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High Yields from the
World's Soundest Banks |
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Published:
December 1, 2008
Famous hockey player Wayne Gretzky once described the key to his
success: "I skate to where the puck is going to be, not to where
it has been." This is great advice for investors in today's
market -- especially when they're looking at Canadian banks.
Canada's banks have taken a hit with the broader market, but
it's where these stocks may be going next that makes them well
worth considering.
Canada has six major domestic banks, which account for over 90%
of the assets of the country's banking industry. All but one of
them, the National Bank of Canada, trade on the New York Stock
Exchange. Royal Bank of Canada (NYSE: RY) is the country's
largest lender by assets, followed by Toronto-Dominion (NYSE:
TD), Bank of Nova Scotia (NYSE: BNS), Bank of Montreal (NYSE:
BMO), and Canadian Imperial Bank of Commerce (NYSE: CM).
Although these five banks are not exactly household names for
U.S. income investors, they should be. They sport dividend
yields of up to 8.4%, boast an average 3-year dividend
growth record of +16.8%, and have upped their dividends over the
past year an average of +18.8%, and thus far there hasn't been a single dividend cut
among them.
Canadian Banks Are The Soundest In The World
It may surprise some readers that Canada's banks were rated the
strongest in the world last month by the prestigious World
Economic Forum. Canadian lenders score top marks as the most
solvent among 134 countries. The banks are also
rated fifth in the world for investor protection and sixth for
financial market sophistication.
Standard & Poor's recently came to the same positive conclusion
about Canadian banks. The credit rating agency wrote in a
mid-October client note that Canadian banks are well positioned
to weather the downturn. Despite some challenges, S&P analyst
Lidia Pareniuk said Canada's banks have "substantially more
robust balance sheets and capital positions and lower risk
profiles" than their peers in either the U.S. or Europe.
Canada's banks have escaped relatively unscathed from the large
subprime mortgage losses suffered by their banking brethren
worldwide. They have combined write-downs of about C$11.6 billion
on U.S. subprime debt and structured finance products. That's
still a tiny portion of some $967.5 billion of write-downs and
losses suffered by banks around the world since the third
quarter of 2007, according to Bloomberg data.
The country has a healthy housing sector, where subprime
mortgages are far less common than in the U.S. Canada's
Department of Finance estimates subprime mortgages represent
less than 5% of all outstanding mortgages in the country,
compared with about 20% in the U.S.
The tightly regulated banking system also helps keep the banks
in good financial shape. The conservative capital ratios of
Canadian banks are the envy of the world. According to Bank of
Canada Governor Mark Carney, Canadian lenders maintain an
average asset-to-capital ratio -- a measure of loans issued to
cash on hand -- of 18. He compared that to an average of 25 for
U.S. investment banks, 30 for European banks, and more than
40 for some major global banks.
Major Entry Opportunity
Despite getting top marks as the world's soundest financial
institutions, Canadian banks are being punished along with their
peers in the U.S. and Europe. Canadian bank stocks, as measured
by the iShares Canadian S&P/TSX Capped Financial Index Fund
(Toronto: XFN), are down over -30% during the past three months.
 And
that spells opportunity. Since price and yield move in opposite
directions, as share prices have fallen, yields on Canadian bank
stocks have risen to unprecedented levels.
For example, shares of Bank of Montreal (also known as BOM), profiled below,
have shed close to -40% since late August, pushing the yield to
8.4%. That's more than two and a half times the bank's average
dividend yield of 3.2% over the past decade.
It's the same story for the Canadian Imperial Bank of Commerce
(CIBC), also profiled below. Today its dividend yield of 8.2%
is nearly two and a half times its 10-year average of around 3.3%.
Of course, a higher-than-usual dividend yield can sometimes
signal investors believe the dividend is at risk. While we can
never rule out a dividend cut down the road, recent actions
suggest that Canadian banks are generally confident in their
future.
Bank of Nova Scotia and Toronto-Dominion both raised their
dividend over the past 12 months, while Royal Bank, Bank of
Montreal, and Canadian Imperial Bank of Commerce upped their
dividend last year and have kept that rate thus far through
2008.
As an added bonus, the reverse side of these above-average
yields is the below-average prices these bank stocks are
sporting right now. In other words, the shares carry strong
capital gains potential. For example, the share price of CIBC
and BMO could more than double if their yields revert to historical
levels. Meanwhile, investors will be paid handsomely while they
wait for a turnaround.
No Government Bailouts
We aren't suggesting Canadian banks have dodged all the bullets
that hurt banks in other countries, but their challenges have
been much more limited. In fact, they are thus far weathering
the financial crisis without looking to the government for huge
bailouts.
Canadian Prime Minister Stephen Harper last month came out
strongly against any such government aid. "'There is no
question, no possibility of bailing out the banks," Harper said. "The banks aren't seeking to be bailed out, the
government won't be bailing them out. That isn't going to
happen."
That's good news for shareholders, since there's no such thing
as a free lunch. The $250 billion capital injection the U.S.
government is providing domestic banks comes with strings
attached. Some of these strings could impact shareholders. For
example, banks that participate in this program cannot buy back
their common shares and will need Treasury approval to increase
their dividends. The approval process will likely rein in
dividend growth in the months ahead.
Still, the Canadian government has taken steps to ensure the
country's banks remain competitive on the world scene. In what
is known as "regulatory arbitrage," there is risk that banks
with government guarantees or funding could have an easier time
raising money in international credit markets than Canadian
banks. That, in turn, could make it costlier for Canadian
companies to access the cash needed to fund operations, forcing
them to cut back lending to consumers and businesses.
As part of a series of measures, then, Canada's government
pumped C$25 billion of liquidity into the country's financial
system. It also agreed to a six-month guarantee on up to C$215
billion of capital that the banks borrow in international
markets to ensure Canadian banks aren't hurt by the rescue
packages other governments offered their own banks. The
government further agreed to buy up to C$75 billion of
government-insured mortgage securities and pledged to take any
further steps to protect Canadian banks from the global credit
crunch.
Canada Not Immune to Global Pressures
Even so, tight credit markets and slowing demand for Canada's
export commodities like oil and metals are weighing on the
economy and dampening the earnings outlook for the country's
banks. Canada's central bank now says the country's economy will
advance by only +0.6% this year and next year, before recovering
to a +3.4% growth rate in 2010.
Meanwhile, analysts have lowered their earnings guidance on
Canada's banks in anticipation of reduced revenues on debt
financings and increased write-downs on debt securities tied to
the U.S. credit markets. Over the past three months, current
earnings estimates for the banks in 2008 have dropped an average
of -14%, while 2009 forecasts are -19% lower. In addition, the
banks are expected to see earnings decline an average -12% this
year, although aggregate earnings are expected to swing to a
growth rate of about +5% in 2009, according to consensus
estimates provided by Thomson Financial Network.
Investors should also be aware that these bank stocks trade as
American depository receipts (ADRs). That means dividends
are priced in local Canadian currency and translated into U.S.
dollars at the going exchange rate. If the Canadian dollar (also
called the "Loonie") strengthens against the U.S. dollar, the
distributions will be worth more for U.S. investors.
Unfortunately, the reverse is also true.
The Canadian dollar tends to rise and fall with oil and metals
prices. The current downward pressure on commodity prices has
pushed the Canadian dollar down to around US$0.78 today, from a
recent high of US$0.97 in late September. As with any
commodity-driven currency, the volatility is a potential risk
factor for investors.
Note: All yield information was
calculated as of 11/20/08. |
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