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Canada’s Big Six Offer Big Payouts

By Ari Charney on June 2, 2016

When it comes to the financial sector, U.S. income investors have leaned heavily on Canada’s Big Six. After all, Canada’s banks have a reputation for conservatism that stands in contrast to their more profligate U.S. peers.

And like many Canadian firms, their dedication to dividends far surpasses their counterparts in the U.S. Over the past five years, for instance, the average bank among Canada’s Big Six has boosted its payout by 7.9% annually. That means shareholders have seen their incomes rise by 46.3% over that period. Not bad. Not bad at all.

Of course, that’s just the average. Three of the Big Six have raised their dividends even more during that time. For instance, Toronto-Dominion Bank (NYSE: TD, TSX: TD) has grown its payout by 10.8% annually over the past five years, giving its shareholders a whopping 67% pay raise over that full period. Nice.

So it’s no surprise that the stocks of these banking behemoths yield more than the average stock on the Canadian market. While the Canadian benchmark S&P/TSX Composite Index (SPTSX) yields 3.0%, the Big Six collectively yield 4.0%.

And because Canada’s banks are serial dividend raisers, their forward yields—a metric that annualizes a company’s most recent quarterly payout and compares it to the current share price—tend to be even higher. Indeed, right now, they average an attractive 4.4%.

With so many dividend-paying stocks bid up by yield-hungry investors, you might assume that Canada’s Big Six trade at premium valuations. However, on both a price-to-earnings (P/E) and price-to-book (P/B) basis, Canada’s biggest banks trade at a discount to the broad market—at 11.7x and 1.7x, respectively, versus 21.6x and 1.8x for the SPTSX.

In fact, while Canada’s broad-market valuation is within shouting distance of its trailing 10-year high, at 22.9x, the Big Six not only trade at a steep discount to their high, which was 18.0x, they also trade at a moderate discount to their average P/E over this period, which was 12.9x.

Even so, such values don’t come without concerns. And Canada’s Big Six have three big concerns at the moment, and one, in particular, has weighed on recent earnings, including the latest earnings season: margin compression from benchmark interest rates that remain near historic lows, the energy crash, and the housing bubble.

At the moment, the two latter factors are commanding the most attention, since a flattening yield curve doesn’t make for compelling headlines.

While real estate markets vary by region, it’s hard to ignore the fact that the average detached single-family home in Canada’s two biggest metropolitan areas—Vancouver and Toronto—cost north of seven figures. Yes, that’s seven figures, not six figures. And, yes, we’re talking about average prices.

These statistics have prompted two Big Six CEOs—the heads of National Bank of Canada (OTC: NTIOF, TSX: NA) and the Bank of Nova Scotia (NYSE: BNS, TSX: BNS)—to sound the alarm this earnings season, with calls for regulators to boost down-payment requirements. Scotiabank CEO Brian Porter said concerns about prices in the country’s two biggest real-estate markets have prompted the bank to cut back on mortgage lending there.

But a housing crash, or at the very least, a soft landing, is not yet underway, while the energy crash has already seen what may have been its ultimate bottom.

Consequently, most headlines this earnings season concerned the rise in bad loans, largely due to the turmoil in the energy sector. Royal Bank of Canada (NYSE: RY, TSX: RY), the largest Canadian bank by market cap, saw bad loans jump by 19% quarter over quarter, to C3.7 billion. Meanwhile, RBC increased its estimate of potential future credit losses by 12% quarter over quarter, to C$460 million.

Fortunately, when comparing these numbers to the bank’s overall loan book, the situation appears contained. RBC’s ratio of gross impaired loans to total loans was just 0.71%.

The same holds true for the rest of the Big Six, whose average ratio of non-performing loans to total loans is a manageable 0.70%.

The one exception right now is Bank of Nova Scotia, whose ratio stands at 1.08%, though that’s not too far off its average of the past few years. That may be due, in part, to the fact that the bank has a more substantial international exposure than Canada’s other banks, particularly in the emerging markets.

So while the Big Six seem to have a reasonably good handle on the energy crash, it remains to be seen how they navigate whatever woes arise from Canada’s housing market.

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