Investing in Canadian banks for the long term

Asset quality and earnings are two of the most important factors when deciding on a bank to invest in, says analyst Dan Werner.

Ashley Redmond 8 July, 2014 | 12:00PM Dan Werner

 

 

Ashley Redmond: I'm Ashley Redmond for Morningstar.ca and I'm here with Dan Werner who covers the big Canadian banks for us. Dan, thanks so much for joining me.

Dan Werner: Thanks Ashley.

Redmond: Every quarter Dan and I get together and discuss the previous quarter's results, but this time we're going to do something a little different. I want to know if investors are considering a bank for a long-term investment, what factors they should be looking at? So, what broad factors should investors consider if they are looking at the big Canadian banks for a long-term investment?

Werner: As a former regulator I have this little formula that you are taught as a bank examiner, that we always call the CAMEL ratings and each acronym stands for each portion of the bank's performance: C is for capital, A is for asset quality, M is for management, E is for earnings and L is for liquidity. The two most important ones are A and E, asset quality and earnings, because a lot of the bank's earnings are balance sheet based. They earn a spread off of what's on the balance sheet in terms of loans or securities.

Now they also have other businesses as well, which leads to earnings and what kind of fee revenues that they're getting. As well, what kind of the cost controls that they have in place, how well they manage those earnings and how well they keep those costs down.

For the next step I’d look at liquidity and how those banks are funded. Most of the Canadian banks are very well funded with very good core deposits. Unlike a lot of European banks that we see, which do a lot of covered bond issuances to fund their banks, the Canadian banks are very liquid in terms of very stable core deposits in their balance sheet.

This leads to how strong their capital is, how much that capital will allow them to continue to grow organically, as well as possibly make future acquisitions. And then M is management, which kind of manages all the other four aspects of it. So keep that acronym CAMEL in mind, every time you are looking for certain things it kind of relates back to that acronym.

Redmond: When investors are looking at the Canadian banks specifically, so the big five Canadian banks: TD, RBC, CIBC, BMO and Scotia. Are there any specific factors among those five banks that investors should focus on?

Werner: They all have their own unique flavour. They all are very strong in the Canadian personal commercial banking— maybe Scotia less so than the other ones, but the other four definitely. But they all have their other kind of flavour in how they earn revenues outside of that.

With RBC, it's in their capital markets group. With TD they are more focused on retail and commercial and in the U.S. and Scotia it is more international. CIBC is definitely more Canadian than the others, but trying to build its wealth management. BMO is in the U.S., but also trying to build its wealth management. So they each have their own way of trying to generate revenues from various sources and they have each found their own niche.

Redmond: As an analyst since you cover the banks so intimately, do you find it's equally as easy to get access to information on each bank, how is the transparency?

Werner: The transparency for the Canadian banks is very good compared to some of the banks that I cover in Europe. The Canadian banks are very transparent in terms of their performance and their past history. You can go to any of their investor relations websites and pull out a ton of information in terms of their earnings releases. As well, they will issue supplemental financials and you can look at their slide presentations that they give to the analysts. So there is a lot of transparency in terms of the major aspects of that CAMEL rating that the Canadian banks will provide to basically anyone.

Redmond: And again just because you do cover them so intimately, is there anything that investor should be cognizant of when they are looking at the banks for a long-term investment? Is there anything that jumps out at you?

Werner: As a long-term investment I like to think about their revenue streams and how sustainable they are over the long term. Obviously Canadian personal commercial banking has been a very big driver lately. I like to look at the competitive advantage that they may have relative to the other banks. As I mentioned before they each kind of have their own niche.

But when I'm looking at the specific numbers I'm looking for changes. Is their margin trending up or down? Is their asset quality trending up or down? What does that mean for their provision for credit losses? What's going on with the wealth management? Is the market doing well? So, should we expect wealth management to do better or is it pulling back?

And what's going on with trading revenue amongst the banks. So you look at lot of different factors for each of the banks in terms of how it’s making money, how it’s managing the costs and increasing profitability.

Redmond: And lastly I'm not trying to pin you into a corner here, but if you were a DIY investor—you are not an analyst and you are looking at the banks as an investment—what one would you invest with?

Werner: Right now I would probably invest in Scotia. I like the diversity of the revenue streams now. They are little bit less Canadian than some of the others [and I think being too Canadian] is a potential risk. I like the size of their international in some of these large GDP growth type countries. And they have a nice capital markets group which does very nicely. So my long-term pick would probably be Scotiabank.

Redmond: Great, thanks so much Dan.

Werner: Thanks Ashley.

Redmond: For more information on the big Canadian banks go to Stocks page of Morningstar.ca.

Securities Mentioned in Article

Security NamePriceChange (%)Morningstar Rating
Bank of Montreal69.24 USD-1.00
Canadian Imperial Bank of Commerce100.03 CAD-1.55
National Bank of Canada60.38 CAD-1.47
Royal Bank of Canada97.60 CAD-1.76
The Toronto-Dominion Bank71.58 CAD-1.46

About Author

Ashley Redmond

Ashley Redmond  Ashley Redmond is a Vancouver-based freelance writer.