Published December 5th, 2016 by The Financial Canadian
I’m a firm believer that the Canadian banks are a peer group that should hold a place in the portfolio of the dividend growth investor.
Among this peer group, Royal Bank of Canada (RY) – referred to as RBC – stands out. Besides just being the largest of Canada’s Big 5 banks, they have many traits that make them an attractive investment today – particularly regarding their dividend.
They are a member of the Canadian Dividend Aristocrats Index. This is a group of elite Canadian companies with 5+ years of consecutive dividend increases (not to be confused with the traditional Dividend Aristocrats Index, which is composed of companies with 25+ years of consecutive dividend increases). You can see the full list of ‘traditional’ Dividend Aristocrats here.
Looking back even further, RBC has paid steady or rising dividends every year since 1943. This demonstrates a level of staying power that is indicative of strong competitive advantages, high profit levels, and intelligent management.
Read on for a full analysis on the compelling investment prospects of Canada’s largest lender.
RBC is a diversified financial services provider. As the largest bank in Canada based on market capitalization (and a number of other factors, for that matter), RBC holds a leadership position in a number of personal banking product lines.
Source: RBC Fourth Quarter Investor Presentation, Slide 24
Given their size, it is no surprise that RBC holds a #1 spot in all but one market (where it holds a #2 spot).
RBC divides their operations into five main business segments:
- Personal & Commercial Banking: comprised of personal banking operations and certain retail investment businesses in Canada, the Caribbean and U.S. as well as our commercial and corporate banking operations in Canada and the Caribbean.
- Wealth Management: serves affluent, high net worth and ultra high net worth clients in Canada, the United States, and selected regions outside North America with a full suite of investment, trust and other wealth management solutions and businesses that provide asset management products and services through RBC distribution channels and third-party distributors.
- Investor & Treasury Services: serves the needs of institutional investing clients and provide custodial, advisory, financing and other services for clients to safeguard assets, maximize liquidity and manage risk in multiple jurisdictions around the world.
- Capital Markets: provides public and private companies, institutional investors, governments and central banks globally with a wide range of capital markets products and services across our two main business lines, Corporate and Investment Banking and Global Markets.
- Insurance: offers life, health, property and casualty insurance products as well as wealth accumulation solutions, to individual and group clients across Canada. We also offer reinsurance for clients around the world.
In general, RBC’s business model is quite similar to the other Canadian banks. Their main distinguishing feature is their focus on expansion in the U.S. markets, which I will elaborate on later.
I will now outline RBC’s recently announced financial performance before moving on to evaluate the Bank’s investment prospects.
On November 30, RBC reported earnings for the 3-month and 1-year period ending October 31, 2016. This section will summarize their financial performance.
First, their quarterly performance compared to the previous year:
- Net income of $2,543 million (down 2% from $2,593 million)
- Diluted EPS of $1.65 (down $0.09 from $1.74)
- ROE of 15.5% (down from 17.9%)
RBC’s quarterly earnings were below analysts’ expectations, and the stock price dropped as a result. However, investors lost sight of the fact that this quarter completes a great overall year for RBC with record net income and progress on a number of other metrics.
Next let’s consider their financial performance for fiscal 2016:
- Net income of $10,458 million (up 4% from $10,026 million)
- Diluted earnings per share (EPS) of $6.78 (up $0.05 from $6.73)
- Return on common equity (ROE) of 16.3% (down from 18.6%)
- Basel III CET1 ratio of 10.8% (up from 10.6%)
While it’s important to monitor your holdings on a regular basis, investors can harm themselves by taking too short of a time horizon. Yes, RBC’s fourth quarter was weaker than expectations, but the underlying business fundamental have not changed. It is highly probable that this bank will continue to be profitable for the next 5, 10, or even 20 years – and for shareholders, this is fantastic news.
Next I will consider the investment prospects of Canada’s largest bank.
U.S. Expansion Efforts
One of the core driving forces behind an investment in RBC is their continued growth in the U.S. Most recently, this has manifested itself through their acquisition of City National Corporation (“City National”) towards the end of last year.
City National is a financial institution located in California that serves high net worth and commercial clients. The transaction, which was announced in January 2015, closed in November of that same year.
The impact of this acquisition on RBC’s earnings was immediately tangible, particularly in the Bank’s Wealth Management segment.
Source: RBC Fourth Quarter Investor Presentation
Clearly, the City National acquisition was one of the major reasons that RBC’s Wealth Management segment reported 55% year-over-year growth in net income.
RBC provided a further update on the progress of City National’s integration with the following slide.
Source: RBC Fourth Quarter Earnings Presentation, Slide 28
It appears as though RBC’s management team is doing a great job of finding cost synergies with City National, as the acquisition’s quarter-over-quarter growth in net income from $82 million to $89 million represents an 8.5% sequential increase.
RBC’s U.S. segment should be a key driver of growth moving forward.
Strength in Asset Management
RBC is known as a leader in the wealth management industry. In Canada, they hold the number one market share in both long-term mutual funds and total mutual funds.
They have also grown their invested assets at a phenomenal pace over time.
Source: RBC Fourth Quarter Earnings Presentation, Slide 25
The AUM growth of RBC Global Asset Management from $119 billion in 2007 to $393 billion in 2016 is good for a CAGR of 14.20%.
Much of their strength in this area has been historically driven by acquisitions. One transaction to note is their 2008 acquisition of Phillips, Hager & North Investment Management Ltd. This Vancouver-based fund manager manages both retail and institutional assets and now benefits from more effective distribution via RBC’s extensive retail branch network.
More recently, RBC has further underscored their strength in Wealth Management with the City National transaction mentioned earlier.
