The big five Canadian banks remain buys

From the universe of top financial stocks, we continue to advise you to buy the big five Canadian bank stocks. They’re safer than most companies, such as suffering commodities producers. They pay better dividends than the market. They raise their dividends often. And they trade at more attractive prices than the market.

The shares of the big five Canadian banks struggled in fiscal 2015. That’s likely because the market is worried about several factors. Just keep in mind that the market is said to ‘climb a wall of worries’. We continue to rate all five bank stocks as buys for attractive and growing dividends, long-term share price gains and to preserve your money.

Our advice is counter to the market’s advice in three cases. The consensus of seven analysts is to ‘hold’ Bank of Montreal (TSX─BMO), commonly known as BMO. The consensus of eight analysts is to ‘hold’ Bank of Nova Scotia (TSX─BNS), commonly known as Scotiabank. The consensus of five analysts is that Canadian Imperial Bank of Commerce (TSX─CM), or CIBC, is rated ‘underperform’. That’s a polite way of saying ‘sell’.

We agree with the consensus on the other two members of the Canadian big five banks. The consensus of nine analysts is that Royal Bank of Canada (TSX─RY), or Royal, is a ‘buy’. Similarly, the consensus of nine analysts is that Toronto-Dominion Bank (TSX─TD), or TD, is also a ‘buy’.

One of the market’s legitimate worries is that the big five’s earnings per share will grow slowly. In fiscal 2016 (which began November 1), BMO’s earnings are expected to rise by three per cent, to $7.21 a share. Scotiabank’s earnings are expected to climb by 3.7 per cent, to $5.93 a share. CIBC’s earnings are expected to inch up by 0.3 per cent, to $9.48 a share. Royal’s earnings are expected to grow by three per cent, to $6.86 a share. And TD’s earnings are expected to advance by 4.8 per cent, to $4.83 a share.

The banks could beat expectations

These earnings estimates are below the big five’s traditional earnings per share growth rates. But we suspect that they could do somewhat better than expected. For one thing, consumers continue to borrow more. Car loans have grown briskly. Also, rising house prices have raised the size of mortgages. And as we often say, ‘the banks have a finger in every pie’. That is, they profit in most aspects of being full financial services providers. With an aging population, this industry is bound to grow.

For another thing, historically-low interest rates have reduced the cost of servicing consumer debt. This means that most borrowers can afford to pay and to avoid defaults. This should hold down the banks’ ‘bad loans’, or ‘provision for loan losses’.

Then, too, half the story is what you earn. The other half is what you spend. The big five banks are aggressively cutting their costs. And share buybacks, of course, also raise earnings per share.

Based on earnings estimates, the big five banks trade at attractively-low, forward price-to-earnings, or P/E, ratios. At a price of $79.70 a share, BMO’s P/E ratio is 11.1 times. At $59.44 a share, Scotiabank’s P/E is 10 times. At $97.81 a share, CIBC’s P/E is 10.3 times. At $76.59 a share, Royal’s P/E is 11.2 times. At $54.77 a share, TD’s P/E is 11.3 times. The S&P/TSX Composite Index’s average trailing P/E ratio, by contrast, is a less appealing 22 times.

Banks are also assessed based on their ROEs (or Return-On-Equity). Last year, BMO’s ROE was 12.32 per cent. In other words, the bank made $12.32 for each $100 owned by the common-stock shareholders. Scotiabank’s ROE was 14.25 per cent. CIBC’s ROE was tops at 18.44 per cent. (We don’t share the analysts’ consensus that CIBC is an ‘underperform’.) Royal’s ROE was 17.82 per cent. And TD’s ROE was 13.2 per cent. Lower ROE on its large and growing American operations has held back the ROE of TD’s overall operations, at least temporarily.

Based on their share prices and dividends, the big five Canadian banks offer attractive yields. With a dividend of $3.36 a share, BMO yields 4.22 per cent. With a dividend of $2.80 a share, Scotiabank yields 4.71 per cent. With a dividend of $4.60 a share, CIBC yields 4.7 per cent. With a dividend of $3.16 a share, Royal yields 4.13 per cent. And with a dividend of $2.04 a share, TD yields 3.72 per cent. The S&P/TSX Composite Index’s yield over the 12 months to December 4 averaged less than 3.07 per cent.

The big banks regularly raise their dividends. The only exception was during the last financial crisis, when regulator OSFI (the Office of the Superintendent of Financial Institutions) wanted them to merely maintain their dividends. OSFI wanted to examine the new international capital requirements and make sure that Canadian banks made the grade. The banks exceeded the requirements and resumed raising their dividends.

Go for growing income and price gains

Rising dividends give you a growing stream of income, of course. They also increase your chances of earning share price gains. That’s because rising dividends will make the banks’ dividend yields better and better. At some point, the yields will become too good to ignore. Then income-seeking investors will bid up the price of your shares.

A critic might sniff that the big five banks almost always trade at better prices than the market and yield more than the market. Our view is that as long as this is the case, its pays to include their shares as core holdings of your portfolio.

Another worry of the market is that Canadian housing markets may suffer a U.S.-style collapse. Indeed, the OECD (Organization for Economic Coordination and Development), the IMF (the International Monetary Fund) and The Economist magazine have warned that Canadian houses are overpriced. Remember that these are independent organizations with no agenda to influence Canadian politics.

One plus is that Canada has regulated its real estate market more tightly. Early on, we avoided a large build up of sub-prime mortgages and so-called NINJA loans (No Income, No Job or Assets. Ninjas were professional Japanese assassins). Amortization rates were substantially shortened. And CMHC (Canada Mortgage Housing Corp.) no longer insures mortgages on houses that sell for $1 million or more. While this cools the real estate market, the banks could lose on some large, uninsured mortgages.

House prices in hot markets like Vancouver and Toronto can’t keep rising as they have in recent years. Otherwise only the wealthy could afford to buy. There aren’t enough wealthy people to buy all the houses for sale at high prices. One partial offset is that gasoline prices are much lower. This can save money, especially for commuters. Also, the lower loonie should improve the competitiveness of Canadian exports. This should create some jobs.

Smaller banks and FinTechs

We’ve focused on the big five banks. At the same time, smaller banks also remain on buy. This includes National Bank of Canada (TSX─NA), Laurentian Bank of Canada (TSX─LB) and Canadian Western Bank (TSX─CWB).

One of the market’s worries about the big five banks is the rise of what’s known as ‘FinTechs’. Some believe that financial technology firms will do to the banks what Uber Technologies Inc. is doing to the taxi industry. Our view is that this threat is exaggerated. The banks are entrenched.

Older Canadians own the lion’s share of money. Most of them have dealt with the big five banks for decades, particularly when you include bank-owned brokerage firms, trust companies, insurers, credit cards and so on. Older Canadians know that the big five Canadian banks are solid. It’s also a nuisance to switch your business to another bank. That’s especially true if you need services that it doesn’t provide.

Some FinTechs look like they’re struggling. Consider California-based Square, Inc. (NYSE─SQ) which is a financial services and mobile payment company. Its initial public offering valued it at US$4 billion. This was down by a third from US$6 billion under its previous round of private financing. If it were doing very well, it would’ve fetched more when it went public.

 

The Investment Reporter, MPL Communications Inc.
133 Richmond St. W., Toronto, On, M5H 3M8, 1-800-804-8846

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