Portfolio Strategy
TD And Royal Bank: Canada's
About To Implode
Jul. 12, 2022 1:05 PM ET | Royal Bank of Canada (RY), RY:CA, TD, TD:CA | BAC, JPM
Summary
Canadian banks are like ships, sailing on a sea of debt. Everything
looks fine right now, but even the Titanic can sink.
We'll take a look at the state of the Canadian consumer, the housing
bubble, comparative valuations, and prospective returns.
In the decade ahead, we estimate returns of 5% to 6% per annum
for RY and TD, but is the risk worth the reward?
MXW Stock/iStock via Getty Images
The Thesis
The list of Canada's largest companies is dominated by banks:
Largest Companies In Canada By Market Cap (CompaniesMarketCap.com)
The Toronto-Dominion Bank (NYSE:TD) and Royal Bank of Canada
(NYSE:RY) are raking in huge profits, with consumers in debt up to their
eyeballs. The problem is, this looks all too similar to the U.S. in 2007.
Let's dig into the risks, to see why we're bearish on Canadian banks.
The Housing Bubble
Canadians have been bidding up the prices of homes over the past few
years, literally. Over the past year, many new listings, especially within
urban centers, received multiple offers above the listing price. Bidding
wars literally broke out. The economies of British Columbia and Ontario
have been especially hot. Vancouver, British Columbia’s largest city, is at
the apex of the bubble. Vancouver is the 3rd least affordable city in the
world. The average home in Vancouver costs 13.3x household income,
and the average price of a detached single-family home is $1,870,000
CAD. Yes, nearly $2 million.
Sailing On A Sea Of Debt
If you own stock in a bank, this is not the kind of headline you're hoping
to see:
News Headline
News Headline (Better Dwelling)
Debt has been growing faster than income in Canada for quite some
time. Recently, household debt to disposable income hit a record high of
180%. For a country to get this indebted, there usually needs to be some
unwise lending by the banks. Canadians are often on a 5-year fixed-rate
mortgage, and will soon be forced to refinance at higher interest rates.
When this happens, the debt squeeze will be severe. Notice that
Canadian consumers are now in significantly worse shape than
American consumers, even if you compare to The Global Financial Crisis
of 2008:
Household Debt To Disposable Income: Canada vs U.S. (Wolf Street)
Canada's corporations are also in terrible financial shape. Just have a
look at the balance sheets of companies like Bell Canada (BCE),
Enbridge (ENB), and Air Canada (OTCQX:ACDVF). It's not uncommon
for Canadian companies to have net debt to income ratios of 10x or
more. These business compete on who can pay the highest dividend,
and their competitiveness and financial positions often deteriorate as a
result.
So why is all this happening? Basically, in 2009, the United States
completely deleveraged, and Canada didn't. Canadian consumers and
businesses have been skating on thin ice with enormous debts and near
zero interest rates for years, but with interest rates on the rise, that's
about to change.
Bankruptcy Risk
Could Canada's biggest banks go bust? Likely not without bailouts
attempts from the Bank of Canada. The latest round of bankruptcies in
Canada's banking industry occurred in the late 80's and early 90's.
Government bailouts failed in 1985. But, had the banks been the size of
TD and Royal Bank, the government probably would've injected a 2nd
round of capital.
The Valuation
TD and Royal Bank are trading at a large premium to book value. This
leaves no margin of safety should recession losses hit home. Just look
what happened to Bank of America and Citigroup's P/B ratios in 2009:
Chart
Data by YCharts
This is how the banks compare to each other, as well as their U.S. peers:
Toronto-Dominion
Royal Bank of
Bank of
JPMorgan
Bank (TD)
Canada (RY)
America (BAC)
Chase (JPM)
ROE
16%
18%
12%
16%
P/B
1.6
1.8
1.1
1.3
P/E
10
11
9
8.5
Balance Sheet Ratios
TD
RY
BAC
JPM
Equity To Assets (%)
5.4%
5.2%
8.2%
7.2%
Cash & Equivalents To Assets (%)
0%
6.1%
8.3%
18.3%
Our main takeaway here is that U.S. banks are both better capitalized
and cheaper than their Canadian counterparts.
Prospective Returns
Over the past 10 years, TD Bank (TD) and Royal Bank (RY) have grown
shareholders equity at 5.5% and 6.7% per annum, respectively. In the
future, Canadian consumers should begin to save more, and take on
less debt. As we go forward, we believe these banks will see slower
growth in their book values, and estimate growth of 5% per annum. This
gives us shareholders equity of $117 billion and $122 billion for TD and
RY in 2032.
Chart
Data by YCharts
We expect multiple contraction following Canada's next severe
recession. Events like this tend to change sentiment and risk premiums,
as well as make the banks themselves lend more conservatively and
even earn less on equity. Currently, many Canadians see banks as blue
chip companies, rather than cyclical investment vehicles. We've
assigned a P/B of 1.3 for RY and 1.2 for TD in 2032. Royal Bank
currently has the best brand in the industry, and is known for its customer
service. TD is weaker in this regard, but this can change over time.
Altogether, our 2032 price targets are $78 and $113 per share for TD and
RY, respectively. This indicates returns of 6% and 5% per annum with
dividends reinvested.
Risks To The Thesis
The risk to this conclusion is that the banks manage to sail smoothly
through the next recession, perhaps with preemptive support from the
Canadian government. If the banks can maintain their market premiums
and continue to grow as they have in the past, you could get higher
returns. Banks could benefit from moderately higher interest rates 10
years out.
The worst-case scenario is Citigroup, which still hasn't recovered from
The Great Recession:
Chart
Data by YCharts
Conclusion
For TD and Royal Bank, we believe the risk and reward do not favor the
common shareholder. We have a "sell" rating on both shares. Canadian
banks are often viewed as blue chip companies, but the Global Financial
Crisis is a sobering reminder of the downside. There is far too much debt
and financial folly in Canada right now. There may be better buying
opportunities after loan losses hit home. If investors would like to hold
their positions in financials, we recommend U.S. banks, which appear to
be both cheaper and better capitalized.
For more on this, check out my articles:
JPMorgan Chase - Buy The Fear
Bank of America - A Bear Market Buy