In the Hamilton Capital Global Bank ETF (HBG; TSX), we generally seek to hold 50% North American banks, with an emphasis on the ~200 publicly traded U.S. mid-cap banks (those firms with <$100 bln in assets). As of the time of writing, HBG had exposure to 23 U.S. banks representing 43% of the ETF’s net asset value.
Relative to their larger peers, U.S. mid-cap banks generally are growing EPS faster. In fact, in Q3, HBG’s portfolio of U.S. mid-cap banks had EPS growth of 19% Y/Y (see “Another Sector Leading Quarter for HBG’s U.S. Banks: EPS Up 19% Y/Y”). In addition, U.S. mid-cap banks are more interest rate sensitive, have significantly less regulatory risk, and are consolidating.
On the last point, we have noted that the strategic positioning of the Canadian banks to participate in U.S. M&A has advanced significantly in the past ten years. The Canadian banks have been aggressive participants over the last decade, acquiring no less than 12 U.S. mid-cap and small-cap banks as the group has sought to build out the U.S. commercial banking platforms.
Not surprisingly, U.S. mid-cap banks remain – by far – the largest destination of capital deployment of the Canadian banks. We expect this trend to continue and believe Canadian bank investors should focus on the 30 largest U.S. mid-cap banks. These banks are small enough to keep acquisition risk low, but large enough to provide strategic benefit. Indeed, of the ten largest U.S. mid-cap banks from a decade ago, the Canadian banks acquired four of them (M&I, Commerce Bancorp, City National plus Banknorth, which was already majority owned by TD).
In this HBG Manager Comment, we highlight three reasons why it is much easier now for Canadian banks to acquire U.S. mid-cap banks than it was a decade ago.
First, the relative scale of the Canadian banks versus the 30 largest mid-cap banks has improved dramatically. Ten years ago, by market capitalization, the Canadian banks were just over 50% larger than these 30 banks; now, they are over three times larger. This means that future deployments in this category of banks will be less risky, both from an asset perspective (i.e. potential impact on asset quality) and an earnings perspective (i.e. less dilutive).
Second, the absolute scale of the Canadian banks’ U.S. commercial bank platforms has grown significantly. M&A accounts for most of this very large increase, as four of the Big-6 having made material acquisitions including TD Bank (Commerce Bancorp, Hudson United, the South Financial Group, and three small Florida banks), Bank of Montreal (Marshall & Ilsley and numerous small-caps), Royal Bank (City National acquired; legacy Centura platform sold), and most recently, CIBC (Private Bancorp, announced in July).
Third, the fact that two quality mid-cap U.S. banks have sold to a Canadian bank in just the past two years suggests a willingness on the part of U.S. banks to accept Canadian bank shares as an acquisition currency. A decade ago, it was conventional wisdom that U.S. mid-caps seeking to sell favoured U.S. acquirers.
This positive sentiment change is likely supported by the Canadian banks’ performance during the financial crisis, combined with years of a harsh U.S. regulatory environment, particularly against the largest banks (in stark contrast to Canada, which arguably has the most pro-bank regulator globally).
To illustrate just how far the Canadian banks have advanced strategically in terms of U.S. expansion, look no further than RBC. When RBC acquired Centura Banks in early 2001, the offering price for this construction-focused bank, located in rural North Carolina, represented a highly material ~10% of RBC’s market capitalization (i.e. C$3.5 bln versus C$30 bln). Fast forward to 2015, RBC was able to acquire one of the most sought-after platforms – City National – at US$5.0 bln. This bank was significantly larger, of higher quality, and yet, the purchase price represented less than 6% percent of RBC’s market cap. Moreover, consider today, there are fewer than 20 banks in the entire U.S. banking sector with a market cap greater than 10% of RBC’s. This is evidence of a huge step forward in relative scale. And this is positive for the banks as they continue to build out their U.S. commercial banking platforms.
It is also one of the reasons we favour U.S. mid-cap banks.
Note: Comments, charts and opinions offered in this commentary are produced by Hamilton Capital and are for information purposes only. They should not be considered as advice to purchase or to sell mentioned securities. Any information offered is believed to be accurate, but is not guaranteed.