Investing Daily

 

Canada stands on the highest plateau these days, casting an impressive glow in the aftermath of the Winter Olympics

-- Roger Conrad & David Dittman

When I first read the above quotation over at Canadian Edge, I immediately jumped to the conclusion that my good friends Roger and David were talking about the Canadian hockey team. But silly me, they were talking about the Canadian banking system and the stellar earnings reports all “big five” Canadian banks had just released during the first week of March. (Only one of the big five is in their buy range right now, however).

Hockey Rivalry

That shows you where my sports-junkie head has been lately. I’m not much of a hockey fan, but I have to admit I am still recovering from “The Loss.” I couldn’t take my eyes away from the Olympic men’s hockey final between the U.S. and Canada this past February. When New Jersey Devil forward Zach Parise of the U.S. team scored the tying goal with only 24 seconds left in regulation time, I jumped up so fast I almost pulled a muscle. But Canada came back in overtime to win and dash America’s dreams of an upset. 

Bank Rivalry

A similar “border battle” is shaping up in the financial world concerning those investors that advocate putting their money in downtrodden U.S. banks versus those who think Canadian banks still represent the better value.

The U.S. Ranks Below Bangladesh?

Thanks to Canada’s resilient natural resource-based economy and prudent bank lending practices, Canadian banks were only lightly hurt by the 2008/2009 global financial meltdown, whereas U.S. banks were located at ground zero of the crisis and were dealt a body blow of historic proportions. Not a single Canadian financial institution has required a government bailout, which is one reason the World Economic Forum’s Global Competitiveness Report 2009-2010 has named Canada’s banking system the soundest in the world for the second straight year. Numero uno. In contrast, 830 institutions in the U.S. banking system have needed bailout money. This might explain why the U.S. banking system is ranked 108^th out of 133 countries, right behind Tanzania and Bangladesh. So up until recently, it’s been no contest – Canada’s banks have won hands down.

Fortune Favors the Risk-Averse

Canadian bank CEOs have been amply rewarded for their excellent risk management: the CEOs of both Toronto-Dominion (NYSE: TD) and Royal Bank (NYSE: RY) now make higher salaries than the CEO of Goldman Sachs (NYSE: GS)! That would have been unthinkable just a few years ago.

Now That’s Dominance!

Take a look at the following graph demonstrating the dominating stock outperformance of Canada’s big five banks versus the U.S. banking index during the past three years:

Source: Bloomberg

Whereas U.S. bank stocks collapsed 53%, Canada’s top five banks actually gained more than 2 percent!  

Prudent Bank Checklist

What about Canada’s banks make them so superior?  A February report by University of Michigan-Flint economics professor Mark Perry entitled “Due North: Canada’s Marvelous Mortgage and Banking System” attempts to answer this question. He lists eight characteristics of Canadian banks that are superior to U.S. banks, but I think the following five are the most important:

1. Full recourse mortgages. In the U.S., a borrower can walk away from her home mortgage and the bank is limited to foreclosing on the house. In Canada, the bank can go after the deadbeat’s personal assets, which makes it less likely that a borrower will be irresponsible and borrow more than she can afford.
2. No tax deductibility of mortgage interest.  Canadians must pay the full cost of owning a home.
3. Higher prepayment penalties. Canadians are discouraged from refinancing their mortgages. U.S. homeowners often used such refinancings to borrow additional cash, which reduced their home equity and increased their indebtedness.
4. Greater bank concentration and geographic diversification. Whereas the U.S. has more than 8,000 banks, Canada has only 82 and the “big five” hold more than 80 percent of Canada’s total bank assets. A smaller number of banks makes it easier for government regulators to supervise lending activities.  Canada’s banks have always operated nationwide which reduces the detrimental effects of an economic decline in any one geographic area, whereas interstate banking was prohibited in the U.S. until 1994.
5. Mortgage Broker Loan Originations are Much Lower. Only 35 percent of Canadian mortgages originate with mortgage brokers whereas 70 percent of U.S. mortgages do. Brokers have much less incentive to uphold strict lending criteria since they get paid per transaction and are not responsible for loans that go bad (unlike the lending banks themselves).

Comparing Performance

These differences are prime reasons why Canadian banks are financially healthier than their U.S. counterparts. Check out the following table comparing the financial attributes of Canada’s big five to a comparative sample of U.S. banks:

Analyzing the Numbers

The Canadian banks have much higher profit margins (column 2) than the U.S. banks, which makes sense when one sees that the U.S. banks have much higher net charge-offs as a percentage of assets (column 4). Charge-offs depress earnings. But the efficiency ratios (column 3) of U.S. banks, which measure the percentage of revenues taken up by costs, are lower. Such a “lean and mean” cost structure suggests that U.S. bank earnings will really skyrocket once the economy improves.

The dividend yields (column 6) of the Canadian banks are much higher than those of the U.S. banks, which again makes sense since U.S. regulators forced banks to cut dividends in exchange for bailout money.  But many U.S. banks have repaid the bailout money and analysts are expecting some to start restoring their dividends this year and next. Specifically, JP Morgan is expected to double its five-cent per share dividend by the second quarter. 

The tangible common equity ratio (column 5) of U.S. banks is higher than their Canadian counterparts, which reflects the hesitance of U.S. banks to make loans and expand their balance sheets. Lastly, U.S. banks look cheaper on a price-to-book basis (column 7), which reflects investor hesitance to pay up for companies that may have to write down assets further.

Over the past year, U.S. bank stocks have performed much better compared to the Canadian banks, ending virtually in a dead heat:

Source: Bloomberg

Are U.S. Banks the Comeback Kid?

Does this improved relative performance portend that U.S. bank stocks will finally pull ahead of the Canadians over the next few years? At least one banking analyst thinks so (a Canadian no less).  Robert Wessel of Hamilton Capital Partners issued a report on March 8^th calling for U.S. banks to “massively outperform” over the next three years. He argues that loan losses have peaked, leading to easy earnings comparisons and strong growth as the economy recovers.

Some smart money managers appear to agree with Wessel’s thesis. John Paulson, the hedge fund manager who made $20 billion dollars in 2007-09 shorting bank stocks and betting on home mortgage defaults, is now buying large amounts of Citigroup stock, as are investing giants George Soros, Eric Mindich, Bruce Berkowitz, and Daniel Loeb.

And economic data also suggests that the worst is over for U.S. banks. In the month of February, the year-over-year growth rate in U.S. bank foreclosures was the lowest in four years.

On the One Hand, On the Other Hand

Personally, I think investors can win buying either U.S. or Canadian banks. If you are more conservative and want dividend income, buy Canadian. With the Bank of Canada widely expected to start hiking interest rates this year and sooner than the U.S. Federal Reserve, the Canadian dollar could appreciate against the U.S. dollar, which would add some extra juice to the returns U.S. investors will get from Canadian stocks.

On the other hand, the capital gains potential for U.S. banks is much higher than for Canadian banks simply because U.S. banks fell further and have further to bounce back.  Investors with a higher risk tolerance will eventually make more money buying American.

Too wishy-washy for you?  Ok, if I have to choose, I recommend buying U.S. banks. I’m still smarting over Canada’s Olympic hockey win so the least I can do is let the U.S. win this border battle.

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If you aren’t a swashbuckler and want the safety and dividends available from non-U.S. banks, KCI’s team of top analysts can help. Roger Conrad’s Canadian Edge offers up the best Canadian bank to buy now and Yiannis Mostrous’ Silk Road Investor has three choice foreign bank stocks in its long-term portfolio. Try both newsletters risk-free! There is no obligation to subscribe.