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In recent articles I have indicated that I like Warren Buffett's 'punch card' analogy when it comes to investing which favors investing in a relatively small number of high quality companies as opposed 'throwing mud against the wall' which involves investing in a large number of companies. I prefer to limit the number of companies in which I invest because I can not possibly closely follow a company given that I like to review the quarterly and annual results and any 'material event' information.
Summary
- The Royal Bank of Canada is currently Canada's largest bank from a market cap perspective (currently ~$153B CDN).
- Since the turn of the 21st century, shareholders have been rewarded with a 14.5%+ average annual total return where dividends have been reinvested and 12%+ where dividends have not been reinvested.
- After several quarters (November 2007 - May 2011) in which the quarterly dividend was frozen at $0.50, RY re-instituted its dividend policy in which the quarterly dividend is increased after two quarters. This, however, ended in May 2020 when COVID-19 hit.
- The bank's strong capital ratios are such that share buybacks and/or an increase in the quarterly dividend could very likely resume in 2021.
- Investors would be wise to consider the risk they are assuming when making an investment as focusing solely on potential return could lead to unpleasant consequences. I view RY's risk as satisfactory for my purposes.
Introduction
Although I am of the opinion a great number of companies are grossly overvalued, there are a few high quality companies I think are undervalued/fairly valued. The Royal Bank of Canada (RY.to), one of my largest holdings at the time I completed my Portfolio Review in August 2020, is one such company. In my opinion, the current valuation and the company's future prospects are such that an investment in RY should present investors with an opportunity to generate a reasonable return on investment over the long-term.
Business Overview
I encourage you to read 2020 Annual Report in which a comprehensive overview is provided.
FY2020 Results and FY2021 Outlook
RY's Q4 and FY2020 results can be accessed here.
FY2020 Diluted EPS of $7.82 was down 11% from FY2019. This decline reflected higher provision for credit losses (increased by $2.5B from the prior year), as RY built reserves given the unprecedented challenges brought on by the COVID-19 pandemic and the impact of lower interest rates. Lower results in Personal and Commercial Banking and Wealth Management were partially offset by robust earnings in Capital Markets as well as higher results in Investor and Treasury Services and Insurance.
On the December 2, 2020 call with analysts in which management discussed FY2020 and the outlook for 2021, management indicated the economy has rebounded well to date. Given the emergence of the second wave of COVID-19 in core markets, however, management expects economic growth to slip over the next couple of quarters.
Despite the uncertainty and volatility in FY2020, the strength and liquidity of RY's balance sheet remained constant. The bank ended the year with a record Common Equity Tier 1 ratio of 12.5%, with Common Equity Tier 1 up nearly $6B over the past year. This provides a $19B buffer against the current regulatory minimum of 9%. In fact, RY is not the only bank which can boast of a strong capital position. Canada's Big 6 banks have been stockpiling so much capital to ensure they could withstand the strains of COVID-19 pandemic, that they now have to determine how to spend all that extra money; as at October 31, 2020 (the banks' fiscal year end, the Big 6 were sitting on $70.4B (US$55.5B) more in Common Equity Tier 1 capital than required by regulators!
RY also increased its allowance for credit loss to over $6B which is up nearly $3B from FY2019. This represents over 4.5 times coverage of the last 12 month write-offs, and nearly 90 bps coverage of loans and acceptances.
On page 5 of 228 in the FY2020 Annual Report you will find the bank's 3 and 5 year medium-term objectives. RY met 3 out of 4 stated financial objectives but fell short on EPS growth, given significantly lower interest rates and the record level of PCL recorded under IFRS 9. Despite current headwinds, the bank remains committed to its medium-term objectives but has suspended 2021 targets highlighted at its 2018 Investor Day.
Credit Ratings
I think far too many investors fail to take into consideration the degree of risk they are assuming with the investments they are making. In my opinion, it is extremely important to consider the risk aspect of an investment and not just the potential reward.
In order to gauge the degree of risk I am assuming with my equity investments I look at how the major credit ratings agencies view a company's debt. I then factor into my analysis the fact that common equity investors assume a greater degree of risk than debtholders. Given this, if I see that a company's debt is non-investment grade I need to very seriously consider whether I truly want to 'speculate'.
We each have our own tolerance for risk so it is certainly not my intent to disuade an investor from 'speculating'. I merely bring the risk aspect of an investment into my review to encourage readers not to just gloss over 'risk'. I want investors to determine whether their assumed tolerance for risk will be the same if the company's share price drops significantly.
In my case, I NEVER EVER want to return to the workforce to generate income because I made poor investment decisions!
Having said this, let's have a look at RY's credit ratings.
We can see that RY's senior debt is rated 'investment grade'. Surprisingly, Moody's and S&P Global rate it at the middle tier level of the upper medium investment grade category. Fitch, however, rates the same debt at the middle tier of the high grade investment grade category. That is a 3 notch difference!! How there could be such a disparity in ratings is beyond me but I will err on the side of caution and go with the lower ratings; I am satisfied with that risk level.
