Double Digit Gains in Cheap Banks

Ken is a member of The Motley Fool Blog Network -- entries represent the personal opinion of the blogger and are not formally edited.

Much has been written and said regarding the Federal Reserve’s monetary policy and the negative impact it has and will continue to have on the U.S. dollar. Much less has been written about how investors can protect the value of their dollars from depreciating while also generating exceptional returns and avoiding high risks. Those objectives can be achieved by investing in businesses that conduct their daily affairs in Canadian dollars but have stock that trades in U.S. dollars.

Stronger than the U.S. dollar

On Jan. 21, 2012, the Canadian dollar hit an all-time low against the U.S. currency of $0.62; since that time it has worked its way steadily higher and is currently trading at a slight premium to the U.S. currency, better than a 65% gain. The Canadian dollar has risen against its U.S. counterpart mainly due to more fiscally responsible policies of their government versus the U.S. The rising Canadian dollar and high-yielding Canadian bank stocks can solve both the income needs and currency devaluation concerns of those investors seeking a solid current income stream with longer term protection of their buying power.

Royal Bank of Canada (NYSE: RY), The Bank of Nova Scotia (NYSE: BNS), and Toronto-Dominion Bank (NYSE: TD) are three Canadian banks trading on the New York Stock Exchange, but each provides investors with the opportunity to invest their U.S. currency in stock that will perform more inline with the economy and currency of Canada. In addition to performance tied to a stronger currency, these banks pay high dividends and offer excellent forward growth projections for their earnings, which should result in strong potential for capital gains in the future.

Royal treatment from Royal Bank

I know a lot of people who complain about the way they are treated by financial institutions with which they have interactions, but  I doubt many investors have serious complaints about the way Royal Bank of Canada has treated them. The rich dividend yield of 4.1% that has risen at an annual pace of 4.6% over the past five years should be enough to put a smile on the faces of just about all of its shareholders. For those with even higher expectations, this business has also produced an annualized average return on equity of 17.8% and delivered net margins averaging 23.4% for the same period.

With analysts projecting earnings to grow at an annual rate of 10% for the next five years at this bank, it would seem likely that the shares would be priced at a premium to the overall stock market and anyone making that assumption would be badly mistaken. This bank currently carries a price-to-earnings multiple of only 10.4 times projected earnings for the year ending October 2014. A share price that rises only fast enough to maintain the current P/E ratio over the next five years will reward shareholders with a total annualized return of slightly better than 14% between capital gains and dividend payments. These are outstanding returns for an investment in a business with an $85 billion market capitalization.

Cheaper price, better yield and faster growth

The Bank of Nova Scotia, with its market capitalization of nearly $67 billion, is slightly smaller than Royal Bank of Canada but it is also cheaper, higher yielding, and projected to grow earnings faster over the next five years.

Its current dividend yield of 4.2% requires a payout ratio of only 43% to maintain and has grown at an annual rate of 4.7% for the last five years. The consensus annual earnings growth predictions of the analysts covering the stock is 12%. The share price would have to rise almost 20% just to reach a price-to-earnings multiple equal to its projected growth rate and, between the share price increases and dividends, will produce an annualized return of 16.2% for shareholders if it simply rises fast enough to maintain the current P/E ratio.

When the least attractive looks pretty good

Toronto-Dominion Bank might well be the least attractive investment of the three I have identified here, but in no way should that be construed to imply it does not currently offer an exceptional investment opportunity today.

The dividend payout from this bank has grown at an annualized rate of 6.5% for the past five years and vastly outpaced inflation. The payout ratio of 39%, producing a yield of 3.9%, is far and away the lowest of the three and its projected five years earnings growth rate of 12% per year is equal to that of The Bank of Nova Scotia. The shares are currently trading at only 9.8 times the consensus earnings estimate for the year ending in October 2014 and the current price-to-book ratio of 1.6 is very reasonable. Between the nearly 4% dividend yield and strong forward growth projections, 16% annualized returns from this stock would not be an unreasonable expectation for investors.

I believe the factors that make this stock the least attractive of the three are the higher debt-to-equity ratio at 2.6 and the lower five-year average return on equity at “only” 13.8% per year. Investors considering allocating capital here should keep in mind that a return on equity of almost 14% per year is nothing to be ashamed of for a bank with a market capitalization of almost $74 billion; it is just not quite as impressive as my other selections.

Final thoughts and reasonable actions

I don’t really know if the Canadian banking industry as a whole is exceptionally valued right now, or if I just happened to select three banks that are; but the three I have looked at here all seem to be compelling opportunities. Investors seeking high yields in solid banks doing business in a safe currency need look no further than these three large Canadian banks and should seriously consider adding positions now. If the Canadian dollar continues to appreciate against the U.S. currency, investors could do even better and face less risk than being exposed to businesses dealing primarily in U.S. dollars.

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Ken McGaha has no position in any stocks mentioned. The Motley Fool recommends The Bank of Nova Scotia (USA). Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy. Is this post wrong? Click here. Think you can do better? Join us and write your own!

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