Summary
- RY continues to be a model cornerstone to any long-term portfolio.
- The bank has been acquiring in recent years to spur growth, both in and out of Canada.
- Short-term risks remain, but the bank is conservative and maintains strong profitability metrics. I see it continuing to beat the market. Long live the king.
It's been awhile since I've covered the Canadian banks, but they remain one of my favorite cornerstones in a long-term portfolio. There are few ways to gain access to such a highly-regulated, profitable, oligopolistic business sector with consistent conservative management. The banks have performed very well over time, and all Big Five will likely be here after I'm gone. Looking at the past couple of decades, despite the great financial crisis, Royal Bank of Canada (RY) has soundly beaten the S&P 500 returns.
Not only that, us American investors got an extra sweetener on top, with the US listing outperforming the home market due to foreign exchange shifts.
An investment of $10,000 in 2002 would have netted you an additional $30,000 in RY stock versus investing in SPY. It's impressive considering the scale RY was already at two decades ago, and is a testament to the bank's long-term performance.
As a quick reminder for those who haven't read any of my previous coverage on the Canadian banks, the market is highly regulated. In the 1990's, a couple of key rulings from the Canadian government striking down mergers effectively set the standard that the Big Five had consolidated enough and were set to operate in an oligopoly. The housing market and lending market overall is more conservative than the American one, and in many ways the banking system is behind in terms of financial innovation. Equity percentages remain high, fees remain higher than most American counterparts, and all of this results in profitability metrics consistently higher north of the border.
Over the years, the banks have typically attempted to acquire and grow outside of their borders with mixed success. TD (TD) has a very successful American operation, and the Bank of Nova Scotia (BNS) has long attempted to crack the Latin American market. RY has also expanded into America in hopes of building out its high net worth and wealth management arms. The City National bank merger a few years ago was a big acquisition for the bank, and one that it's still a little unclear is driving improvements to the bottom line as much as was previously hoped. I think this may be even more clear given the bank's two most recent acquisitions were Brewin Dolphin, a British wealth management firm, and HSBC Canada, recently announced in the home market. Management provided some perspective on the earnings call on their expectations for HSBC:
[Y]esterday, we announced the acquisition of HSBC Canada, with an implied consideration of approximately $12.5 billion, net of the locked box agreement, or less than 9x fully synergized 2024 earnings. And given expense synergies and potential revenue opportunities, this transaction is financially compelling. It also offers the opportunity to add a client base in the market we know best. It also positions us as a bank of choice for commercial clients and international needs, newcomers to Canada and affluent clients who need global banking and Wealth Management capabilities.
I'm more bullish on additional moves inside the bank's own borders. Although growth in Canada is limited, the functional profitability metrics are superior, and the main reason I want to own a Canadian bank versus American ones. I'm not entirely confident in this assertion, but I don't believe the Canadian bank management teams are vastly superior to those in other countries as a rule. We are getting better metrics based on the overall banking framework.
RY management should be able to flex the bank's scale to drive efficiency gains and drive much more rapid earnings accretion in their HSBC acquisition than City National. Some discussion from an analyst question on the earnings call adds some perspective here:
Doug Young
Just going back, City National was mentioned a few times in the comments. And when I look at the results, adjusted earnings were down 32% quarter-over-quarter, 42% year-over-year. And you can layer in the NIM comments and NIM expansion has been -- and that's on adjusted earnings, obviously. But NIM expansion has been quite strong, but average earnings haven't -- it hasn't shown through in the bottom line. And so I'm just curious, is this all PCLs? Is this a continuation of the investments? It's hard to get a sense of this given the disclosure. But -- and more importantly, when should we start to see a pivot in the bottom line?
Nadine Ahn
So in terms of we've been commenting over the last couple of quarters our continued investment in this business given the strength of growth we've had in terms of tripling the size of the bank, so we have seen very favorable NIM expansion over the year as interest rates have been rising given the asset sensitivity of City National's balance sheet. We have been similar to what I explained to Ebrahim in Canada, we have also been reducing some interest rate sensitivity in the City National as well to protect us from further downside to the extent that interest rates start to come off in the U.S.
From what we're seeing from an operating leverage standpoint, for City National, we do have the benefit of not only the very strong volume growth that we've seen this year. We expect it to moderate going into 2023. We do see that NIM expansion continue to drive the revenue top line. But the expense growth that we've been investing in has persisted and will persist into next year as we continue to invest in the infrastructure. So realistically, that's just probably going to be a journey over the next year or two. Maybe Graeme can speak to just the credit quality in the book and what we're seeing there.
City National has grown to $100B in assets, but the bank continues to invest to improve operating leverage and improve efficiency ratios. This will be a key portion of the bank to watch going forward. RY has successfully set itself up as the 6th largest wealth advisory firm in the US by assets, with $510B in assets under administration, and continues to grow its US lending arm off a small $9B base.
Looking at overall efficiency ratios, RY remains well below peer averages and has continued to drive the ratio down as they recover from the pandemic. The bank has absorbed significant expense growth in attempts to retain top talent in its Capital Markets division and overall salary inflation, but management continues to project positive operating leverage into next year due to rising interest rates and productivity benefits on top of market revenue recovery.
