Canadian Banks are King

Most readers are likely aware that Canadian bank stocks have been a good investment. This week’s chart highlights just how profitable investing in Canadian banks has been relative to other potential investments over the last 20 years. The ‘Big 6’ Canadian Banks (BMO, CIBC, National, RBC, Scotia & TD) performance is shown in the red bars relative to the performance of broader stock indexes such as the S&P 500 and S&P TSX as well as bank stock indexes from other regions (U.S., Europe, Japan & Emerging Markets). The bars at the top of the chart represent the annualized return from investing in each respective index over the past 20 years. For example, investing in the ‘Big 6’ Canadian banks has returned an average of 13% per year over the past 20 years relative to the S&P 500 at 11.4% per year and the S&P TSX at 8.8% per year.

The world’s most sophisticated investors (e.g. pension funds, hedge funds, etc.) analyze investment returns relative to risk. It’s one thing to say that your portfolio returned 15% last year but do you understand how much risk you took to achieve that return? Most people don’t, which is why they turn to professional money managers to help them achieve their objectives while taking the least amount of risk required. In other words, the goal of professional investment managers is to maximize risk-adjusted returns. There are several ways to measure risk-adjusted returns, one of the best known being the ‘Sharpe Ratio’ which calculates the excess return earned over a risk-free rate (e.g. government bond) per unit of volatility. This week’s chart is great because it depicts return relative to risk on the bottom of the chart, and, once again, notice that Canadian banks have outperformed the broader equity markets (e.g. S&P 500) as well as banks in other regions of the globe on a risk-adjusted basis.

Why has the performance of Canadian bank stocks been so strong and will this outperformance continue? Unfortunately, I don’t have a crystal ball and can’t predict the future. However, we can examine the factors driving Canadian bank outperformance and question if there is likely to be a change in these factors. The long-term outperformance of a company’s stock can be driven by several factors but two of the most common are the quality of the management team and strategic barriers to entry. The first factor is relatively easy to understand; stronger management teams tend to make better decisions which lead to higher profits and ultimately drive share prices. The second factor, barriers to entry, is a bit more complicated. If a company earns a high profit margin, competitors will enter that sector, compete for business; driving down prices and profit margins. If, however, significant barriers to entry exist which make it difficult for new businesses to compete, existing companies can continue to earn excess profits. The ‘Big 6’ Canadian banks have a significant barrier to entry, legislation. Canadian federal legislation (The Bank Act) regulates which companies can operate as Schedule 1 Banks in Canada which limits the ability of foreign banks to compete. In this way, Canadian banks operate more like an oligopoly which can maintain high profit margins indefinitely.

The ‘Big 6’ Canadian bank stocks have been excellent investments and continue to attract the ‘best and the brightest’ management teams given their ability to compensate these individuals beyond what most companies or organizations can pay. Furthermore, federal legislation effectively limits competition in the Canadian banking sector which contributes to higher profit margins. If these factors remain unchanged, Canadian banks will remain well positioned as attractive investments.