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Beaten-down U.S. banks may have edge on Big Six

This will sound heretical at first but there are good reasons for Canadian investors to increase holdings of U.S. banks at the expense of domestic bank portfolio weightings.

The relative health of U.S. and Canadian household credit conditions is the key factor. Canadians have packed on debt, which now stands at a record 163 per cent of disposable income. Americans, primarily because they were able to walk away from mortgage debt without penalty after the financial crisis, are also setting debt records – record lows.

The next few years are likely to see reductions in household debt levels, one way or another in Canada. Americans, on the other hand, have plenty of room to increase borrowing, and there are already signs that credit growth is accelerating. The report on U.S. consumer credit for October showed a monthly gain of $18.2-billion (U.S.), almost $4-billion ahead of analyst expectations.

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Bank profits are the primary beneficiary of credit growth, at least until things get stupid, so in this sense U.S. banks have a brighter outlook.

There is also the matter of valuations. Profitability for Canadian banks took a hit during the crisis, with average return on equity (ROE) falling from 23 per cent to 11 per cent, but nothing like the drubbing the U.S. banks took. The average ROE for the KBW Bank Index plummeted from 16 per cent to minus-18 per cent.

The domestic banks are now gliding along comfortably with an average ROE of 18 per cent, but this level may be tough to maintain if Canadians cut down on their borrowing. U.S. banks are far less profitable at 8.2 per cent but have a lot more room for improvement as credit growth continues.

Price to book value (P/BV) ratios tell a similar story. Canadian banks trade at just under two times book, below the 2006 highs of three times and in line with the early 2000s. U.S. banks are trading at just over one time book value or roughly half of 2006 levels. (Note: book value is calculated differently in Canada and the U.S., so we can't assume American banks are twice as attractive as Canadian banks based on this measure.)

The track record for domestic banks stocks is so good that no sensible person is going to tell Canadian investors to sell all of their domestic bank stocks and buy U.S. banks with the proceeds. But it's also the case that over the next two years there is a better chance for earnings and profit improvement from U.S. banks than for their Canadian counterparts.

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