Canadian Bank Stocks: 2 to Buy, 1 to Sell

by Dan Burrows | May 30, 2013 12:45 pm

A decelerating economy and frothy housing market have investors worried about the future of Canadian banks.

And they probably should be. Our neighbors to the north can’t seem to catch a break these days. The economy is sucking wind, hurt by the steep drop in global commodities prices and truly epic levels of consumer debt.

Two years ago, the Canadian economy was growing at an annual rate of as much as 3.8%. Today it’s squeaking along at an annual rate of 1.1% — and the trend is decidedly down.

At the same time, residential property prices have leaped nearly 90% in the last decade, and Canadians have loaded up on debt. Indeed, household debt now amounts to 165% of disposable income. Americans’ personal balance sheets were similarly bloated during the darkest days of the mortgage crisis.

The commodities-and-debt-fueled economic boom is over, and housing appears overheated. No wonder the market is leery of Canadian bank stocks.

But hefty dividends, diversified revenue streams and compelling valuations make some of them look pretty good right here, while others appear too risky for the potential rewards.

Here, then, are two Canadian bank stock buys — and one to avoid:

Buy: Bank of Nova Scotia

Don’t let the provincial name fool you: Bank of Nova Scotia (BNS[1]) is the Canadian lender with the least exposure to the domestic economy. Acquisitions and a truly global strategy have made the bank a sprawling international firm with operations in faster growing markets in Asia and Latin America. Those overseas businesses accounted for half of last year’s profit.

As Moody’s says in a note to clients:

“BNS has the most diversified earnings profile of the peer group at the business segment level and arguably the most line of business diversification within those segments, given the numerous geographies in its international division and its diversified capital markets lines of business.”

Furthermore, the bank has a history of low earnings volatility, thanks to the “consistent quality of execution against its diversification strategies,” Moody’s says.

Shares in BNS traded on the New York Stock Exchange have held up well for a major Canadian bank, losing just 1% so far this year. Furthermore, at a price-to-book value (P/B) of 1.8, BNS doesn’t appear overvalued, trading in line with the Canadian big-bank average. Meanwhile, it sports a forward dividend yield of 4.1%.

Buy: Bank of Montreal

On the plus side, Bank of Montreal‘s (BMO[2]) residential mortgage business is smaller than the competition’s. On the downside, the firm has relatively high exposure to other consumer loans, both secured and unsecured. Indeed, according to Moody’s, BMO held 20% of total Canadian consumer loans at the end of October.

Fortunately, the bank has other critical revenue streams — notably its capital markets business, which kicks in about a quarter of profits. It’s also growing its corporate and investment banking business in the U.S., where capital markets are on the upswing.

That business diversification and increasing U.S. exposure — about 30% of BMO’s business already comes from American retail banking — offers a cushion against deteriorating credit quality at home.

BMO shares trading on the NYSE are off 1.5% year-to-date, making the P/B a relatively compelling 1.5.

Even better, BMO is a dividend machine. The current yield stands at 4.8% and the five-year average is a whopping 5.2%. Perhaps best of all, the bank hiked its payout by an average of 9% a year during the past decade.

Sell: Canadian Imperial Bank of Commerce

True, the dividend yield is 4.7% with a five-year average of 5.4% and the bank has the strongest balance sheet in the sector, according to Bloomberg, but Canadian Imperial Bank of Commerce (CM[3]) looks too vulnerable to further economic deterioration.

CIBC is not only the smallest of the big Canadian banks, but it’s also the least diversified. Yes, it has wealth management and wholesale banking divisions, but two-thirds of revenue and earnings come from domestic retail and business banking.

Here’s Moody’s again:

“In the event of a sharp system-wide economic shock, or a prolonged period of low growth and low interest rates, CIBC has only modest ‘shock absorbers’ in the form of diversified earnings to offset earnings erosion and/or capital charges attributable to increased Canadian consumer loan losses.”

Shares in CIBC traded on the NYSE are off 3.7% year-to-date and still look expensive relative to peers. The P/B of 2 equates to a premium of more than 10% vs. the big-bank average.

As of this writing, Dan Burrows did not hold a position in any of the aforementioned securities.

  1. BNS:
  2. BMO:
  3. CM:

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