Investing in Foreign Banks: What You Need to Know

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Foreign banks can help you diversify your portfolio, and can also be excellent choices for income investors.

In this episode of Industry Focus: Financials, host Michael Douglass and banking specialist Matt Frankel discuss some of the things investors need to know when considering non-U.S. banks.

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A full transcript follows the video.

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This video was recorded on March 5, 2018.

Michael Douglass: Welcome to Industry Focus, the podcast that dives into a different sector of the stock market every day. It's Monday, March 5th, and we're talking about investing in international banks. I'm your host, Michael Douglass, and I'm joined by Matt Frankel. Folks who have been listening for a little while know that we did a three-part series on the big American banks. We started with the investment banks, then we went to the universal banks, and then we ended with the commercial banks.

Now, with that as a background, and using the same framework that we've been using to approach banks, let's talk a little bit about international banks. The first thing we should note here is that international banks, in a lot of was, are pretty similar to U.S.-based banks. Generally speaking, they take in money as deposits, they lend it out at a higher rate, and that's how they make their money. And they have largely the same valuation metrics as U.S. banks, too.

Matt Frankel: Yeah. Just like the U.S. banks, you can find foreign banks that are purely commercial banks, investment banks, universal banks, kind of like our three-part series that we just did. And you use kind of the same valuation metrics to evaluate them. Price to tangible book is always one of our favorites when it comes to banks. Again, don't put too much stock into the price to earnings ratio with a bank. The price to tangible book combined with profitability metrics such as return on assets, return on equity, which by the way, you want to see about 1% and 10%, give or take, on those, respectively, efficiency ratio, when you put those metrics together it gives you a good picture of what you're buying for your money.

Douglass: And I'll double underline efficiency ratio as such a useful way to understand how effective the bank is at making sure that top line revenue flows down to the bottom line. Of course, foreign banks, international banks, also have some differences from the U.S. One of them that we should note is that every country has a somewhat different framework for how they approach banking. There's a lot of diversity out there. It's very hard to paint with a broad brush stroke. But, there are a couple of things we can keep in mind. One of which is, they aren't regulated by the Fed. Usually, that means they have a little bit more control over their dividend policy.

Frankel: Yeah, because they kind of make their own capital plans. For a couple of sentences of background, in the U.S., banks have to submit to what are called the stress tests every year and submit a capital plan, which is what they intend to do with their profits, including dividends, share buybacks. And the Fed has to approve this, essentially saying that if a bank gave X amount of dividends and bought back X amount of shares, under a worst-case scenario, they would still be just fine, capital-wise.

With foreign banks, you generally don't have that. Like Michael said, different countries have different regulations. But, generally, foreign banks get to set their own dividend policies, which leads to better dividend stocks. Anyone who focuses on income for investments generally doesn't like the U.S. banks because their dividends are stuck at 1-2% right now. But, in the case of foreign banks, one of my favorites that I'm going to talk about quite a bit this episode is Toronto-Dominion Bank, which most Americans know as TD Bank. They pay close to 4%. The other major Canadian banks pay around 4%. Other major international banks, like Credit Suisse, for example, pays around 4%. So, for income investors, the fact that these foreign banks are allowed to set their own dividend policies for the most part, is a nice little feature that could add some more income to your portfolio and still give you exposure to the banking sector.

Douglass: Yeah. Of course, there are a few other things we should keep in mind. One of the big ones is, as I noted earlier, these are often headquartered in very different countries, with very different currencies. Currency fluctuation can be a big thing, it can make a really big difference to U.S. investors as they're approaching a bank based in, say, the U.K. vs. one that's based in Canada. There are very different things going on geopolitically with those two countries right now, and it's something you have to consider.

Frankel: Yeah, definitely. With TD, just going back to their example, if you look at a chart of TD's dividend over the years, you might at first glance think they changed their dividend every day. But their dividend is paid out in Canadian dollars, which have fluctuated quite significantly over the past few years in relation to U.S. dollars. Just to give you a statistic, over the past five years, the U.S. dollar has strengthened by more than 22% against the Canadian dollar, which has had big implications not only for the dividend, but for the stock price, as well.

The same holds true for other countries around the world. Which is why, when it comes to foreign banks, I generally advise sticking to the most stable countries in terms of currencies. I tend to avoid emerging markets, for example, when it comes to banks. Currency fluctuations are definitely something to keep in mind, not only with dividends but in terms of the share price as well. Your stock can drop without any other reason than the U.S. dollar got stronger.

Douglass: And one of the more underlying business things we should talk about here, political and economic stability is a thing that we can assume in a lot of the world, but it's also something we can't assume in a lot of the world. And many of these financial institutions operate in places that, frankly, you really don't know what's going to happen, there's a lot of political instability. And that could be a sizable issue. Even, think of ike Greece. Had Greece defaulted, that would have done some really interesting things to the financial system there, and it would have had some really big negative implications for the banks.

