Special Free Report From The Motley Fool

What Every Bank Shareholder MUST Know

When it comes to the Canadian banks, it’s often said there’s only one thing you need to know: You must own their shares. It’s the attitude of many investors as they make bank shares a staple in their portfolio. Likewise, most Canadian equity mutual funds have at least one of the banks among their top holdings.

This should surprise no one. Financial services are the largest sector in the TSX, and Canada’s three largest banks by market capitalization – Royal Bank of Canada (TSX: RY)(NYSE: RY), Toronto Dominion (TSX: TD)(NYSE: TD), and Bank of Nova Scotia (TSX: BNS)(NYSE: BNS) – are also among Canada’s largest companies overall.

Canadian banks are also regarded as very stable, especially compared to their international competitors. They face limited competition, especially compared to the American banks, allowing them to be especially profitable. Our banks also (for the most part) escaped the financial crisis relatively unscathed. And today, they are very well-capitalized.

That said, there are concerns for the banks and their investors. At home, Canada’s real estate market is generally viewed as overheated, and consumer debt levels are at an all-time high. Most people aren’t predicting a crisis like the one that the United States experienced in 2008. But a pullback in real estate prices and/or consumer lending could put a damper on loan growth.

Of the Canadian banks that have significant operations abroad, the environment is not as profitable. This has made earnings growth a concern for each of the big five. This is especially true for the two banks with significant retail businesses in the United States: TD and Bank of Montreal (TSX: BMO)(NYSE: BMO).

How expensive are the shares?

Because the banks are so stable and profitable, investors must pay a premium, at least when looking at book value (the value of a company’s shareholders’ equity as measured on the balance sheet). Share prices for the Canadian banks range from 1.7 times to 2.5 times book value, while the largest banks in the United States can trade below 1.0 times book value.

The big five are much less expensive when looking at them on an earnings basis. Price-to-earnings ratios range from 13.7 for CIBC (TSX: CM)(NYSE: CM) to 19.4 for TD, not high numbers for such strong companies. Clearly there are concerns about the Canadian housing market, the Canadian consumer, and growth prospects. These concerns are not entirely unfounded.

Canada’s banks have also been much more stable over the past decade. While much of this has been due to an ideal operating environment (which may not last), the big five deserve some credit too. They survived the crisis far better than their American counterparts, and have generally avoided making other major missteps too. As a result, their shares have provided solid returns over the past decade, ranging from 6.3% per year (BMO) to 12% per year (RBC & TD).

Due to this stability, the banks can be viewed as a good place to find dividends (yields range from 3.6% to 4.1%). Not coincidentally, the bank with the lowest P/E ratio (CIBC) also has the highest dividend yield, and vice versa (TD has the highest P/E ratio and lowest dividend yield).

The point for investors: What does all this mean for bank stocks?

The Canadian banking industry can be summed up by four simple words: reversion to the mean. In other words, if a bank has a bad year, it’s not particularly difficult to recover. And if a bank enjoys a fantastic year, it often ends up coming back to earth as competitors catch up.

In fact, some commentators have advocated a very simple strategy for investing in Canadian banks: Every year on January 1, simply buy the bank stock that performed the worst the previous year. Then repeat that step every 12 months. That strategy would have returned 17% per year from January 1, 2004, to December 31, 2013, without even including dividends. The comparable number for the iShares S&P/TSX Capped Financials Index is only 8% per year.

While it would be imprudent to base an investing strategy on past stock movements, this anomaly does underscore a crucial point: Canadian bank investors tend to overreact to short-term issues, creating opportunities to pick up the out-of-favour bank at a cheap price.

As we look at each of the individual bank stocks, it’s important to keep the following themes in mind:

• Limited competition, strong regulation, and solid capital positions make the banks very profitable and stable. This is reflected by high price/book ratios.
• There is a general trade-off between value (low price/earnings and high dividend yield) and growth, just like in any other industry.
• The banks have operated in a fantastic environment over the past decade. Given concerns about Canadian housing and the Canadian consumer, darker days may be ahead.
• The banks are generally quite similar to each other.
• Short-term issues tend to fade over time. Thus the best investments tend to be in banks that are most out of favour.

Royal Bank of Canada

Company Snapshot: (data as of August 13, 2014)

Market cap: $114.7 billion
Recent share price: $79.61
Trailing P/E: 13.72
Price/Book Value: 2.5

Royal Bank is Canada’s largest bank by market capitalization, assets, and net income, and arguably has also been Canada’s best-performing bank over the past decade. Over the past 10 years, RBC’s shares have returned 11.4% per year, which ranks it number one among the big five.