Further, their AUM growth remains robust and they continue to hold leadership in market share.
Source: RBC Fourth Quarter Earnings Presentation, Slide 27
With AUM levels showing robust growth during recent quarters, it is reasonable to believe that RBC’s wealth management business will continue to be a driver of growth moving forward.
Dividend Yield, Growth, and Safety
Along with the other Canadian banks, RBC has an above-average dividend yield of 3.8%. This dividend analysis will mostly be focused on growth and safety.
In terms of growth, RBC has done a tremendous job of growing shareholder income over time.
Source: Publicly Available Financial Statements
Dividend growth from $0.57 in 2000 to $3.08 in 2015 is good for a CAGR of 11.9%.
Looking back over the longer-term, RBC’s dividend record is similarly impressive. As I’ve mentioned, the Bank has paid a steady or rising dividend in every year since 1943. They are also a member of the Canadian Dividend Aristocrats Index, a group of elite Canadian companies with 5+ years of consecutive dividend increases.
Perhaps even more impressive than RBC’s dividend growth is the continued safety of their dividend.
Based on fiscal 2016’s financial performance, RBC’s payout ratio was 48%. This is within their targeted payout ratio of 40%-50%, meaning that RBC has a little room to grow their dividend if earnings remain flat.
Further to RBC’s individual financial performance, they are indeed a member of the Canadian banks – often considered to be the soundest group of financial institutions in the world.
RBC did not cut their dividend during the financial crisis, though they did freeze its increases for two years. This is impressive during a time when many of their American counterparts were slicing their dividends in half, and others were requiring bailouts.
With all this in mind, I am confident in RBC’s ability to continue to produce steady and rising dividends for the foreseeable future.
Exposure to the Oil & Gas Sector
I’ve spent plenty of time describing why RBC is a good investment for safety, dividends, and growth.
However, there is no such thing as a riskless investment. It is important to consider all possible downsides before deploying money on a new investment.
One concern on the minds of many investors is RBC’s exposure to the oil & gas industry. With the continued downturn in commodity prices, defaults on oil & gas loans would increase the Bank’s provisions for credit losses and negatively impact their bottom line.
RBC has done a great job on reducing the potential impacts of this risk. First, consider the following slide.
Source: RBC Fourth Quarter Investor Presentation
First of all, RBC’s drawn exposure to the oil & gas industry has actually been on the downtrend the past few quarters. If their borrowers were truly experiencing difficulty paying back their debt, the opposite would likely occur. This is reassuring.
Secondly, a large proportion (57%) of RBC’s undrawn exposure to the oil & gas industry is to investment grade counterparties. This means that if the oil bear market worsens, then much of the newly drawn credit will be to investment grade counterparties, which are inherently lower risk.
My last point will be with regard to the proportion of RBC’s total loan book that is dedicated to the oil & gas sector, which is only 1.2%. While this is not as low as some of the other banks in RBC’s peer group (TD comes to mind), this proportion is still small on an absolute basis.
I am not concerned about RBC’s exposure to the oil & gas industry. Besides RBC’s internal risk management and portfolio construction, there are macroeconomic indications that oil prices are on the rise. The recent OPEC decision to cut supply comes to mind.
Concerns Surrounding the Canadian Housing Market
Another risk on the minds of many RBC investors is their exposure to Canadian residential mortgages.
The Canadian housing market is at all-time highs, particularly in hot markets like Toronto and Vancouver. Investors are concerned that a slowdown in these markets will negatively impact banks like RBC. Homeowners, accustomed to rapidly increasing home prices, may become unable to refinance their mortgages if home prices stay flat or decline.
There are a number of key insulators to this risk that I will discuss here.
First of all, RBC’s portfolio of residential mortgages is only a portion of their overall loan book.
Source: RBC Fourth Quarter Earnings Presentation
Residential mortgages compose only 47.5% of the Bank’s overall portfolio of loans. Narrowing our view to only Canadian Banking, the story is slightly different:
Source: RBC Fourth Quarter Investor Presentation
Looking at the data, it’s clear that just over two-thirds of the Bank’s Canadian Banking retail loan book is secured against residential real estate. It’s helpful to remember that the bank has other ways of generating interest income.
Taking a deep dive into the Bank’s loan book reveals that it is high in quality.
Source: RBC Fourth Quarter Investor Presentation, Slide 20
The Bank’s home loan book is widely diversified across geographies, with a high proportion of the loans (47%) being covered by Canada Mortgage and Housing Corporation (CMHC) insurance. This insurance pays the bank the balance of the mortgage in the event of a default and the borrower must pay monthly insurance premiums in exchange. The borrower benefits by being approved for a mortgage with a smaller down payment.
Lastly, if the worst case scenario were to occur and the bottom falls out of the housing market, it is slightly comforting to know that RBC’s competitors will all be facing the same challenges. Given RBC’s size and strong capital structure, Canada’s largest lender may be able to capitalize on opportunities presented to them by smaller competitors.
I believe that RBC will remain profitable in light of all but the most severe downturns in housing prices.
The Bottom Line
I believe RBC has many of the qualities of a great dividend investment.
They have a phenomenal record of dividend safety and growth, paying a steady or rising dividend since 1943 and being a member of the Canadian Dividend Aristocrats Index.
Even though the stock has dipped a bit due to investors’ perception of their fourth quarter earnings results, the underlying business remains strong. Do not be swayed by their short term price fluctuations.
“The single greatest edge an investor can have is a long term orientation.”
– Seth Klarman
I believe that in 5, 10, or 20 years, today’s purchasers of RBC will be rewarded. RBC is compelling dividend investment. The company currently ranks as one of the top dividend growth stocks – and a buy – using The 8 Rules of Dividend Investing.