Look to Canada for Healthy Banks

A CANADIAN NATIVE likes to give this quiz to his u.s. friends: What's the most boring word in investing? Answer: "Canadian." How can you make it even more boring? Put the word "banks" behind it.

But boring can be beautiful, especially when trouble erupts.

Yes, the shares of banks in the Great White North were badly bruised during last year's global meltdown, but they deserved better. Thanks to strict regulation, Canada's banks don't make subprime loans, and a typical mortgage term is only five years, greatly moderating balance-sheet risk. The largest banks have a virtual monopoly, controlling their regional markets for residential mortgages, credit cards, retail deposits and brokerage services. With their stout balance sheets and conservative bent, Canada's banks look healthy. Indeed, a recent World Economic Forum report rated the Canadian banking system as the world's soundest. In comparison, Switzerland was No. 16. The U.S. limped in at No. 40, just behind Germany (at No. 39) and ahead of the U.K. (at No. 44).

This isn't to say that Canada's financial system weathered the 2007-2008 financial debacle unscathed. Combined, the five largest banks -- Royal Bank of Canada (RY), Toronto-Dominion Bank (TD), Bank of Nova Scotia (BNS), Canadian Imperial Bank of Commerce (CM), Bank of Montréal (BMO), along with No. 6 National Bank of Canada (NA.Canada) -- have had more than $22 billion in write-downs in their securities and trading businesses since early 2007. But their American and European counterparts have fared far worse, and none of the Canadians has needed a government bailout. And now, RBC analyst André-Philippe Hardy argues, they are even less exposed to credit risk than in the past because loans make up 40% of assets, versus 45% in 2008 and 70% in the 1980s and 1990s.

Another positive: In Canada, when someone defaults on a mortgage, lenders have more recourse than do mortgage lenders in the U.S. What's more, RBC research views Canadian banks as well-insulated from some of the troubles to the south, even though they operate in the States. Through October 2008, the Canadians had only $16 billion in U.S. residential mortgages on their balance sheets -- a mere 3.5% of their total residential loans.

In some ways, anyone who invests in one of the five biggest Canadian banks -- all of which trade in both New York and Toronto -- pays a premium; in other ways, the stocks are bargains. Royal Bank of Canada, Toronto-Dominion and Bank of Nova Scotia are the group's most attractive members because they boast the most potential to boost profits through foreign growth. Each sells at more than two times book value, while some of their U.S. peers fetch less than book. But they all boast substantial dividends, rack up higher returns on assets and sell at lower multiples of current and expected earnings than their south-of-the-border rivals. The largest Canadian banks trade at an average of about 12 times estimated 2010 profits, compared with 13.7 times for JPMorgan Chase (JPM), 19.9 for Bank of America (BAC) and 72 for Citigroup (C).

The northern banks are benefiting from a robust Canadian dollar that makes it easier to expand by buying foreign companies; operations abroad already account for about a third of their earnings. And they are being helped by the fact that Canada's recession has been somewhat milder than those in the U.S. or much of Europe.

"The next 12 months still look good," Rohit Sehgal, a money manager at Toronto's Goodman & Co. Investment Counsel, says of the Canadian banks, which he thinks should be helped by cost-cutting, a more favorable yield curve and a likely decline in nonperforming loans.

Based on normalized earnings projections, RBC estimates that TD and Scotiabank shares could rise more than 18% over the next year. Wall Street analysts see the pair climbing by a more modest 14% and 8%, respectively, and Royal Bank advancing by 10%. Add dividends, and the potential total returns look juicier.