Royal Bank is updated and rated (higher) Buy at $101.92
Note that, as an experiment, I have opened this post to comments. Click to comment. I am thinking that once in a while it might be useful to allow comments on a post.
Large banks tend to very profitable. Royal achieved a 17.0% return on owner’s equity in 2017. And, in its personal and commercial banking division it has been running at about a stunning 28% after-tax return on owners equity for at least the last three years.
In some ways the high returns on equity are surprising. Economic theory would suggest that competitors would come into the space and profits would be pushed down. And despite claims that Canadian Banking is an oligopoly, there are actually plenty of choices. In Canadian Airlines, three or even just two competitors have usually resulted in a low-profit industry. So why is Canadian banking so profitable with five large banks and numerous smaller banks and credit unions to choose from?
In my view, the biggest reason is that customers really don’t shop around that much. Once a customer has their main chequing account with a given bank, they tend to stay for many years. With pre-authorized debits it is quite inconvenient to switch to a different bank or even to switch to a different credit card. Banks take advantage of that inertia by charging lucrative fees.
Part of the reason, too is that smaller competitors tend to have higher costs due to their smaller scale.
As banking and money itself has become increasingly digital and self-serve, the operating costs for banks has fallen as a percentage of revenue. But so far, competition has not resulted in much in the way of fee reductions.
A possible reason for the high ROEs of banks is that it is a risky business. Banks operate with shockingly low levels of common equity. Royal Bank has a common equity ratio of just 10.9% of risk-weighted assets. (But this is considered high by banking standards.) On a non-risk-weighted basis, its common equity is only 5.71% (that’s leverage of 17.5 times!). After deducting goodwill, Royal Bank reports that its leverage ratio is 4.4%. That’s leverage of 23 times! On its face, that level of leverage looks risky. But Royal Bank has a very sophisticated and massive risk-management program that is designed to result in low risks. This includes limiting loans to risky businesses and having a material portion of loans in government insured residential mortgages. Credit rating agencies agree that the risks are low and have assigned Royal Bank a credit rating of AA minus despite the low equity / high leverage.
With an ROE of 17% and a price to book ratio of 2.2, and a P/E ratio of 13.8, Royal Bank appears to be an attractive investment.
But despite the risk management system, that high leverage could be a problem in certain scenarios. Royal Bank has estimated what its loan losses would be in the event of a sharp recession including a drop in house prices. But those numbers can only ever be estimated. Also, it is possible that new technologies will increase competition in banking and force a decline in fees and profitability.
Overall, an investment in Royal Bank and probably the other big Canadian banks looks attractive. It would not be prudent however to go “all in” on the banks even though such a strategy would have worked out well in the past. I can’t say what a reasonable exposure would be since it would vary widely due to individual circumstances.