2023-05-04 12:00:35 ET
Summary
- Building on a 153-year dividend history, Royal Bank has achieved a best-in-class annualized dividend growth rate of 9.8% over the past 20 years.
- Reflecting its quality and franchise strength, Royal Bank trades at a premium valuation relative to its peers.
- While it is not a bargain, Royal Bank has achieved the best 20-year total return of the large Canadian financials.
- The bank is well-capitalized with ample liquidity, making it the name I want to own going into a banking crisis.
- With my long-term time horizon, I have been adding more to this name in recent weeks.
Author's note: All figures in Canadian currency unless otherwise noted.
On May 1, 2023, U.S. regulators seize First Republic Bank ( FRC ), and sold the assets to JPMorgan Chase ( JPM ). First Republic based in San Francisco is the third midsize bank to fail in past two months. It is also the second-biggest bank failure in U.S. history. The failure of yet another large regional bank in the U.S. underscores the importance of owning high-quality financial stocks.
With a long-term time horizon and a preference for sustainable dividend growth, Royal Bank of Canada ( RY) remains one of my top holdings. With its history of consistent dividend growth, efficient operations, and substantial scale, Royal Bank has been a top ten position for me for at least 15 years. I remain impressed by the bank's consistent long-term earnings growth through all market conditions. To that end, I added more to my position this week.
To be clear, I don't expect that the banking sector is going to be a strong performer in the immediate future, however I am firmly convinced that over the long run, this businesses will continue to outperform. While the extent of bank insolvencies in this most recent banking crisis is unknown, it is clear that quality names with reasonable risk profiles are better positioned to preserve investor's capital. Should the banking crisis spread further, the highest caliber franchises will benefit from a flight to quality. This analysis will focus on the bank's quality, dividend safety, valuation and risks. For a deeper dive into Royal Bank's profile and operations please see my previous coverage here .
Scale Matters
As the largest bank in Canada, Royal Bank has substantial scale. With a market capitalization of $185B, the bank is approximately the size of the Canadian Imperial Bank of Commerce ( CM ), the Bank of Montreal ( BMO ), and The Bank of Nova Scotia ( BNS ) combined. Royal Bank is 5th largest in North America by assets, ahead of Goldman Sachs ( GS ) and Morgan Stanley ( MS ). It is also the 10th largest bank in the world by market capitalization and the 23rd largest bank by assets.
Since 2017, Royal Bank of Canada has been identified as one of the 30 Globally Systemically Important Banks "G-SIB" by the Financial Stability Board in Basel, Switzerland. Factors contributing to this designation include: "the size, the interconnectedness, the lack of readily available substitutes or financial institution infrastructure for the services they provide, their global (cross-jurisdictional) activity and their complexity". This designation requires Royal Bank to hold excess Common Equity Tier 1 for additional potential loss absorption. The recognition of Royal Bank's vital role in the global financial system underscores the bank's leadership position in the Canadian, U.S. and the international markets where it operates.
In modern banking, scale has a significant impact on performance as cost efficiency improves with size. This is especially true in digitized markets, as scale helps to spread out the M&A and R&D costs associated with developing and deploying digital banking and fin-tech solutions. Scale also helps with compliance and regulatory costs.
For Royal Bank, scale has also allowed it to pursue a growth-through-acquisitions strategy. In addition to Royal Bank, the domestic Canadian banking market is dominated by five other large incumbent financial institutions: Toronto-Dominion Bank ( TD ), Bank of Montreal, Bank of Nova Scotia, Canadian Imperial Bank of Commerce, and National Bank of Canada ( NA:CA ) that collectively account for 90% of the Canadian banking market. With high barriers to entry and limits on foreign entrants, these banks earn high returns on capital in the domestic Canadian market and can invest these profits in international growth. In Royal Bank's case, their privileged leadership position in the Canadian market has allowed the company to pursue large acquisitions in the U.S. and Europe in recent years. Recent examples include:
- 2023 HSBC Canada acquired for $13.50B
- 2022 Brewin Dolphin acquired for $2.4B
- 2015 City National Bank acquired for $4.5B
Royal Bank's scale also allows it a high degree of diversification. Not only does the bank derive 40% of revenue from outside of Canada, this portion continues to grow through acquisitions in the Caribbean and other wealth management markets. Even in the domestic Canadian market, Royal Bank operates at a truly national scale with operations in every province, serving approximately 10 million clients through over 1,200 branches. Not only is Royal Bank larger than any of the U.S. regional banks, it is not limited to one region that could be adversely affected by a slowdown in a particular industry. This helps to diversify the bank's mortgage and loan exposure across many cities and regions.
