The Easy Money in Canadian Banks May Be Gone: These 2 Still Have Room to Run

Canadian bank stocks have gone from boring bargains to the market’s favourite crowded room. Since February, the TSX financial sector has climbed 22%, helping push the broader index to record highs. Investors who bought during the gloom have already been paid rather handsomely for ignoring it.

The rally changed the question

Now comes the harder part. Financial companies represent 37% of the TSX, up from 31% in March, while Canada’s five largest banks trade at an average of roughly 15 times forward earnings. That’s above the 12-times average for their largest U.S. peers and near a multi-decade relative high.

The sector no longer needs investors simply to notice that the economy didn’t collapse. Further gains will likely depend on earnings growing into those richer valuations. That makes selecting individual Canadian bank stocks more important than buying whichever ticker happens to wear a red sign outside a branch.

With that in mind, I’d look for banks with an internal improvement story that can continue even if the sector’s valuation stops expanding. Improving credit costs, rising returns on equity, business reshaping, and dividend growth can still move a stock when the broad recovery trade has run its course. Two banks currently offer different versions of that setup.

BMO

Bank of Montreal (TSX: BMO) spent several years asking investors to be patient with its Bank of the West acquisition and U.S. expansion. That patience is finally producing more visible numbers. Second-quarter adjusted earnings per share (EPS) increased 40% year over year to $3.67, while adjusted return on equity improved from 9.8% to 13.5%.

The biggest swing came from cleaner credit results and stronger performance across the bank. Provisions for credit losses fell to $739 million from $1.05 billion, while adjusted U.S. banking income rose 30% in U.S. dollar terms. Canadian banking earnings increased 15%, wealth management climbed 39%, and capital markets surged 46% on an adjusted basis.

BMO now no longer needs one heroic division to carry the quarter. Commercial lending also grew sequentially in Canada and the United States, suggesting its expensive U.S. platform may finally be shifting from integration project to earnings contributor.

BMO stock trades around 16 times forward earnings. That isn’t cheap, although another year of stronger U.S. returns could make today’s valuation look less dramatic. Investors also receive a $1.71 quarterly dividend, up 5% year over year, for a yield of approximately 2.7%.

BNS

Bank of Nova Scotia (TSX: BNS) offers the messier but potentially more rewarding turnaround. Management has been reducing exposure to lower-return Latin American operations and redirecting capital toward Canada, Mexico, and the North American trade corridor. Its investment in U.S.-based KeyCorp adds another way to participate without building an American bank from scratch.

The early results are encouraging. Second-quarter adjusted EPS rose 33% to $2.02, while adjusted net income reached $2.65 billion. Revenue growth, improving margins, and better operating efficiency helped offset still-elevated credit costs. Management also raised the quarterly dividend from $1.10 to $1.14.

Scotiabank stock’s $4.56 annualized dividend yields approximately 3.7%. The shares trade around 17 times trailing earnings, so the turnaround is no longer a secret. However, further progress toward management’s higher return-on-equity goals could still support earnings growth after the initial rerating.

Foolish bottom line

Both banks remain exposed to consumer weakness, commercial real estate, unemployment, and loan losses. BMO’s U.S. business still has to justify years of investment, while Scotiabank stock’s restructuring could take longer than investors expect. Richer sector valuations leave less room for an ugly quarter.

The effortless bank trade may be finished, but earnings-driven gains don’t have to be. BMO offers improving U.S. returns and broad profit growth, while Scotiabank stock offers a higher yield and an unfinished strategic rebuild. I’d buy gradually, keep the overall financial allocation sensible, and use Canadian bank exchange-traded funds instead if choosing between turnaround stories sounds too much like unpaid overtime.