Which Canadian Bank Stock is Best?

Let’s take a break from discussing obscure small caps and talk about some of the largest, most popular, and many would argue the most iconic names of the Toronto Stock Exchange. Yes, I’m talking about Canada’s largest bank stocks.

(For those of you who subscribe for the obscure and the overlooked, don’t worry. Next week we’re doing to delve into some cheeeeeap oil stocks.)

Like a lot of Canadian investors, your author has large positions in seven major Canadian banks. From largest to smallest, my positions include:

1. Bank of Nova Scotia

2. Canadian Imperial Bank of Commerce (CIBC)

3. Toronto-Dominion Bank (TD)

4. Royal Bank of Canada

5. Bank of Montreal

6. National Bank of Canada

7. Equitable Bank

These seven stocks represent approximately 15% of my portfolio and about 13% of my total dividend income. For someone who diversifies as widely as your author, these are the equivalent of the crown jewels. They’re positions I plan to hold for a very long time, happy to collect my dividends as these legendary financial institutions continue to harvest profits from every corner of the Canadian economy.

Canada, of course, is a mature market whose only real growth prospects come from immigration or an upcoming supercycle in commodities. It also has what many pundits view as a fragile housing market, one that seems to be seeing some profound weakness as interest rates rise. But the nice thing about housing — and the banks that lend against it — is twofold. Toronto and Vancouver may be rolling over, but cities in Alberta and Saskatchewan are booming. A collection of regional economies helps. And mortgage default insurance (which is underwritten largely by the federal government) protects lenders from the worst of an imploding housing market.

In short, you have six large banks (and Equitable, an interesting challenger) who dominate the Canadian banking scene. These bankers are smart, disciplined, and have the implicit trust of the market. Since they dominate in so many corners of the market many pension funds and index funds have no choice but to own large positions in each. They’re also seen as the default option for foreign investors looking for Canadian exposure.

Financial results are also consistently excellent. Loan losses are small, thanks to the aforementioned federally-backed mortgage default insurance scheme. It’s hard to go broke when the feds insure your riskiest loans. Earnings tend to go up every single year, with dividends following closely behind. And when it comes to metrics like efficiency ratios and returns on equity, Canada’s banks post some of the best results on the planet.

For the most part, this intro is preaching to the choir. Many Canadians have a good chunk of their portfolio in our largest banks, attracted to everything I just said, plus a history of solid long-term returns. Each of the largest Canadian banks have returned 10%+ annually to investors over the last century, mostly consistent returns with plenty of dividends. I fully expect that to continue, as does the rest of the market. Even if there are a few hiccups along the way.

But which Canadian bank stock should you buy today? That’s the question everyone wants to talk about. You’ve got to have a favourite, right? I sure do, but first let me present a simple way to pick the Canadian bank stock with the best long-term return profile.

My Simple Rule

It’s really quite simple. The way to ensure you outperform the market on Canadian bank stocks is to…

Drumroll please…

You simply buy the one that has underperformed over the last five years.

Do you see why I needed all that preamble? Because I just gave away the secret in one sentence.

The nice thing about Canadian banks is they’re just different enough that narratives can drive each of the names. TD is the one with exposure to the eastern seaboard in the U.S. Royal Bank is the one that has expanded into U.S. wealth management. BMO and its subsidiary Harris Bank are big in the midwest U.S. The big criticism for CIBC used to be its Canada-centric focus, although it recently bought U.S. assets to help squash that. Now it’s National Bank that gets the too-much-Canadian-exposure discount. And Scotiabank has substantial Latin American assets. All of these are just different enough that investors will sell the bank with a poor performing secondary business in favour of one where are cylinders are firing.

With this rule in mind, let’s take a look at what happened over the last five years:

This might not be the easiest chart to read (you get what you pay for, basically), so let’s put the five-year returns here. We’ll add another column that include the returns including reinvested dividends:

There. Even the Boomers should be able to see what’s going on.

A couple observations:

1. Even through a covid shutdown and now a slowing housing market, Canadian bank stocks have performed quite well

2. Look at the impact dividends have. Even if you didn’t reinvest dividends back into bank stocks and you put them to work somewhere else, the compounding effect is quite similar

3. Even though Scotiabank lagged, dividends ensured it wasn’t a disaster. This is a big reason I insist on dividends

Results of this test from 2012 to 2017 were interesting. The laggers were BNS (12.8% CAGR, including reinvested dividends) and NA (12.9% CAGR including reinvested dividends). So it works! Kind of.

The bank stock I like best

It’s very simple. I continue to like Scotiabank best, and not just because it’s been the worst performer, either. Although I’m the first to admit that’s a full 75% of my thesis.

Canada’s third largest bank has suffered from a litany of problems over the last few years. It was the most aggressive lender to oil and gas companies a decade ago, a policy that came back to bite them when oil crashed. They got much of that debt off the balance sheet just in time for oil to spike again. Timing on both sides was impeccably bad.

Scotiabank also has earned a reputation for being the most aggressive of the Big Six on the mortgage lending side. One piece of evidence to back this up is the company’s share among mortgage brokers. BNS consistently has the best market share with mortgage brokers, even beating out lenders like First National that operate exclusively in that space.

But the big thing holding Scotiabank back is its exposure to Latin America. Approximately a third of its earnings come from assets in nations like Mexico, Peru, Colombia, and Chile. Despite the promise of these emerging markets, they never quite live up to expectations. Various issues keep these countries from realizing their full potential.

Is that changing? Damned if I know. Macro is not my game. But there are a few reasons to be optimistic. Demand for commodities is heating up, with many of these economies overly reliant on the sector. Mexico and Colombia produce nearly 2M and 1M barrels of oil per day, respectively. Chile is famous for copper and other mined substances. These economies should be better positioned in today’s world than other emerging markets like Africa and Southeast Asia.

This should, in turn, lead to higher profits for Scotiabank’s Latin American division.

There’s also the issue of investor sentiment. Many have sworn off Scotiabank forever, content in the knowledge that Latin America will never recover. The thesis has worked out pretty well for the last few years, so it should continue indefinitely. Or at least that’s how the logic goes.

Want proof? I’ll share this on Twitter immediately after I publish. Just watch the comments come in on how Scotiabank will never outperform again.

Sentiment changing is a powerful factor, but it requires patience. I’ve been pounding the table on Scotiabank for the better part of five years. As you saw above, I’ve been wrong. It would have been better to invest in literally any other large Canadian bank. But dividends ensured the investment wasn’t a disaster, and the longer we wait the tighter the spring gets coiled. I think we’re looking at a 15-20% CAGR over the next 5 to 10 years as investor sentiment switches to liking emerging markets again.

The bottom line

There’s a reason why I own all six of Canada’s largest banks rather than putting all my cash into Scotiabank. I’m often wrong, and I’m the first to admit finding an edge when analyzing such widely held companies is no picnic. In other words, hedge your bets because I picking bank stocks is hard.

That’s good advice in general, really.

But I’m still going to stubbornly say Scotiabank is the bank stock I think has the best medium-to-long term potential today. And as the last five years proved, if I’m wrong, it still won’t be a disaster. You’ll still collect your nearly 5% dividend that should easily grow 5-8% a year. And if I’m right, you should be able to double your money in the next five years. That might not be a home run, but it should be plenty good enough for a conservative income investor.