RBC has a very strong market position in Canadian banking, with a number one or number two ranking in every product category. But what really separates RBC from Canada’s other banks is its capital markets and wealth management businesses – RBC has the tenth largest capital markets and sixth largest wealth management businesses in the world!

It is these two businesses where RBC has put its main focus. In capital markets, the financial crisis forced many banks in the United States and Europe to scale back and focus on building up capital. The most extreme example of this was UBS’s decision to lay off 10,000 workers – one sixth of its workforce – in 2012. Events like that have allowed RBC, which escaped the financial crisis with minimal damage, to fill the void and pick up market share. Net income from capital markets has increased by over 32% in the last two years alone.

Wealth management has been a similar story. After the financial crisis, RBC has been able to expand its wealth management business while others have retreated. But unlike investment banking, RBC has been growing its wealth management business through acquisitions. A perfect example occurred in 2012 when RBC acquired the Latin American operations of Coutts, a private wealth manager owned by Royal Bank of Scotland (RBS was one of the worst-hit banks during the crisis).

RBC will continue to focus on capital markets and wealth management in its effort to grow earnings. Last year CFO Janice Fukakusa said that RBC is still seeking wealth management deals of up to $5 billion.

What we like

RBC already has a leading position in Canada, but it also a convincing plan to continue growing earnings. Its investment banking and wealth management businesses are not only industry-leading, but provide RBC with a great place to reinvest its capital. We also like its impressive 10-year track record.

What we don’t like

The main problem with RBC shares is its price and, in turn, its valuation. As of this writing, shares trade near their all-time high, and the bank’s 2.5x price-to-book value ratio is the highest among the big five. Also RBC’s capital markets business, which accounts for over 20% of earnings, exposes the bank to higher volatility than the other banks.

Based on the current share price, if you’re looking for a large bank with a big capital markets business, then the American banks probably provide more value.

What to wait for

The main thing you should wait for is a pullback. Right now, everything is going right for RBC, and that is reflected in the bank’s stock price, which provided shareholders with hefty returns over the past year. If you’re patient, there could be better opportunities.

Toronto-Dominion Bank

Company Snapshot: (data as of August 13, 2014)

Market cap: $104.1 billion
Recent share price: $56.52
Trailing P/E: 15.1
Price/Book Value: 2.1

Toronto-Dominion is Canada’s second largest bank based on market capitalization, and unlike RBC, is much more focused on retail banking. But like RBC, it has performed very well over the past 10 years – its shares have also returned over 12% per year in the last decade. Helping it accomplish this is the fact that TD famously dodged the financial crisis as well as any other bank. As a result of this track record, outgoing CEO Ed Clark was recently named Canadian Business Magazine’s “CEO of the Year.”

In Canada, TD is arguably Canada’s premier bank. It battles with RBC for leading market share in most categories. It earned the top spot in JD Power & Associates’ consumer satisfaction survey for the eighth year in a row. And more recently, it solidified its leadership position in credit cards by becoming the primary issuer of Aeroplan cards. All of this has made a return on equity in the Canadian Banking segment of over 45% possible.

TD is also aggressively pursuing the United States market, which it has been doing for the last 10 years. Unfortunately, it has not been easy. The financial crisis and slow recovery have certainly not helped, but TD’s main problem is a more competitive environment, which makes U.S. banking much less profitable. Return on equity last year was just north of 8%, which is actually an improvement over 2011 and 2012.

TD’s problem is that the United States is where all the growth opportunities are. And in order for TD’s growth ambitions south of the border to be rewarding for shareholders, the bank will have to improve its profitability in the region.

What we like

We mainly like TD’s track record, which has been outstanding under Mr. Clark. The bank’s operations in Canada clearly show that TD knows how to gain a market-leadership position, make its customers happy, and make a lot of money at the same time. TD is without doubt one of Canada’s most admired companies, and for good reason.

What we don’t like

There are two things we don’t like:

• The U.S. banking operations. This segment has yet to show it can make a reasonable return on investment. This is an area where TD has made some expensive acquisitions in the past, and the bank hopes this will be the prime source of growth in the future, as well. But this is clearly a show-me story.
• Valuation. TD is even more expensive than RBC. The stock has returned more than 30% over the past 12 months, and is now the second most expensive of the five on a price-to-earnings basis. While there are plenty of things to be admired about TD, the company’s shares seem fully valued at this point.

