Investors with a low tolerance for risk who seek a reliable stream of dividend income may wish to consider BMO (BMO) for income and safety.

It was my first full-time employer following my graduation from university in 1980. Although I like the bank for sentimental reasons, this has no bearing on my decision to invest in it. I was employed with BMO in Calgary, Alberta between 1980 – 1984. During this timeframe, I was old enough to understand the ramifications of a recession; the Canadian oilpatch was hit extremely hard! Just prior to returning to university to pursue my MBA, BMO acquired Chicago-based Harris Bank in the summer of 1984.

Upon completion of my MBA, I resumed my banking career where I had the good fortune of being employed until early retirement in 2016. During my career I witnessed the:

• October 1987 market plunge;
• implosion of the real estate market in the early 1990s;
• bursting of the dot-com bubble in 2000; and
• 2007 – 2008 Global Financial Crisis.

Personally witnessing the devastation these events had on many companies and individuals with whom I had dealings helped me become a prudent investor.

I rank The Global Financial Crisis as being one of my most influential events from an investing perspective. In fact, were it not for The Global Financial Crisis, it is very possible BMO may have never acquired Marsh & Isley in 2011.

Coincidentally, I was a member of my employer’s Financial Institutions corporate cash management team during The Global Financial Crisis. I distinctly remember how some supposedly sound US banks were ‘here one day and gone the next’. The Global Financial Crisis taught me that there can be a disconnect between appearance and reality. Companies that appear to be financially sound might truly be accidents waiting to happen. What I am now witnessing with many SPACs and MEME investments is reminiscent of some of the ‘junk’ that imploded during The Financial Crisis.

Fast forward to the present and we see the Harris Bank and Marsh & Isley acquisitions in the US were shrewd acquisitions; BMO’s US operation generates ~40% of the bank’s total adjusted net income.

BMO – Q2 2021 Earnings Presentation

I don’t know if we will witness another Financial Crisis during our lifetime. I, however, mention the above in the hope investors realize the current market conditions are not ‘normal’. The ‘good times’ will not last indefinitely and the present is a good time to dial back risk.

NOTE: The Bank of Montreal (BMO) reports in Canadian dollars and is listed on the TSX and the NYSE. All financial information in this post is expressed in Canadian dollars.

BMO – Dividend and Safety – Business Overview

BMO is North America’s 8th largest bank by assets, with total assets of $949 billion as of October 31, 2020 (FYE2020).

Through the following 3 operating groups, it provides a broad range of personal and commercial banking, wealth management, global markets and investment banking products and services:

• Personal and Commercial Banking;
• BMO Wealth Management; and
• BMO Capital Markets.

It serves ~8 million customers across Canada through its Canadian personal and commercial banking arm, BMO Bank of Montreal and more than 2 million personal, business and commercial banking customers through BMO Harris Bank, based in the U.S. Midwest.

BMO also serves customers through its wealth management businesses – BMO Private Wealth, BMO InvestorLine, BMO Wealth Management U.S., BMO Global Asset Management and BMO Insurance.

BMO Capital Markets provides a full suite of financial products and services to North American and international corporate, institutional and government clients, through its Investment and Corporate Banking and Global Markets divisions.

In the bank’s ongoing efforts to optimize efficiency and to focus capital and investment in areas where it has an advantaged market position, BMO announced on April 12, 2021 that it had reached a definitive agreement with Ameriprise Financial, Inc. to sell the entities that represent BMO’s EMEA Asset Management business; a Q4 2021 closing is subject to regulatory approvals and other customary closing conditions.

On April 30, 2021, BMO completed the sale of its Private Banking business in Hong Kong and Singapore to J. Safra Sarasin Group, a Swiss-Brazilian private bank.

BMO – Financial Review

On May 26, 2021, BMO released Q2 Results as at April 30, 2021 in which it reported:

• an increase in adjusted ROE to 16.7%;
• an improvement in its adjusted efficiency ratio to 56.6%; and
• strengthening of its CET1 ratio to 13.0%.

BMO – Q2 2021 Financial Highlights

A bank’s efficiency ratio illustrates a bank’s profitability. The calculation consists of dividing expenses by net revenues. The value of the net revenue is found by subtracting a bank’s loan loss provision from its operating income.

CET1 capital is the securities that serve as a bank’s first line of defense in a financial crisis. The CET1 ratio compares a bank’s capital against its assets. The major banks use Tier 1 capital as a starting measure to test the liquidity and ability to survive a challenging monetary event; this capital conservation buffer is 2.5% of risk-weighted assets.

The Office of the Superintendent of Financial Institutions (OSFI) expects all institutions to maintain target capital ratios equal to or greater than the 2019 minimum capital ratios plus a conservation buffer level. For all institutions, this means a target CET1 ratio of 7%, 8.5% for Tier 1 and 10.5% for Total capital (1.7. Capital targets, point 54 on page 16 of 24).

The problem Canada’s 6 largest banks face currently is that as of FYE2020 (October 31), they reported a combined $262 billion in CET1 capital. This accounts for ~12.3% of their risk-weighted assets while regulators require this ratio to be considerably less.