Lastly, significant scale allows for business segment diversification. Royal Bank's size creates the opportunity to lead in multiple business segments and compete at scale. Approximately half of earnings are derived outside of the core Personal & Commercial Banking segment, through Capital Markets, Wealth Management and Insurance. In addition to the exposure to fee-bearing capital in the wealth management segment, diversification across segments reduces the portion of revenue derived from lending, which mitigates Royal Bank's overall risk.
Dividend Growth and Safety
Following Royal Bank's January 2023 increase, the quarterly dividend is now $1.32 or $5.28 annually per share. At current prices, this equates to a 3.93% yield. While this is among the lowest yields in the Canadian banking sector, it reflects the resilience of the bank's share price. While a ~4% yield is attractive, it may appear lackluster compared to BNS or CM currently yielding >6%. While the yield is lower, Royal Bank makes up for it in dividend consistency and growth.
The Royal Bank of Canada commenced its common share dividend program in 1870 and has paid a dividend every year since. Over the past 153 years, the bank has continued its payments through the Great Depression, World War 2, the Global Financial Crisis and the Covid-19 pandemic. Not to mention oil price declines, housing market corrections and the full spectrum of business cycles and interest rate environments.
While a regulatory directive halted dividend growth from 2020 to 2021, Royal Bank of Canada maintained its dividend during the pandemic. Despite this pause in dividend growth Royal Bank has still posted an impressive dividend CAGR of 7.3% over the past 10 years. Over the past 20 years, Royal Bank has achieved a best-in-class annualized dividend growth rate of 9.8%. This growth has been supported by a 10-year EPS Growth Rate of 8.5%.
RBC's trailing 12-month payout ratio is 50%, below the sector average of 55%. Based on consensus N12 month EPS, this ratio is expected to fall to 45% over the next 12 months as earnings normalize from a soft Q1 2023. This should put the 2023 payout ratio in the mid-range of the firm's 40-50% payout target, allowing for continued dividend growth. As an indicator of its earnings consistency, Royal Bank has not had a dividend payout ratio surpass 55% of EPS in the past decade.
Enrolling in Royal Bank's Dividend Reinvestment Program can also earn investors a 2% discount on reinvested dividends.
Valuation and Total Returns
As Warren Buffett once said in a letter to his shareholders: "It's far better to buy a wonderful company at a fair price than a fair company at a wonderful price".
Royal Bank trades at a premium to its peers due to the quality and consistency of its earnings. This valuation is correlated with its long-term returns. With a current P/B ratio of 1.84X, Royal Bank is trading below its average P/B of 2.13X. Over a 15-year period, Royal Bank consistently commands a premium valuation relative its peers. This top-tier valuation is evident at the peak and trough of the economic cycle. It is worth noting that the delta between the median P/B is larger at trough than at peak points in the cycle. This emphasizes the importance of owning quality names during turbulent market conditions. Where other high quality franchises including TD and BMO both traded below book value during this period (which includes both the Global Financial Crisis and the pandemic) Royal Bank's lowest P/B was 1.43X. This is strong indicator of lower valuation volatility and higher earnings resilience.
Looking past Royal Bank's premium valuation and lower dividend yield relative to its peers, the bank has a record of outperformance over the long-term. This is in part driven by Royal Bank's consistency in earning best in class returns on equity. Each calendar year from 2019-2022, Royal Bank had the best ROE of the biggest five Canadian banks. Only smaller and quickly growing National Bank of Canada has posted a consistently higher ROE record. Similarly, Royal Bank leads its peers with a Q1 2023 efficiency ratio of 50.8%.
