When American investors consider buying stock of a bank, the first ones that usually come to mind are the dominant forces in American banking. Banks like Wells Fargo & Co (NYSE:WFC), Bank of America Corp (NYSE:BAC), and JPMorgan Chase & Co. (NYSE:JPM) come to mind. But I strongly feel it would be wise for investors to consider one from the Great White North.
According to the World Economic Forum, Canada’s banking system has been ranked the strongest in the world for three years running. In 2012, CNBC released its list of the 50 safest banks in the world. Canada had seven banks in the top 50, more than any other country.
Five heavyweights dominate the banking scene in Canada. In order of market capitalization they are: Royal Bank of Canada (USA) (NYSE:RY), Toronto-Dominion Bank (USA) (NYSE:TD), The Bank of Nova Scotia (USA) (NYSE:BNS), Bank of Montreal (USA) (NYSE:BMO), and the Canadian Imperial Bank of Commerce (USA) (NYSE:CM) rounds off the list.
Dividend discussion
Some of the largest banks in the United States have decent yields. Among America’s five largest banks, Wells Fargo and JPMorgan Chase lead the way with each yielding 3%. Three percent is certainly a respectable yield. But all of the largest five Canadian banks yield more than JPMorgan and Wells Fargo, every single one! Let’s take a look:
| RY | TD | BMO | BNS | CM | |
| Dividend Yield | 4.3% | 4.0% | 5.0% | 4.4% | 5.2% |
| Payout Ratio (TTM) | 45% | 43% | 48% | 43% | 46% |
| First Dividend (mm/yyyy) | 10/2000 | 9/2000 | 8/2000 | 10/1998 | 9/2000 |
| % of quarters missed(since first dividend) | 19.6% | 19.23% | 15.38% | 17.24% | 11.54% |
All five of these dividends have similar payout ratios, and began paying a dividend around roughly the same time. If I had to pick one of these dividends, I would go with the CIBC. It has the highest yield, and has been the most consistent dividend payer of the five.
Two of Buffett’s favorite bank metrics
Two of the best metrics for getting to the bottom of whether a bank is of a higher quality than its peers are return on assets and return on equity.
Return on assets is a measure the amount of profits the company generates relative to the amount of assets it took to earn those profits.
Return on equity is a measure of the amount profits a company is able to generate relative to how much equity capital is being utilized by the firm. In both cases, the higher the ratio, the better.
Here’s how the Canadian big five stack up in terms of ROA and ROE. I’ve also included an American bank that is generally regarded as being of high quality, Wells Fargo.
| RY | TD | BMO | BNS | CM | WFC | |
| Return on Assets (TTM) | .9% | .8% | .7% | .9% | .9% | 1.7% |
| ROA avg: 2008-2012 | .7% | .7% | .6% | .8% | .5% | .3% |
| Return on Equity (TTM) | 17.9% | 14% | 13.9% | 16.8% | 19.8% | 13.1% |
| ROE avg: 2008-2012 | 16.9% | 17.2% | 13.0% | 19.4% | 14.6% | 11.9% |
Wells Fargo managed to crush the Canadians in return on assets over the TTM, other than that, WFC doesn’t have much to brag about. Personally, I place more value on five-year averages than one year’s results. Over the past five years, in terms of ROE, The Bank of Nova Scotia has led the way with a scorching 19.4%!
The famous tier 1 capital ratio?
The Federal Reserve of the United States has been conducting annual stress tests since 2009. Whenever they take place, the figure everyone’s eyes are drawn to is the famous tier 1 capital ratio. The tier 1 capital ratio is a gauge of how well a bank could withstand an economic crisis of epic proportions.
Computation of the ratio can get incredibly complex, but the basic idea is this. The tier 1 capital ratio is the ratio of a bank’s core equity capital to risk weighted assets. Just what exactly do those terms mean?
Core equity capital consists mainly of shareholder’s equity and disclosed reserves. In this situation, shareholders equity represents the total amount that investors have placed in the firm (via purchasing shares and bonds), not the equity amount listed on the balance sheet. Bank reserves are pretty simple.
