Experts weigh in on the benefits and drawbacks of investing in Canadas top banks

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There are three major reasons why investors are drawn to Canadian bank stocks, according to experts – they are considered safe investments, they provide high-paying dividends, and they are often great for long-term holding.

Although banks have underperformed in the Toronto Stock Exchange (TSX) Index in the past year due to the economic disruption caused by the pandemic, experts say they are now gaining momentum as the economy slowly reopens.

“The good news is that in 2021, [Canadian banks] have once again started to outperform,” wrote Dan Kent, active dividend and growth investor, in an article for Stocktrades.ca. “In fact, through the first few months of the year, every single one of Canada’s banks are outperforming the index.”

“Despite the runup in price, the potential for rising rates and a strong economic rebound are reasons enough to start or add to your positions today. Even without those tailwinds, Canada’s banks are among the strongest investments in the country,” he added.

Kent, however, warned of the drawbacks. Because of the uncertainty of the coronavirus crisis’ impact in the banking industry, the Office of the Superintendent of Financial Institutions (OSFI) has placed a cap on dividend raises as a part of a range of temporary measures.

“The good news is that banks have proven capable, and the impacts haven’t been as bad as feared,” Kent wrote. “Furthermore, these measures were not a reflection of their financial positions. The banks are excellent stocks, and the measures were implemented out of an abundance of caution.”

Kent added that the OSFI has begun scaling back on these measures and it is only matter of time before it lifts the cap on dividend raises.

“Once the go-ahead is given, expect all of Canada’s banks to resume their strong history of dividend growth,” he wrote.

What are the indicators of a good bank stock?

Investors use several key indicators to assess the value and growth potential of a stock. Here are some of these indicators, according to the Ontario Securities Commission (OSC).

Market capitalization: Also called market cap, this refers to the total value of a company’s shares of stock. The figure is calculated by multiplying the stock price by the total number of outstanding shares. The market cap enables investors to understand the relative size of a company against another.

Price-to-earnings (P/E) ratio: This is the ratio of a company’s stock price to its earnings per share (EPS). The number is calculated by dividing the current price per share of a company’s stock by its EPS. The P/E ratio indicates whether a stock’s price is high or low compared to a company’s earnings.

Price-to-book value ratio (P/B): This is the ratio of the company’s market cap to its book value. It is calculated by dividing a company’s stock price per share by its book value per share. Investors searching for a well-priced stock with reasonable growth potential often go for low P/B ratio to identify possible stock picks as this indicates that they are paying less for more book value.

Dividend yield: This is the ratio of how much a company pays out in dividends annually relative to its stock price. The number is calculated by dividing the annual dividend per share by the price per share. It tells investors how much cash flow they are getting.

Dividend payout ratio (DPR): This is the ratio of how much a company pays out to investors in dividends compared to what the stock is earning. It is calculated by dividing the annual dividends per share by the EPS. The DPR indicates how well a company’s earnings support its dividend payments.

What are the best Canadian bank stocks to buy this year?

Wealth Professional Canada has searched investment research platform YCharts’ data to find the best Canadian bank stocks to buy in 2021 using the key indicators above, along with a few expert insights. The list below is arranged from largest to smallest market cap. The numbers are based on YCharts’ June 18 data.

All banks listed are Canadian dividend aristocrats, meaning they are listed on the TSX and a member of the S&P Canada BMI, has increased their dividends for at least five consecutive years, and boast a market cap of at least $300m.

1. Toronto-Dominion Bank (TD)

Market cap: $158.39bn
P/E ratio: 11.21
P/B ratio: 1.768
Dividend yield: 3.47%
DPR: 35.96%

Among the country’s big six banks, TD Bank has the highest exposure to the US, with more than two-fifths of its revenue coming from south of the border. Kent noted that the US’ more successful vaccine rollout compared that in Canada can push it to outperform.

According to Kent, TD Bank has averaged 6.83% and 8.79% annual earnings growth in the past five years, including 2020, which was greatly impacted by the pandemic.

“These are the highest growth rates among any of the big six banks,” he wrote. “This is one of the primary reasons TD Bank has been able to grow its dividend at a rapid pace and owns the highest dividend growth rate of its peers.”

2. Royal Bank of Canada (RY)

Market cap: $144.31bn
P/E ratio: 13.41
P/B ratio: 2.071
Dividend yield: 3.43%
DPR: 44.85%

Royal Bank’s main advantage is its global exposure, according to Kent. This diversification enables to bank to provide stable revenue and earnings as many economies deal with the COVID-19 crisis.

