadian banking sector continuing to grow and post profits, which I think is a much smarter and safer bet.
Here’s a another bonus of ZEB: while its underlying bank stocks pay quarterly dividends, ZEB pays monthly dividends. If you’re looking for consistent income, this ETF is the way to go, especially considering it’s paying an annualized distribution yield of 5.19% as of August 25, 2023.