Risk weighted assets are what is being measured against core equity capital. Calculation of RWA requires assignment of a risk factor to all tangible assets on the balance sheet (with a few small exceptions, for example equity interest in a subsidiary having nothing to do with banking).
The scale ranges from 0% to 100%. Assets that are essentially without risk, for example cash and U.S. government backed securities, are assigned a 0% risk factor. Incredibly risky assets like unsecured loans are assigned a risk factor of 100%. Only assets with a risk factor above 0% contribute towards the risk weighted asset total.
I may have massively oversimplified things, but some of the nuances of this formula, to me at least, seem pointlessly complex. I hope you were able to achieve a basic understanding (which was as far as I got) of this ratio that has become a prominent metric for evaluating banks. Here’s how Canada’s big five compare with Wells Fargo in tier 1 capital ratio.
| RY | BMO | TD | BNS | CM | WFC | |
| Tier 1 Capital Ratio | 9.1% | 9.7% | 8.8% | 8.2% | 12.2% | 8.39% |
The top tier 1 ratio belongs to the Canadian Imperial Bank of Commerce. Who would’ve guessed that the smallest of the big five would outperform the mighty Wells Fargo?
Recent developments
In the past few months, each of these Canadian banks have taken steps to ensure solid performance in the coming years:
In the second quarter of 2013, Toronto-Dominion Bank (USA) (NYSE:TD) purchased the credit card portfolio, containing nearly $6 billion in loans, of Target Corporation (NYSE:TGT). That acquisition no doubt contributed towards its YoY earnings growth of 6%.
Royal Bank of Canada (USA) (NYSE:RY) has taken a stand against high frequency trading, an activity that is anathema to true investors. Executives at the bank recently announced plans for a new exchange in Canada that be constructed in a way as to be less hospitable to high frequency traders than the TSX. As an investor and not a trader, I applaud when companies do things like that. It speaks of the bank’s desire to do what’s best for its customers, not what will generate profits the fastest, which in the long run will pay off for the bank in terms of an enhanced reputation.
In April, the Canadian Imperial Bank of Commerce significantly expanded its American wealth management operations via the acquisition of Atlantic Trust Private Wealth Management for $210 million. Not a gigantic acquisition by any means, but it is in line with the bank’s strategy to seek, as promulgated by CEO Gerald McCaughey, “gradual acquisitions of moderate size.” No Autonomy-like fiasco should ever hit this bank.
Final Foolish thoughts
Investors looking for a bank to invest in should look no further than Canada. In terms of tier 1 capital ratio all but one of the “big five” have a higher ratio than Wells Fargo, a bank that is always near the top of the class when stress testing time arrives. In terms of average ROE for the past half decade they all have left Wells Fargo in the dust.
Many investor’s are afraid that incredibly low interest rates coupled with climbing consumer debt levels will inevitably lead to a bursting housing bubble in Canada’s future. But I still see these banks, with strong records of financial prudence and stability, as being better investments than the vast majority of their American counterparts.
In addition, several of these banks have taken significant steps to increase American exposure, notably Toronto-Dominion Bank (USA) (NYSE:TD) and the CIBC.
Personally, my favorite bank of the big five right now is the CIBC. It has the largest dividend yield, and the lowest percentage of quarters in which it missed a payment. It also had the highest ROE figure (most recently) and tier 1 capital ratio. If a crisis hits Canada, the CIBC will be well equipped to handle itself.
My personal preference aside, right now I don’t think you can really go wrong with any of the banks in Canada’s big five.
The article Thinking About Buying a Bank? Consider Canada originally appeared on Fool.com and is written by Ryan Palmer.
Ryan Palmer has no position in any stocks mentioned. The Motley Fool has no position in any of the stocks mentioned. Ryan is a member of The Motley Fool Blog Network — entries represent the personal opinion of the blogger and are not formally edited.
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