Canadian banks to take on volatility

By all indications, the ongoing volatility that has rattled global stock markets over the past few weeks is likely to persist. A slew of negative macroeconomic indicators including a weakening global economy, the China virus epidemic,  political events and trade wars are forcing Canadian investors to retreat to their own backyards for opportunities.

Meanwhile, the Canadian economy is boasting a better growth outlook than other developed markets. The time may be right for investors to fortify their portfolios with homegrown options. And the Canadian banking sector, one of the strongest pillars of the nation’s economy, looks like a particularly attractive place to hide during market volatility.

Not only do leading Canadian lenders enjoy a favourable banking environment at home, but their growing market share in the U.S., impressive balance sheets and significant capital buffers also make them compelling all-weather prospects. The following financial juggernauts are well placed in an oligopolistic market structure to weather economic shocks and grow profit while offering dividends that are nothing to sniff at.

Canada’s leading bank, Toronto-Dominion (TD) operates three business segments including Canadian retail banking, U.S. retail banking, and wholesale banking. The bank owns a 42% ownership stake in U.S.-based discount brokerage TD Ameritrade.

Toronto-Dominion is one of six leading Canadian banks that collectively hold roughly 90% of the nation's banking deposits. “The bank derives approximately 60% of its revenue from Canada and 35% from the United States, with the rest from other countries,” says a Morningstar equity report, noting the bank has done a particularly admirable job on its Canadian retail operations where it holds leading market share for most key products.

The lender, which has roughly $350 billion in Canadian assets under management, is the number-one card issuer in Canada and is positioned to maintain its dominance for years to come.

Toronto-Dominion also boasts a significant presence stateside where it has more branches than any Canadian bank. While the company has a higher exposure to more growth in the U.S., “it has much lower returns on equity for banks on average than Canada,” partially due to acquisition costs, cautions Morningstar equity analyst Eric Compton.

TD’s sustainable competitive advantage, or wide moat, is built on factors including the best deposit mix, leading market share in Canada, moaty nonbank businesses, and the favourable Canadian banking environment, says Compton, who recently raised the stock’s fair value from $81 to $82.

One of Canada’s two largest banks, Royal Bank (RY) offers personal and commercial banking, wealth management services, insurance, corporate banking, and capital markets services. While concentrated in Canada, which accounts for two-thirds of its revenue, the financial behemoth has additional operations in the U.S. and other countries.

“It has done an admirable job of expanding its nonbank lines of business, running efficient banking operations, and generating some of the best returns for shareholders in the industry,” says a Morningstar equity report, which forecasts RBC to remain at the top spot for years to come.

Royal Bank also remains a dominant force in global capital markets, a segment that is expected to “continue to be a strong contributor to net income,” says Compton, but warns that growth could taper off and earnings may turn volatile during market downturns.

The bank’s wealth-management segment also generates stellar returns on equity. “RBC remains a top asset manager and gatherer in Canada, and is also experiencing outsize growth from the former City National [a U.S. private bank it acquired in 2015], where cross-selling and client integration efforts have gone well,” says Compton, who recently nudged the stock’s fair value from $110 to $111.

Royal Bank’s wide moat is built on superior operating efficiency, leading share in Canada, and the favourable Canadian banking environment.

The fourth-largest bank in Canada, Bank of Montreal (BMO) offers diversified financial services through four business segments: Canadian personal and commercial (P&C) banking, U.S. P&C banking, wealth management, and capital markets. The bank derives roughly 60% of its revenue from Canada and 30% from the U.S.

“BMO has a well-established Canadian banking presence, an established U.S. retail operation in the Midwest, and growing commercial and capital markets capabilities,” says a Morningstar equity report, pointing out that it’s the second-largest asset manager and the second-largest ETF provider in Canada.

The lender has a more commercially focused book and boasts a sizeable share of the domestic commercial lending market, particularly for loans under 25 million. “Additionally, BMO has the lowest relative exposure to residential mortgage loans among its peers, helping to mitigate some of the risks within its loan book,” says Compton, who concedes, however, that a major housing crisis could trigger a recession and “hurt commercial loans indirectly.”

The bank has also been building its commercial lending strength in the U.S. while clocking double-digit loan growth over several years. “We like BMO’s presence in the U.S., as it has built up respectable deposit market share numbers, generated material growth, and has avoided some of the mistakes other Canadian banks have made in attempts to expand south,” says Compton who puts the stock’s fair value at $103.