Three bank stocks to profit from rising interest rates

A rising rate environment creates a growth tailwind for the banking sector.

Vikram Barhat 1 August, 2017 | 5:00PM

The Bank of Canada in July decided to raise the overnight interest rate by 25 basis points, from 0.50% to 0.75%. The first in seven years, the rate hike from the central bank has a clear message: there's growing confidence in Canada's economic recovery. In fact, the BoC has already hinted at the possibility of another rate hike before the year is out.

Canada's largest banks, which collectively hold roughly 90% of the nation's banking deposits, wasted no time in upping their prime interest rates. While this may have implications for consumers, a rising rate environment is supportive of financial institutions and, along with other positive economic indicators, creates a growth tailwind for the banking sector.

Despite the effects of low oil prices and a cooling housing market, Canadian banks remain on a strong footing and face no existential threat thanks to strategic allocation of capital to higher-return businesses and cutting costs through technological upgrades and shedding operational fat.

For investors, this may be an opportune time to take a closer look at some of Canada's leading banks. These lending institutions have a long runway of growth paved with strong fundamentals, deep capital reserves, strong revenue, and diversified businesses and geographical footprint, according to Morningstar equity research.

The Toronto-Dominion Bank
Ticker: TD
Current yield: 3.59%
Forward P/E: 11.3
Price: $64.26
Fair value: $72
Data as of July 31, 2017

One of Canada's two largest banks,  Toronto-Dominion (TD) offers wholesale, personal and commercial, and wealth management services in Canada (60% revenue), the United States (34%) and other countries. The company also owns a more than 40% stake in TD Ameritrade, a U.S.-based discount brokerage.

With a strong focus on Canadian retail operations, TD has grown into a number-one or -two market share for most key products. The bank also has a leading market share in business banking in Canada. "With roughly $350 billion in assets under management, top-three dealer status in Canada, and being the number-one card issuer in Canada, we expect it to remain one of the dominant Canadian banks for years to come," says a Morningstar equity report.

TD has a significant presence in the U.S. with more branches stateside than any other Canadian bank. It also operates a major discount-brokerage business. "This industry is ripe for growth as investors seek out lower-cost alternatives, and the bank could leverage its knowledge of the industry in Canada, where do-it-yourself investors have a harder time finding competitively priced platforms," says Eric Compton, Morningstar equity analyst, who recently raised the stock's fair value from $63 to $72.

Although the sector isn't immune from macroeconomic risks related to household debt and the frothy housing market, Compton says TD "does have a relatively lower exposure to the uninsured domestic real estate market in Canada, putting it in a less risky position in a downturn."

Compton attributes the bank's strong competitive edge to its superior market share in the advantageous Canadian banking environment, a better deposit mix, and exposures to profitable non-bank businesses.

Canadian Imperial Bank of Commerce
Ticker: CM
Current yield: 4.64%
Forward P/E: 9.9
Price: $108.08
Fair value: $125
Data as of July 31, 2017

Canada's fifth-largest bank with more than $450 billion in assets and 11 million clients worldwide,  Canadian Imperial Bank of Commerce (CM) provides a range of financial products and services through three business units: retail and business banking, wealth management and wholesale banking.

CIBC recently reported a better-than-expected second-quarter profit of $1.06 billion, compared with $947 million, a year earlier. CIBC's Canadian retail banking, which has historically generated high returns, produces an average of 70% of overall net income.

While the lender's wholesale banking segment hit some rough patches a decade ago, it has since been able to resolve these issues and renew its focus on its Canadian banking business.

The lender has the largest credit exposure to the energy sector among Canadian banks, but is sharpening its focus on boosting profitability through personal and commercial banking, its largest and most important operating segment, says a Morningstar report. "The bank," say the report, "is working to change its culture to become 'relationship focused' in attaining and retaining clients rather than just selling products."

The bank is also pulling levers to bulk up its wealth-management segment. "CIBC wants to generate a greater proportion of its income from this lucrative, fee-based business, which now constitutes only 13% of net income," says Morningstar sector director Stephen Ellis, who raised the stock's fair value estimate from $119 to $125. "More recently, CIBC has had success in organically increasing assets under management with stronger sales of long-term mutual funds."

Royal Bank of Canada
Ticker: RY
Current yield: 3.66%
Forward P/E: 11.8
Price: $93.01
Fair value: $97
Data as of July 31, 2017

Canada's biggest lender with more than $1.20 trillion in assets,  Royal Bank of Canada (RY) offers diversified financial services including personal and commercial banking, wealth management and investment banking, in North America and beyond. The bank derives two thirds of its revenue from Canada, with the rest spread out primarily across the U.S. and the Caribbean.

"We expect Royal Bank of Canada to continue to be a steady player within its retail and commercial Canadian banking operations," says a Morningstar report. "It also continues to be a major player in global capital markets, experiencing tremendous growth over the past several years."

Like its peers, Royal Bank has had to look beyond Canada to find areas to invest excess capital. The bank's latest acquisition, its largest ever, of U.S.-based bank City National Corp, will allow for a greater access to the U.S. market where it is targeting high-net-worth customers, says Compton, who recently increased the stock's fair value estimate from $88 to $97.

"It also has the largest amount of assets under management [$600 billion] and assets under administration [$5 trillion] among the Canadian banks, giving it the largest exposure to this higher-margin, fee-based business, and a larger share of clients' overall wealth," he adds.

Compton, who forecasts Royal Bank to "remain one of the dominant Canadian banks for years to come," projects average loan growth of more than 4%, deposit growth slightly higher than that, and 19% return on tangible equity.

RBC has raised dividends multiple times since 2011, with an average annual dividend growth of roughly 8%, he says.

Editor's note (Disclosure): The author owns a small position in shares of Toronto-Dominion Bank.

Securities Mentioned in Article

Security NamePriceChange (%)Morningstar Rating
Canadian Imperial Bank of Commerce109.88 CAD0.44
Royal Bank of Canada106.29 CAD0.38
The Toronto-Dominion Bank76.03 CAD0.45

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Vikram Barhat

Vikram Barhat  Vikram Barhat is a freelance writer.