What to wait for

Like RBC, a pullback in the shares might create a better buying opportunity. This could come from weakness in Canada, perhaps due to issues with the housing market or Canadian consumer. The other thing to wait for is some evidence that the U.S. banking operations can be more profitable.

Bank of Nova Scotia

Company Snapshot: (data as of August 13, 2014)

Market cap: $87.9 billion
Recent share price: $72.25
Trailing P/E: 13.4
Price/Book Value: 2.0

Bank of Nova Scotia is Canada’s third largest bank, and also its most international, with only 52% of net income coming from Canada. The company is especially strong in emerging markets, specifically three geographic regions: Latin America, the Caribbean, and Asia. Its track record over the past decade is not as strong as RBC’s or TD’s, but the bank still did a great job surviving the crisis – over the past 10 years, Bank of Nova Scotia shares have returned 9.4% per year.

Bank of Nova Scotia certainly has its weaknesses (many of them in Canada) where the bank does not have the same franchise strength as many of its peers. For example, the bank has not placed much emphasis on credit cards in Canada and, as a result, has very low market share (although Bank of Nova Scotia has placed a priority on rectifying this).

Internationally, there have been plenty of concerns, especially this year with emerging markets performing so poorly. New CEO Brian Porter has indicated the bank will focus on four countries in particular, all of which are in Latin America: Mexico, Colombia, Peru, and Chile. These countries are all healthy, growing quickly, and badly under-banked, providing a tremendous opportunity for Bank of Nova Scotia to grow its business.

What we like

Bank of Nova Scotia has a very clear strategy for growing earnings outside of Canada; its international banking businesses are a perfect place for it to reinvest capital. Given these opportunities, the shares are not particularly expensive, with both price-to-earnings and price-to-book ratios close to the Canadian bank average.

Bank of Nova Scotia did get caught up in the emerging markets’ selloff, making its shares the second weakest performing of all the banks over the past 12 months. This has made its valuation much more palatable. And, as mentioned earlier, buying the weakest-performing bank stock has worked well in the past.

There’s yet another advantage behind Bank of Nova Scotia’s international exposure: Of all the banks, Bank of Nova Scotia is the least sensitive to the growing economic concerns back in Canada.

What we don’t like

Bank of Nova Scotia’s presence in emerging markets is certainly a great strength, but it does pose some concerns at the same time. Latin American countries owe much of their strong growth over the last 15 years to the commodity boom. And if China slows further (or worse), like many fear it will, it will pose a major challenge to Bank of Nova Scotia’s areas of focus. For example, Chile and Peru are the world’s largest and third largest copper producing countries, respectively. And China consumes about 40% of the world’s copper.

Bank of Nova Scotia is well aware of the risks involved, but hasn’t had to deal with any major crises in Latin America since Argentina in 2001. So we must remember that much of Bank of Nova Scotia’s success since then is due to good luck. Shareholders are hoping that the bank’s luck won’t run out.

What to wait for

As mentioned earlier, the best time to buy a bank’s shares is when short-term issues are grabbing the headlines, and the stock price has become depressed. That is exactly what has happened with Bank of Nova Scotia. So, there’s a strong argument for not waiting at all and buying the shares right away.

Bank of Montreal

Company Snapshot: (data as of August 13, 2014)

Market cap: $51.4 billion
Recent share price: $79.61
Trailing P/E: 12.2
Price/Book Value: 1.7

Bank of Montreal (BMO) is Canada’s fourth largest bank, and also one of the country’s oldest companies.

Like TD, BMO’s growth strategy revolves around the United States. But while TD is focused on the East Coast, BMO has had a strong presence in the U.S. Midwest ever since buying Harris Bank in 1984. More recently, in 2011, BMO doubled its retail banking operations in the U.S. with its $4.1 billion stock purchase of Wisconsin-based Marshall & Ilsley Corp.

Unfortunately, compared to the banks previously mentioned, Bank of Montreal does not have as wonderful a track record. The bank was hurt badly during the financial crisis, having to report a $1.33 billion provision for credit losses from securitized products in 2008. Also, its shares have returned less than 7% per year over the past decade, near the lowest among its peers.

Today, Bank of Montreal is one of Canada’s least profitable banks. Its net margin (net income divided by revenues) in Canada is only 26%, last among the big five. Return on equity for BMO is about 14%, again near the bottom of the big five.

Don’t let all of this scare you, though. It’s important to remember that BMO is still a very strong bank by international standards, whether measured by capital ratios or by profitability. Such is the nature of Canadian banking.

