BMO has beaten expectations. The hard part now is expectations are rising

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If you had to pick out a winner from Canada’s banking sector over the past year, Bank of Montreal BMO-T would be a contender – raising the question of whether BMO is emerging as the top bet in the group.

From the day when the Big Six banks began to roll out their fiscal first-quarter results on Feb. 24, to the conclusion of the reporting season on March 3, BMO’s shares gained 2.4 per cent.

While slightly behind Bank of Nova Scotia’s BNS-T 3.1 per cent gain over this period, BMO easily outperformed the peer average.

What’s more, BMO – Canada’s fourth-largest bank, based on assets – has outperformed all of its peers over the past 52 weeks, with a gain of 38 per cent or a substantial 10 percentage points above the average.

What is BMO doing right?

Part of the explanation relates to the simple fact that the shares have looked cheap relative to the bank’s estimated profits.

According to a year-old report from RBC Dominion Securities, BMO shares traded at 8.7 times estimated 2022 earnings in February, 2021. That was the lowest price-to-earnings ratio among the Big Six, and it suggested that the shares were reflecting relatively low expectations.

The shares remained the cheapest in the group heading into the latest quarterly reporting season as well.

Using a similar report from RBC RY-T from mid-February, BMO’s shares had a price-to-earnings ratio of 9.5, based on estimated 2023 earnings. That was the lowest of the Big Six and well below Toronto-Dominion Bank’s TD-T premium P/E of 11.6.

Low valuations might not be attractive if a bank is reporting lacklustre profit growth. But BMO is no slouch: Its net earnings for the first quarter, ended Jan. 31, increased by 46 per cent from the same quarter last year.

Analysts often prefer to look at adjusted figures that ignore unusual sources of profit. This gives them a better sense of how a bank is performing on a day-to-day basis.

But even here, BMO shone in the first quarter, owing partly to strong trading revenue and commercial lending growth in Canada and the United States. After ignoring gains from the bank’s hedging and the sale of its European asset-management business, its adjusted earnings increased by 27 per cent over the past year, beating all peers.

What’s more, the adjusted earnings result exceeded analysts’ estimates by nearly 19 per cent – just shy of National Bank of Canada’s earnings “beat” but well ahead of the other four big banks.

BMO isn’t just succeeding with profit growth, though. The bank is also winning praise among analysts for ratcheting up efficiency by its keeping expenses in check.

“BMO is the top-performing Big Six bank over the past 12 months, in large part due to an easy-to-appreciate ‘story’: efficiency momentum,” Gabriel Dechaine, an analyst at National Bank of Canada, said in a research note released just before the start of the earnings season.

The bank’s efficiency ratio – which compares operating costs with revenue – declined to 53 per cent in the first quarter, down from 56 per cent in 2021 and 60 per cent in 2020. A low ratio is better, because it means that revenues are growing faster than expenses.

Clearly, BMO is demonstrating to investors that its stock deserves a higher valuation. What’s less clear is whether the bank will continue its winning streak.

Much depends on its deal to expand its U.S. footprint with the acquisition of San Francisco-based Bank of the West, which was announced in December. At a purchase price of $17.1-billion, it’s the biggest-ever U.S. acquisition by a Canadian bank.

But the deal is not expected to close until later this year. That leaves months of uncertainty among investors, particularly over how many new shares BMO will issue to help finance the acquisition – leading to potential shareholder dilution, as profits are spread out among more shares.

Since BMO is performing well and building up its capital reserves, analysts are sounding more upbeat about the deal as the threat of dilution subsides.

“While BMO is still projecting that it will need to raise $2.7-billion in the open market, we increasingly believe that this figure is unlikely to get larger,” Meny Grauman, an analyst at Bank of Nova Scotia, said in a note.

New share issuance could even be smaller, he added, if regulatory approval takes longer than expected and BMO builds up even more capital.

BMO has performed well amid low expectations. The challenge now: It has to keep up the momentum as expectations rise.

Full disclosure: The author owns shares of BMO Equal Weight Banks Index ETF.

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