What are we looking for?
Canadian banks that may be positioned to outperform their peers in a rising interest rate environment.
To combat high inflation, the Bank of Canada is expected to announce an increase in the target overnight interest rate by 0.5 of a percentage point on Wednesday. This trend is expected to continue as analysts expect the target policy rate, currently at 0.5 per cent, to increase to 2 per cent by the end of 2023, according to FactSet.
Banks generate profits from two main avenues, interest income (revenues from lending) and noninterest income (from capital markets, insurance, wealth management). Rising interest rates tend to benefit banks by boosting their interest income, owing to higher yields on instruments such as commercial and residential mortgages. Therefore, investors can profit by investing in banks that generate the highest proportion of their total revenues from interest income.
To identify such companies, we use FactSet’s Universal Screening tool to pull all publicly traded companies listed on any Canadian exchange. We then narrowed down our list using the parameters below:
- Market capitalization greater than $100-million;
- Classified within the International Banks Industry, according to FactSet;
- Net interest income greater than zero over the past 12 months;
- Finally, we ranked the 10 remaining companies according to the percentage of their revenues derived from interest income over the past 12 months.
For informational purposes, we’ve also included the price-to-earnings ratio, dividend yield, and year-to-date and one-year total returns.
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What we found
Equitable Group Inc., a Toronto-based residential and commercial lender, topped our screen with 95 per cent of its total revenues generated from interest income. Equitable may offer investors value as it trades at a P/E ratio of 7.4, which is the cheapest amongst all the companies that passed our screen. Equitable Bank, its subsidiary, has an agreement to acquire an 84 per cent majority stake in Concentra Bank, a Saskatoon-based wholesale bank, which is pending regulatory approval. The deal, announced on Feb. 7, is expected to close later this calendar year.
Not surprisingly, all of the Big Six banks passed our screen. They ranked, in terms of percentage of revenue derived from interest income, in the following order: Bank of Nova Scotia, Canadian Imperial Bank of Commerce, National Bank of Canada, Toronto-Dominion Bank, Bank of Montreal, and Royal Bank of Canada. Scotiabank had 65.6 per cent of its total revenues coming from interest income; additionally, it offers investors geographical diversification as Latin American operations account for 30.1 per cent of its revenues (not shown), according to FactSet.
Conversely, RBC ranked last, offering 49.9 per cent of its revenues from interest income. The bulk of its noninterest income comes from its sizable wealth management, capital markets and insurance divisions. RBC recently entered into an agreement to acquire Brewin Dolphin Holdings PLC, a London-based investment management services provider, which will further bolster its international wealth management offering.
Investors should also consider a few risks of investing in banks: 1) rising interest rates could lead to a slowdown in the broader economy, leading to a lower volume in overall lending; 2) savings rates could increase with interest rates, which are viewed as an expense to banks in exchange for customers choosing to bank with them; and 3) Ottawa is planning to levy additional taxes on Canadian banks and insurers.
The information in this article is not investment advice. FactSet assumes no liability for any consequence relating directly or indirectly to any action or inaction taken based on the information contained above.
Full disclosure: The author personally owns shares of BNS, CM, NA, TD, BMO and RY.
Arjun Deiva, CFA, is a vice-president at FactSet Canada’s consulting division.
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