What we like

The main thing we like is the valuation, which is cheap by Canadian banking standards. Its price-to-book ratio of 1.7x is the lowest among the big five, and its price-to-earnings ratio is near the bottom too. Clearly there is a lack of popularity for the company’s shares, and this may provide an opportunity for contrarian investors.

What we don’t like

BMO’s weak track record and lack of profitability are a real concern. Put simply, the bank has had trouble delivering and, as a result, the shares have not performed particularly well.

What to wait for

Like the other big five banks, BMO has posted strong numbers over the past year, and this has helped its share price. But investors should probably wait until BMO posts consistently strong numbers over a long period of time. This will require a lot of patience, but in the meantime, there are likely better opportunities among the Canadian banks.

Canadian Imperial Bank of Commerce

Company Snapshot: (data as of August 13, 2014)

Market cap: $40.1 billion
Recent share price: $100.81
Trailing P/E: 12.8
Price/Book Value: 2.4

CIBC is Canada’s fifth largest bank by market capitalization, and also the one that has changed strategy the most over the past five years. To understand why, one only needs to look back to the financial crisis.

CIBC suffered far more than any of the other big five banks during the financial crisis, with $10 billion in write-downs in 2008 and 2009. In response, CEO Gerry McCaughey focused primarily on lowering the risk profile of the bank. This meant pulling back on its ambitious plans in the United States and focusing on plain old (some would say boring) Canadian banking.

As a result, CIBC is more focused on Canadian banking than any of the other big five, and it shows. Its return on equity of 20.9% ranks number one among its peers, and it is also among the best capitalized. It certainly helps to focus so much on the highly profitable Canadian market, which accounts for 83% of CIBC’s net income (and 92% of its outstanding loans).

CIBC’s focus on Canada certainly has its advantages, but also raises some serious concerns. The main one is that growth will be difficult to come by. Another way of putting it: The bank has nowhere to reinvest the earnings it generates from its highly profitable Canadian banking business. Dividend increases and share buybacks are not enough to appease investors. To address this, CIBC has made growth in wealth management a priority, but that will mainly require growing by acquisition, which can be very costly nowadays.

There’s another concern with CIBC’s complete focus on Canada: The bank is arguably more exposed to a Canadian housing crash than any of the other big five. As a result, CIBC’s shares have a lower price-to-earnings ratio than any of its larger competitors (its low multiple may partly be due to leftover trauma from the financial crisis).

What we like

Thanks to the bank’s focus on Canada, CIBC is Canada’s most profitable bank. It is also arguably the most stable, making it a solid option for most portfolios. We also like the bank’s low price-to-earnings ratio, and as mentioned earlier, CIBC has the highest dividend yield among the big five, at 4.1%.

What we don’t like

The bank’s focus on Canada is also a curse. Lower growth prospects and a supersized exposure to Canada’s housing sector should make any investor nervous. It’s also worth noting that the 10-year return of CIBC’s shares rank well below the average of the big five. Of course, much of that is due to CIBC’s experience during the financial crisis.

What to wait for

We would like to see CIBC show it can reinvest its earnings effectively, and we should get an answer soon. According to numerous insiders, CIBC is in the midst of an attempt to buy Seattle-based Russell Investments, best known for its indices. The price tag reportedly could be as much as $3 billion.

It may be worth waiting until this story plays itself out. At the very least, it will show whether CIBC has to – and is willing to – overpay for acquisition targets in order to achieve growth.

Foolish bottom line

The past year has been wonderful for both the banks and their shareholders. Thanks mainly to a strong housing market, a resilient Canadian consumer, and improving economic conditions in the United States, the banks seemingly can do no wrong. Even Bank of Nova Scotia shares have returned 22.2% over the past 12 months, despite being the second worst-performing shares over this time period.

If history is any indication, Bank of Nova Scotia is, in our opinion, likely the best option. Its shares have the lowest returns over the past 12 months, likely an overreaction to the bank’s emerging markets exposure. Furthermore, its valuation multiples are quite low considering its growth prospects in Latin America. And its track record over the past decade should make investors feel at ease.

That being said, this may not be the best time to purchase any of the bank stocks at all. It’s almost certainly not as good a time as it was last year. But if you’re looking for strong Canadian companies that pay a solid dividend, the banks are still a great place to look.

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Company snapshots as of August 13, 2014. All other figures as of June 30, 2014. As of August 13, 2014, Fool contributor Benjamin Sinclair has no positions in the stocks mentioned above. The Motley Fool has no positions in the stocks mentioned above. All figures stated in Canadian dollars unless otherwise noted.

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