“Given its size and status as the largest company in the country, Royal Bank provides unparalleled safety,” he wrote. “It is one of those rare stocks that you can buy at any point. While you don’t necessarily want to overpay, today the company is well-priced and should continue to do well for years to come.”

Christopher Liew, chartered financial analyst and creator of Wealthawesome.com, meanwhile, noted that one major advantage of investing in Royal Bank is its high dividend growth rate.

“Its 25-year dividend CAGR is about 11.3%,” he wrote. “And since its stock is also less costly than other banks ($64.50 per share at the time of writing this), you will get more shares for the same amount of investment, and a higher dividend growth rate would ensure that payout increases benefit you more.”

3. Bank of Nova Scotia (BNS)

Market cap: $77.32bn
P/E ratio: 13.35
P/B ratio: 1.496
Dividend yield: 4.34%
DPR: 58.99%

The primary reason why it is good invest in Scotiabank stocks is the “amazing yield” the bank is currently offering, according to Liew.  

“It has also, unfortunately, been the slowest recovering bank after the March crash,” he wrote.  “If you want to lock in a good yield, the time might be ripe because once it recovers, the yield will shrink, and to make up for the pandemic-driven losses, the next year’s payout growth might not be very generous.”

4. Bank of Montreal (BMO)

Market cap: $65.88bn
P/E ratio: 14.57
P/B ratio: 1.628
Dividend yield: 3.22%
DPR: 41.58%

Kent describes BMO as one of the most consistent performers among all Canadian banks.

“Outside of this past year where previous underperformance has led to it leading its peers, BMO has consistently been [in the] middle of the pack in terms of performance,” he wrote.

Liew added that while the bank’s dividend yield is not “particularly impressive,” its capital growth history in the past 20 years and its ability to replicate this make the company’s stocks potentially great for long-term holding.

“Its balance sheet is strong, its annual revenue growth is impressive, and the bank managed to maintain a pretty steady net income margin for the last five years,” he wrote. “Right now, the stock might be considered discounted, but if you want to buy it, a better time would be another dip. That way, you would be able to lock in a better dividend yield.”

5. Canadian Imperial Bank of Commerce (CM)

Market cap: $52.22bn
P/E ratio: 12.77
P/B ratio: 1.647
Dividend yield: 3.83%
DPR: 48.52%

One of the major draws for investing in CIBC is the “generous yield” it offers compared to other banks, according to Liew.

“If you can invest a sizeable sum in this bank stock now, you’d be able to lock in a very juicy yield,” he wrote. “And since it has also been a dividend aristocrat for nine years, the bank is highly unlikely to slash its yield in the future.”

However, Liew pointed out that the company’s growth has remained stagnant after posting “one of the best recoveries” after the market crash and may stay this way until economy totally recovers from the pandemic’s impact.

“But if you are willing to hold on to the security for a long time, it might outperform many of the flashier (but unstable) growth stocks you might want to invest in,” he wrote. “Its balance sheet is stable but not very strong, but the bank has been increasing its revenues steadily for the last five years. This means even if the stock’s performance is not mimicking it, the institution is actually improving its returns.”

6. National Bank of Canada (NA)

Market cap: $30.91bn
P/E ratio: 14.59
P/B ratio: 1.968
Dividend yield: 3.1%
DPR: 35.81%

National Bank is Liew’s top choice to buy stocks from this year for two reasons – its rewarding balance of dividends and the potential for capital growth.

“National Bank… has increased its dividends for ten consecutive years,” he wrote. “It’s offering a decent 4.1% yield (as of May 18) right now, though if you get a chance to buy into the company during a market crash, you’d be able to lock in a significantly better yield.”

7. Canadian Western Bank (CWB)

Market cap: $3.027bn
P/E ratio: 10.96
P/B ratio: 1.076
Dividend yield: 3.34%
DPR: 41.43%

CWB is another bank with an impressive dividend history. According to Liew, the bank has been growing its dividends for 28 straight years and considered a dividend aristocrat even beyond Canada’s borders. But investing in CWB stocks also has its share of drawbacks.

“The yield is decent, and the payout ratio is very secure, but that’s about it,” he wrote. “Its share price history is shaky, and the 10-year CAGR is just 3.48%.”

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