Royal Bank (TSX:RY) and TD Bank (TSX:TD) have moved higher in recent weeks. Investors who missed the bounce in the TSX banks are wondering if RY stock or TD stock is still undervalued and good to buy for a self-directed Tax-Free Savings Account or Registered Retirement Savings Plan portfolio.
Bank stock outlook
Investors started dumping bank stocks in 2022 when the Bank of Canada and the U.S. Federal Reserve began increasing interest rates to get inflation under control. The fear among investors is that the central banks have been too aggressive in their approach and will ultimately force the economy into a deep recession.
Rate hikes take time to work their way through the system. There is clear evidence that consumers are starting to ease up on spending as they get hit with higher borrowing costs. The employment market remains robust, but layoffs are mounting, and job listings are starting to decline, as businesses adjust to the economic slowdown.
The drop in the prices of bank stocks likely went too far, and bargain hunters have moved into the sector in the past month in the hopes that rates have peaked and that there will be a soft landing for the economy.
Investors should expect some ongoing turbulence until there is clarity on when the central banks will start to reduce rates again to avoid driving the economy into a prolonged slump. Economists broadly anticipate a short and mild recession to occur. If that turns out to be the case, bank stocks are probably still cheap.
Royal Bank is Canada’s largest bank, with a current market capitalization of nearly $175 billion. The stock trades for close to $124 at the time of writing. That’s up from the 2023 low, around $108 but still down from the $147 it hit in early 2022.
The bank remains very profitable, even in the current challenging economic conditions. Royal Bank reported fiscal 2023 adjusted net income of $16.1 billion. This is a bit higher than fiscal 2022.
Adjusted diluted earnings per share (EPS) increased by 2%. Adjusted return on equity (ROE) fell to 15.4% from 16.6%. Despite the dip, RBC is still very profitable by global bank standards.
Royal Bank finished fiscal 2023 with significant excess cash. The common equity tier-one (CET1) ratio was 14.5%. Canadian banks are required to have a CET1 ratio of 11.5%, so there is ample protection against an economic crisis.
Normally, Royal Bank wouldn’t keep this much money sitting on the sidelines, but a good chunk of the cash is earmarked to cover the $13.5 billion the bank has agreed to pay to acquire HSBC Canada. The deal is still waiting for final government approval. If it gets the green light, Royal Bank investors should benefit in the next few years.
Royal Bank just announced its second dividend increase in 2023. The decision suggests the board is comfortable with the profit outlook, even as provisions for credit losses (PCL) increase due to the surge in interest rates by the Bank of Canada and the U.S. Federal Reserve in their battles to get inflation back down to the 2% target.
At the current share price, Royal Bank provides a 4.45% dividend yield.
TD is another Canadian bank giant with a current market capitalization of close to $150 billion. The stock trades for close to $82 at the time of writing compared to about $76 at the low point this year and is still down from the $108 the stock fetched in the first part of 2022.
TD also remains very profitable. The bank generated fiscal 2023 adjusted net income of $15.14 billion compared to $15.43 billion in fiscal 2022. Adjusted diluted earnings per share came in at $7.99 compared to $8.36 last year. The adjusted ROE was 14.4% for the year, down from 15.9%, but it is still at a strong level.
TD finished fiscal 2023 with a CET1 ratio of 16.2%. The bank built up a war chest to pay for its planned US$13.4 billion acquisition in the United States, but TD ultimately walked away from the purchase of First Horizon, a regional bank, citing regulatory hurdles.
TD investors are probably relieved the deal didn’t go through. The company had agreed to pay US$25 per share for First Horizon. At the time of writing, the stock trades for less than US$14 per share.
TD now intends to grow the American business organically, which will use up some of the cash pile. It also wouldn’t be a surprise to see another acquisition emerge, possibly in a different market, while bank valuations remain under pressure.
TD had to walk back its guidance for earnings growth after it ended the pursuit of First Horizon. That’s part of the reason the stock took such a big hit before the recent bounce.
Investors are still getting paid. TD just increased the dividend by 6.25%. The new quarterly payout of $1.02 per share provides an annualized yield of about 5% at the current share price. This should be a signal to shareholders that the bank isn’t too concerned about the risks to the loan book, even as high interest rates push more borrowers into a difficult situation.
Is one a better pick?
Royal Bank and TD pay attractive dividends that should continue to grow. At this point, TD offers a better yield and is probably more oversold, so I would probably go with TD as the first choice for a portfolio targeting passive income.
Royal Bank could come under some pressure if the government decides to block the HSBC takeover. If that turns out to be the case, investors might want to buy the dip. Royal Bank has been a great creator of shareholder wealth over the long run and deserves to be an anchor position in any buy-and-hold portfolio.