Now, we know that preferred shares rank in priority to common shares in the event something terrible happens to the company. Looking at the preferred share ratings we see Moody's has assigned at Baa3 which is the lowest tier of the lower medium investment grade category. S&P Global rates that very same debt BBB+ which is the top tier of the lower medium investment grade category. This is a 2 notch difference!
Although Moody's rating of RY's preferred shares is one notch above 'Non-investment grade speculative', I certainly do not think RY's common shares are speculative and am satisfied with the risk I am assuming with my RY investment.
If there is one thing I would like you to take away from this credit ratings review is the extent to which risk increases when you go from 'Senior Debt' to 'Preferred Shares'. In the case of S&P's ratings, there is a 3 notch drop and in the case of Moody's there is a 4 notch drop!
So....if you're investing in Tesla (TSLA) whose long-term debt is rated B2 and BB by Moody's and S&P Global respectively, just what kind of risk do you think you are taking on with your TSLA common share investment? B2 is the middle tier of the 'highly speculative' category and BB is the middle tier of the 'non-investment grade speculative' category. There is a 3 notch difference between both ratings but regardless of this, your TSLA common shares are highly speculative and carry substantial risks.
Valuation
In FY2020, RY generated $7.82 in diluted EPS. With shares currently trading at ~$108, RY's PE using last year's results is ~13.8 versus 11.68, 12.07, 12.89, 13.37, 11.02, 13.40, 13.58, 11.18, 11.74, and 13.37 in FY2011 - 2020.
While management is not providing FY2021 guidance, 15 analysts have provided estimated adjusted EPS figures for FY2021 ranging from $8.21 - $9.35 with a mean of $8.73. Using this range and the current ~$108 share price, we get a forward adjusted PE range of ~11.55 - ~13.15. If we err on the side of caution and go with $8.60 we get a forward adjusted PE of 12.56.
COVID-19 has certainly impacted current economic and business conditions but RY appears to be managing its business extremely well. While it is difficult to predict FY2021 results I am confident that the business is being managed so that RY's share valuation will remain somewhat in line with historical levels.
Details on RY's dividends can be accessed here.
In recent years, RY would reward investors with a moderate dividend increase twice a year. When COVID-19 hit in early 2020, however, RY paused its dividend increases. The quarterly dividend has remained constant at $1.08/share/quarter but RY has weathered the 'storm' well and, as I noted earlier, excess capital accumulated over the past several months could very well be deployed for acquisitions, share buybacks, and/or dividend increases. While I do not have a crystal ball I suspect RY might communicate how excess capital is to be deployed as early as February 24th when Q1 results are to be released.
Even if a dividend increase does not materialize, shareholders are receiving a ~4.00% dividend yield ($4.32 dividend year/ ~$108 share price). This really is not a bad dividend yield considering the current low interest rate environment.
On the share count front, I see that RY reported an average number of 1,428,770 (000's) diluted common shares outstanding in FY2020 versus 1,433,754 (000's) in FY2010.
Final Thoughts
In recent articles I have indicated that I like Warren Buffett's 'punch card' analogy which states that 'an investor should act as though he had a lifetime decision card with just twenty punches on it.' I view this as a bit extreme and have expanded this figure to 30 - 35. As a result, I am looking to increase my exposure to reasonably valued / undervalued companies versus initiating new positions. This is somewhat difficult in this environment since the valuation of so many companies have become detached from their underlying fundamentals. As I have mentioned in previous articles, I think investors will be hard pressed to generate decent returns when they invest in companies that are trading at 30+ times forward earnings.
RY is still one of my top 10 holdings (it was when I last did a comprehensive analysis of my holdings in August 2020) and despite the share price run up since late October 2020 I view shares as still being reasonably valued.
Following today's RY share purchase, my total RY holdings will now generate low 5 figures in annual dividend income which can be reinvested to acquire additional shares so as to generate more dividend income (the wash, rinse, repeat principle).
On a final note, RY is hosting its 'RBC Capital Markets Canadian Bank CEO Conference' on January 11th. If RY remotely interests you as an investment, you may wish to check the Events and Presentations section of RY's website over the next few days to listen to the webcast before it expires; the webcast of the 2020 conference has expired.
Stay safe. Stay focused.
I wish you much success on your journey to financial freedom!
Note: Thanks for reading this article. Please send any feedback, corrections, or questions to [email protected].
Disclaimer: I have no knowledge of your individual circumstances and am not providing individualized advice or recommendations. I encourage you not to make any investment decision without conducting your own research and due diligence. You should also consult your financial advisor about your specific situation.
Disclosure: I am long RY.
I wrote this article myself and it expresses my own opinions. I am not receiving compensation for it and have no business relationship with any company whose stock is mentioned in this article.