Whenever I listen to earnings calls or read the transcripts, it's funny to see how the questions play out. I imagine analysts at times like a tank full of sharks, where they all ask questions in the same vein when they sense blood in the water. For a long time, it's been about the Canadian housing market. I'll give an update a little later in the article on that, but this call was about net interest margins. On almost any other call, it's trying to suss out whether a recession has started, even if the metrics don't show it.
In this case, net interest margins are definitely something investors should pay attention to.
Banks tend to benefit from interest rates increasing, as spreads across the business rise between deposits and lending products. However, based on the bank's positioning, there can be more or less variability and sensitivity to rates depending on the status of shorter versus longer term deposit and loan products. Management is projecting rates to peak this next year and begin to decline, so they are attempting to shift the mix to lower the bank's sensitivity to a falling-rate environment. There are a huge amount of moving parts to this, and based on the volume of questions, it's apparent that's top of mind for everyone.
In an oversimplified way of looking at it, the bank will not be immune no matter what. Eventually, results will suffer somewhat, so investors should watch NIM's compared to peers as well as the bank's efficiency ratios. Ultimately, the banking system is used to rates near zero as they have been for the past decade, so I have no doubt they can reposition themselves to operate in that environment again. After all, in a lower rate environment, you'd expect significant refinancing and new lending activity to help salve pains elsewhere in the business. Rates wouldn't be dropping if the central bank didn't see inflation tailing off and improvements in the economy.
As far as risk overall, the bank is positioning itself conservatively expecting some pressure in loan performance from here. The CFO discussed this on the call:
Last quarter, we began increasing our allowances on performing loans reflect deterioration in the macroeconomic outlook. This quarter, we started to see those headwinds manifest, and credit outcomes have started to normalize towards pre-pandemic levels. With this backdrop, we continue to prudently build our reserves. Provisions on performing loans this quarter reflect changes to our base case scenario. It's incorporated in earlier and modestly more severe recessions than previously expected, increases in delinquency rates and credit downgrades and ongoing portfolio growth. In total, our allowance for credit losses on loans increased by $170 million this quarter to $4.2 billion.
Moving to Slide 23 and 24, gross impaired loans were up $140 million or 1 basis point this quarter, noting new formations of impaired loans increased for the third consecutive quarter. Provisions on impaired loans were up $84 million or 4 basis points compared to last quarter, with increases in each of our major lending businesses. The increases in impaired loans and provisions were anticipated to reflect the normalization of credit outcomes I noted earlier. I do want to emphasize that both impaired loans and provisions remain well below pre-pandemic levels. For context, our PCL on impaired loans ratio of 12 basis points remains less than half of 2019 levels.
Based on the bank's remarks, there aren't significant signs of declining performance yet. It was expected to see a normalization in PCL's and GIL's, so I'm not alarmed by these results. The Canadian banks as a rule have been well-positioned and conservative with their loan portfolios.
Looking specifically at the mortgage loan book, the bank broke out above by geography to show exposure to different areas of the country. In the most recent housing boom, the Vancouver and Toronto areas were the most overheated and represented the highest risk of a bubble bursting. However, as I've discussed in previous articles, we are looking at significant amounts of equity in those loans. At origination, the average LTV of 72% overall is significant. With 20% down payments as the norm for uninsured loans in America with other programs allowing 3.5% or lower, the overall loan portfolio in Canada is in a better position for a housing downturn.
The housing market has begun to cool, and prices are dropping across the country, so this provides some perspective as to why the analysts have moved off the housing market as the topic du jour and onto net interest margins. For some additional light reading, Seeking Alpha recently published an article about the Canadian housing market I found interesting .
Looking at returns on equity, RY declined most recently. I haven't dug into BMO's results enough to speak to the spike they show here, but outside of that, RY still leads the pack with TD, which are traditionally the two strongest Canadian banks.
The bank returned 80% of earnings in the most recent year through either dividends or buybacks, but earnings growth came in at only 3% on 2% revenue growth. The company's buybacks of $5B at the current valuation appear appropriate, and management has halted buybacks into next year until the HSBC acquisition closes. I see the dividend as well covered, and it remains a priority for the bank, which has paid one for over a century. The loan-to-deposit ratio remains near a conservative 100%, and the CET1 ratio is well within regulatory frameworks.
As always, remember that for American investors, if you hold Canadian dividend payers in a tax-sheltered account, you don't pay taxes on dividends.
Looking at the bank's long-term graph, it's a benchmark for consistency. Earnings have grown at an average of 10% per year, and the bank is rarely overvalued compared to its average. There have been a few periods where it was a great idea to buy, including the depths of Covid, 2009, and 2016. Today, the bank is just below its long-term average, and the dividend yield stands at about 3.8%.
Based on its long-term average multiple and analyst estimates for earnings growth, an investment today could yield around 15% annualized total returns. This is above the long-term CAGR for the bank, but entirely possible depending on a ton of different factors going forward from here.
RY is making a lot of moves to spur growth. The company is maintaining positive operating leverage, and recently struck a deal to further expand within Canada. City National remains an open question, and a key area to watch going forward for investors. Additionally, the bank's positioning for a change in interest rates will be a driver of results in the coming quarters. As always, RY is positioned conservatively, and maintains excellent profitability metrics. It's a buy, and I anticipate that it continues to beat the market from here.
For further details see:
Royal Bank Of Canada: Long Live The King