Frankel: And for some bank stocks, it did. National Bank of Greece, for example, their investors got wiped out. And not just instability, but a lot of places around the world are in different stages of the business cycle than we are. Europe, for example, is a few years back when it comes to recovering from the financial crisis. So, they haven't had the massive run up in bank stocks like we've had. To underline the point, they're not the U.S. Keep that in mind when you're trying to choose a foreign bank. Take a few minutes to get to know the political climate over there.

Douglass: Right. And one of the key things with that political climate to consider, as well, is the regulatory regime. As you mentioned, a lot of the international banks aren't subject to the same regulations as the U.S. banks. Again, that makes sense. These are foreign countries. But, for countries that really under-regulate their banks, what you could see is a bank that appears to really be knocking it out of the park on ROE and ROA, and they're making scads of money, and that's because they're making a lot of risky loans that, the moment that economy turns, really, really bad things start to happen. At the end of the day, for me, the key with any bank is not how it performs when it's doing well, it's how it performs when everything is going very poorly. That's really going to be the measure of a long-term investment.

Frankel: Yeah, definitely. Fortunately for us as investors, unfortunately for people who were invested then, we got to see how a lot of these banks reacted to tough times over the past decade or so. In some cases, they did pretty well, like in Canada, for example. And in some cases, like in Greece and a lot of other places in Europe, it wasn't so great. So, I would definitely advise, to continue on Michael's thought, going back about 10 years and seeing how some of these banks you're considering investing in performed in '08, '09, and in the years since. Like I said, a lot of places are still a little bit behind the U.S. in terms of recovering from the financial crisis.

Douglass: Right. You've talked a little bit about TD Bank. I'd love to hear a full-on pitch on the bank, so, why you like it. I think for anyone who's thinking about an international bank, it's a good place to start. Let's just talk through that a little bit.

Frankel: Before I get into TD, Canadian banks in general, there's a few good ones. Bank of Nova Scotia, Bank of Montreal are other good ones. The Canadian banking system has been much more well-behaved, I guess you'd say, than the American banking system. American banks average a crisis every 15 years or so, on average. The last Canadian banking crisis was in 1839. It's a much more stable system. The banks just behave better on their own.

But, moving on from that, TD I love out of the three for its diversification and dual-threat. They're one of the leading banks in Canada, and they have a growing U.S. presence. For people listening on the West Coast, for example, TD really isn't there yet. But in a lot of markets on the East Coast, they've built up a dominant presence. New York City, for example, they're one of the top three by market share there. And they've done it in a way that's different from a lot of U.S. banks, which are closing branches and trying to ship everything away from actually interacting with people. TD prides itself as being America's most convenient bank, which, they picked up that title from one of the companies that they acquired. They keep their branches open late, they keep them open on weekends, Sundays, even, in a lot of cases. I remember I used to have TD Bank in New Jersey, and I could go through a drive through and deposit a check with a person at 10:00 PM in certain locations. So, a really customer-centric business model.

And not only that, they have some of the best asset quality of any banks. They have one of the best credit ratings in banking. Credit ratings, S&P rates them as AA-. And they're all around, great asset quality, great management, can set their own dividend policy. Like I said, they pay about 4%. They've paid dividends every year since before the Civil War. People make such a big deal over the dividend aristocrats, which have increased their dividends for 25 consecutive years. TD has paid dividends since 1858 and has increased their dividend for much of that time, over the past couple of decades, by more than 10% a year. So, when you compare that to the track record of a lot of U.S. banks, European banks, it just looks so much better from a standpoint of an investor who likes stability.

Douglass: Yeah. I think that's a good point and makes a lot of sense. Certainly, when I think about international banks, I'm not currently invested in any, but when we were talking before the episode, Matt was talking to me about Toronto-Dominion Bank. And I said, I need to spend a little bit more time looking at them and vetting them. Because, while I tend to be skeptical of the American big banks because I just don't think there's anything that really marks them out from the others, in terms of the ability to long-term seize market share and really build on past success and hopefully outperform the market -- that's my goal, hopefully that's a lot of investors' goals -- I think, if TD is doing such a good job of growing market share, and they're doing so in a responsible manner, and that's one of the key things I've been needing to dig in on, then that's a pretty darn good place to start when considering international banks.

And certainly, international exposure belongs in a lot of portfolios. It can be a riskier part of the portfolio in some cases, although, perhaps with a large-cap from Canada, not so much. But, it certainly makes sense to not be 100% correlated with the U.S. economy, but to also be elsewhere.

Frankel: On that note, if you were invested in foreign banks in 2008 and 2009, you did much, much better than if you were invested in U.S. banks. That's the diversification that you're referring to.

Douglass: Yeah, exactly. Folks, that's it for this week's Financials show. Questions, comments, you can always reach us at industryfocus@fool.com. As always, people on the program may have interests in the stocks they talk about, and The Motley Fool may have formal recommendations for or against, so don't buy or sell stocks based solely on what you hear. This show is produced by Austin Morgan. For Matt Frankel, I'm Michael Douglass. Thanks for listening and Fool on!

Matthew Frankel owns shares of The Toronto-Dominion Bank. Michael Douglass has no position in any of the stocks mentioned. The Motley Fool has no position in any of the stocks mentioned. The Motley Fool has a disclosure policy.