Over the past decade, Royal Bank has earned compound annual total returns of 12.7%. This result handily surpasses the large Canadian bank average of 10.4% over the same period. For context the average annualized return of the S&P 500 index from 1957 through to 2022, is 10.15%.
Risk Analysis
Royal Bank is well capitalized with a CET1 ratio of 12.7%, up 10 bps from last quarter. According to DBRS Morningstar , this CET1 level, translated to a capital cushion of $17.3B over the minimum regulatory requirement. Following the anticipated closing of the HSBC Canada acquisition in 2024, Royal Bank is still expected to have a CET1 ratio that will exceed 11.5%.
Royal Bank's leverage ratio of 4.4% exceeds the regulatory requirement of 3% set out by the Office of the Superintendent of Financial Institutions. For the quarter ended January 31, 2023, Royal Bank's liquidity coverage ratio was 130%, up from 125% the previous quarter, comfortably exceeding the regulatory minimum thresholds of 100%. This coverage ratio equates to a surplus of approximately $88B, compared to approximately $73B in the previous quarter. This risk and leverage profile has earned Royal Bank investment grade credit ratings from all major ratings services.
Royal Bank's most significant franchise risk is its mortgage exposure. While this mortgage book has continued to perform well, rising interest rates, high consumer debt levels and high housing costs in Canada are red flags. Despite these risks, the delinquency rates for the entire Canadian banking mortgage portfolio was stable last quarter at just 16 basis points. This compares to U.S. residential mortgage delinquency rates of closer to 2%. Approximately 1/3 of Royal Bank's mortgage portfolio is variable rate.
According to DBRS Morningstar , Royal Bank benefits from a conservative loan portfolio with reasonable loan-to-value ratios:
DBRS Morningstar expects a modest deterioration in asset quality metrics from the current unsustainably low levels as credit conditions normalize. DBRS Morningstar remains concerned about the high household debt levels and the potential impact of a housing-related downturn in the Canadian economy and its knock-on impact on consumer-related loan portfolios. However, RBC's real-estate secured lending portfolio, like that of all large Canadian banks, appears to be conservatively underwritten with 27% of these loans being insured at Q1 2022 and the low uninsured loan-to-value ratio of 48% providing a substantial buffer.
As a precautionary move reflecting rising interest rates and high household debt levels, Royal Bank has increased its total provisions for credit loss by $427M over the past year to $532M. Historically, Royal Bank has had much lower PCLs relative to its size than its large Canadian bank peers. Additionally, Royal Bank leads its group in loan quality with among the lowest % of gross impaired loans over the past five years.
While Royal Bank is well positioned to enter a banking crisis or economic slowdown (especially relative to other financials) there are headwinds that will likely impact the entire financial sector. NIM expectations for U.S. banks have started to compress in the wake of recent failures. This could be an indicator that Canadian bank margins will follow suit.
It is early days in the current banking crisis. It is unclear how things will unfold and the extent of the contagion. During the Global Financial Crisis, Canadian bank stocks didn't bottom until almost a year into the first U.S. bank collapses. There may be buying opportunities in the future should fundamentals in the sector deteriorate. While there could be lower prices ahead, long-term investors can continue to add to quality blue-chip names like Royal Bank at current levels.
Investor Takeaways
Royal Bank is a high-quality financial services stock that combines dividend and EPS growth for a strong total return. The bank's best-in-class operating and loan metrics coupled with a strong capital position can give investors' confidence that Royal Bank will continue to produce strong results through the quality of its business. I own other Canadian banks including TD and BNS, however with the current uncertainty in the banking sector, I am adding to the highest quality name in the sector. With a 153 year dividend history, I am confident that Royal Bank will continue to provide dividend growth and offer strong total returns over the long-term.
Note for U.S. Shareholders
Royal Bank trades on both the Toronto Stock Exchange and the New York Stock Exchange under the symbol "RY". Canadian Dividends can generally be sheltered from the 15% tax withholding when held in U.S. retirement accounts. Please consult a tax professional if needed.
For further details see:
Royal Bank of Canada: The Bank To Own Going Into A Banking Crisis