Monday, November 27, 2006

Morningstar on Banks

  
Morningstar, Ryan Batchelor, CPA, 27 November 2006

After reviewing the newly expanded International Stalwarts list in the October issue of Morningstar StockInvestor you may have asked yourself, "What gives with all of the Canadian banks?" In addition to Royal Bank of Canada, which was one of the original Stalwarts, we added four additional wide-moat Canadian banks to the list last month: Bank of Montreal, Bank of Nova Scotia, Canadian Imperial Bank of Commerce, and Toronto-Dominion Bank.

I believe these are all very solid banks that would make fine investments if they fell to our 5-star prices. In addition to their strong business models, which we'll highlight below, the Canadian banks are quite shareholder friendly and pay healthy dividends. At our consider buying prices, and based on this year's current dividend, each of the 5 banks would sport a dividend yield near to or above 4%.

It is, however, a little ironic to be talking about Canadian banks--which, quite frankly, can seem a little boring--given the highly publicized recent initial public offering of China's largest bank, Industrial & Commercial Bank of China, or ICBC, in October. While we don't cover this firm yet--it's listed only in Hong Kong and China--the IPO was the world's largest ever, raising more $22 billion, and was received with much fanfare--and a very large opening day price pop--across China and Hong Kong.

To give you a flavor for the demand for ICBC, local media in Hong Kong reported that individual investors in Hong Kong placed orders to buy almost $54 billion of the IPO, while institutional investors wanted $325 billion worth! One Hong Kong newspaper suggested that more than 1 million people, or one in seven Hong Kong residents, placed an order to buy the stock.

Canada's Banking Environment

In contrast to the hype and excitement surrounding China and its 1.3 billion people clamoring for banking, the sleepy Canadian banks just quietly keep plugging along serving a nation that has 40 times fewer people. They do it with little fanfare, quietly creating lasting value for shareholders by virtue of their wide moats.

Unlike the United States, which has a very fragmented banking industry, Canadas top six banks (the five Stalwarts members plus one we don't yet cover) dominate the Canadian market with roughly 90% market share in deposits and assets. Banking is also big business. Even though more than half of Canada's exports are commodity-related, its largest industry, as measured by gross domestic product, is financial services.

When evaluating potential investments, I like to see a dominant firm because thats usually strong evidence that there is some sort of a moat that allowed the firm to attain its position. This assumes, of course, that the firms are earning high returns on capital--which each of the five Stalwart banks do, with an average return on equity of about 17%. Our expert on Canadian banks, Michael Kon, identified three main reasons that the top banks dominate.

First, the banks tout themselves as home-grown Canadian banks, which we believe appeals to Canadians' sense of nationalism. Second, there are rules and regulations in Canada that make it very unattractive to start a new bank there, especially for foreign banks trying to penetrate the market. Third, because the large banks are so entrenched, they have vast networks of branches, automated teller machines, and established brands that act as steep barriers to entry for potential competition. I'll also add on to these three reasons my own belief that while the banks certainly compete against each other, there hasn't been much churn among bank customers, so I think there are some unwritten rules of competition that help ensure that the banks maintain their livelihoods.

While these banks dominate Canada, the country is certainly not China. Growth rates in Canada will make even the most patient investors yawn, thanks primarily to these banks' already-dominant positions. As a result, almost all of the banks use their Canadian operation as a cash cow to fund international expansion. This strategy leads to a big risk: The risk of a great business throwing cash at marginal ideas because it doesn't have anything better to do with the money. We've accordingly given each of these businesses average, rather than below-average, risk ratings.

The Bright Side of Lower Margins

Surprisingly, the financial metrics of Canadian banks are relatively underwhelming, with margins noticeably lower than their U.S. counterparts. This may seem counterintuitive, given their dominant market positions. However, high margins in banking attract not only competition, but also regulatory and political scrutiny. (Who wants the big bad dominant banks to be plundering society?) So theres an incentive to post good, but not great, margins if you hold a dominant market position. The key point is that despite so-so margins, they earn returns on capital well above their cost of capital. This is the linchpin of a wide moat, and these banks do it consistently.

My Favorite Canadian Bank

While all five Stalwarts are excellent banks, I'm particularly fond of Bank of Nova Scotia. In Canada, this bank has posted an impressive 31% return on equity over the past five years, a testament to its wide moat. Unlike most of its peers, which expanded to the United States in search of growth, BNS attacked Latin America. It has worked well so far. The firm's foreign operations have generated a very healthy 17% return on equity over the last five years.

The bank's expense efficiency and business diversification isn't as good as some of its peers, but the firm manages its balance sheet very well. Its net interest margins--a key measure of banking that measures the spread between what it earns on its assets and what it pays for its liabilities expressed as a percentage of assets--are higher than its peers, thanks to careful management of interest-rate risk. Unfortunately this bank's not trading for a very cheap price right now--that's true of the other Canadian banks as well--but it's certainly worth keeping them on a watch list and patiently waiting for a fat pitch opportunity to present itself.
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