The long-term winners among Canadian banks will be stay-at-home institutions that shy away from international expansion, according to analysts at Veritas Investment Research in Toronto.
Their argument, laid out in a recent report, offers a counterblast to the conventional wisdom that insists foreign acquisitions are the only way for Canadian banks to achieve significant growth.
It’s a perspective that investors may want to keep in mind as Canada’s Big Six banks start to report earnings this week.
Bank of Montreal BMO-T missed analysts’ targets on Wednesday. The shortfall occurred largely because of increased provisions the bank is making for loan losses in a weakening economy. However, the bank’s acquisition of San Francisco-based Bank of the West in February added to the uncertainty about what lies ahead.
Toronto-Dominion Bank TD-T, which reports Thursday, has already been stung by its cancelled deal to acquire First Horizon Corp. of Tennessee. TD will incur a US$225-million fee as the result of its decision earlier this month to walk away from the acquisition.
However you view these recent cases, Canadian banks have lots of experience with underwhelming foreign assets, according to Nigel D’Souza and Roshan Paunikar of Veritas.
In their report, entitled “The Tortoise and the Hare,” they argue that “slow and steady” wins the race in Canadian banking. They conclude that the banks that generated the best risk-adjusted returns over the past decade were the “tortoises” that focused on Canadian banking rather than the “hares” that raced out to pursue international diversification.
In keeping with that perspective, the Veritas analysts have “buy” ratings on both Royal Bank of Canada RY-T and National Bank of Canada NA-T. They applaud those two institutions for their focus on domestic banking and, to a lesser degree, on wealth management and capital markets.
In contrast, the analysts have “reduce” ratings on Toronto-Dominion Bank and Bank of Nova Scotia BNS-T, both of which have substantial international operations. They also have “sell” recommendations on Bank of Montreal and Canadian Imperial Bank of Commerce CM-T.
The Veritas team points to recent history to buttress their case. Both RBC and National Bank have grown their share prices faster than their peers over the past 10 years, “which we attribute to each bank’s focus on growing earnings from Canadian banking, wealth management and capital market franchises,” the analysts write.
In contrast, the banks that focused on expanding their international banking operations “generated lower share price returns and trade at lower book multiples, which likely reflects elevated risks for international banking.”
Those international risks shouldn’t be shrugged off. The report stresses how unusually stable the Canadian banking scene is by comparison to the rest of this hemisphere.
“Since 1840, Canada has not experienced a bank crisis,” it notes. Over the same period, the United States has suffered 12 major banking crises. Meanwhile, Latin America has ricocheted among “bouts of political uncertainty, financial crisis, bank failures and currency devaluation.”
To be sure, the stability of Canadian banks comes at a cost. The industry is in many ways a highly regulated oligopoly. It is not renowned for its innovation or for its customer friendliness or for its fierce competition.
From an investor’s perspective, though, there are advantages to this cozy arrangement. The Veritas team notes how dependably the Canadian banks generate mouth-watering returns on equity, year after year, on their domestic banking activities.
Within Canada’s borders, the Big Six benefit from all the advantages that go along with being powerful incumbents. They tap into low-cost funding from “a concentrated and sticky” base of depositors. They face only limited competition to lower banking fees. They profit from the economies of scale that come with running large national operations.
Many of those advantages vanish when Canadian banks step outside the country’s borders and wrestle with stiffer competition in riskier environments. Since 2018, the Big Six banks have enjoyed a return on equity of 34.7 per cent in their Canadian banking operations versus a mere 12.5 per cent in their international banking activities, Veritas calculates.
To the Veritas analysts, the message is clear. “Canadian banks that focus on Canadian banking outperform Canadian banks that focus on growing international banking,” they write. “We expect National Bank and [RBC] to outperform over the long term.”