Now, the banks are carrying ~$80 billion in excess CET1 capital. Many banks internally target a ratio of ~11% and the Big 6 still have an extra $40 billion in CET1 capital beyond that level.

Investors initially welcomed the build-up of capital to protect against a possible wave of defaults resulting from economic shutdowns to fight the spread of COVID-19 because it reduced the likelihood banks would be forced to raise money thus diluting shareholders’ equity. It also further assured investors the banks’ dividends were safe as many investors rely on this dividend income. However, excess capital is now becoming a drag on the banks’ return on equity. The present challenge is how best to deploy this excess capital.

Real Estate Portfolio Quality

BMO’s Q2 earnings presentation provides a good risk review showing the Bank’s tight risk control. Given that the Canadian residential real estate market is currently the 2nd most frothy after New Zealand, I purposely highlight BMO’s Canadian Residential-Secured Lending portfolio.

BMO – Q2 2021 Earnings Presentation

Many homes selling for well in excess of list price and through ‘bidding wars’. I envision many Canadians could face financial difficulty within the next few years. Having said this, the Big 6 vividly remember previous challenging business environments and are tightly controlling risk. In my opinion, investors can be reasonably confident BMO will not implode.

BMO – Credit Ratings

The banks which found themselves in dire straits when The Financial Crisis hit were those with a heavy reliance on wholesale funding.

Wholesale funding uses a variety of commercial credit markets including federal funds and brokered deposits by lenders. It can work well but can be more expensive than traditional routes and this method of funding carries unique risks and considerations.

I distinctly remember Bear Stearns urgently requesting the immediate return of significant overnight deposits held with my employer in an effort to stave off its collapse. My employer did not rely on these overnight deposits but Bear Stearns most certainly did and we all know what happened to Bear Stearns!

A well-established bank, such as BMO, has a strong capital base and it also has a large base of customer deposits. This reduces BMO’s reliance on wholesale funding thus lowering investor risk.

BMO – Investor Presentation – June 2021

My investor profile is such that I do not speculate and I pay close attention to risk. As an equity investor I know my risk is far greater than that of debt holders. I, therefore, invest primarily in companies whose long-term unsecured debt is investment grade.

The major rating agencies assign the following ratings to the Senior Debt of Canada’s major banks.

While Fitch Ratings has just recently downgraded the Canadian operating environment for banks, the ratings are still investment-grade.

These ratings, in essence, define the banks as having a STRONG capacity to meet their financial commitments. The banks, however, are somewhat more susceptible to the adverse effects of changes in circumstances and economic conditions than obligors in higher-rated categories.

All the ratings reflected above are satisfactory for my risk tolerance.

BMO – Dividends and Share Repurchases

Dividends and Dividend Yield

The historical dividend information reflected on BMO’s website is sorely lacking and investors can find better information on the TMX Group Limited website; BMO’s shares are listed on this Canadian exchange.

BMO was founded in 1817 and its track record of consecutive years of dividend distributions is 192 years dating back to 1829; this is the longest of any company in Canada. BMO is one of six Canadian companies and one of six Canadian banks to have paid a dividend for over 100 years.

Source: BMO Q2 2021 Fact Sheet

BMO regularly increases its dividend with the periodic interruption of increases. Indeed BMO is a Canadian Dividend Aristocrat. Following the August 28, 2007 $0.70 dividend, there were no increases until the August 28, 2012 $0.72 dividend. While BMO and its Canadian counterparts froze their dividends, many US banks cut their dividend.

BMO’s current $1.06 quarterly dividend was first declared on December 3, 2019. With the onset of COVID-19 in Canada, OSFI suspended share buybacks and dividend increases by Canadian banks and insurers in March 2020. This was part of a raft of measures intended to gird against the economic impact of the COVID-19 pandemic and potential recession.

Although OSFI believes there may be exceptional circumstances where a non-recurring payment of special, or irregular, dividends may be acceptable, there is no immediate plan to lift the broad freeze.

In order to qualify for exceptional circumstances:

• a firm’s capital and liquidity must remain strong following the payout;
• the special dividend should be limited to a special business objective and not be distributed to a broad group of shareholders.

The major Canadian banks have very strong capital ratios and could increase their dividend or distribute a ‘special dividend. OSFI, however, indicates there remains too much uncertainty to change its expectation on regular dividends. Current conditions are stable but the financial impacts of the COVID-19 pandemic are yet to be fully realized.

Despite the significant increase in BMO’s share price subsequent to the May 2020 low (~ low $60s), the current $4.24 annual dividend yields ~3.4% on the basis of the current ~$125 share price as of this writing.

The bank is well-capitalized and its year-to-date adjusted dividend payout ratio is 34.2%. This places it in a position to resume regular dividend increases or to distribute a ‘special’ dividend once OSFI permits this.

Share Repurchases

BMO’s FY2011 – 2020 average diluted issued and outstanding shares (in millions) is 607, 649, 650, 648, 647, 646, 652, 645, 640, and 642. The YTD 2021 figure currently stands at ~647.7.

According to a Bloomberg Intelligence study, the Canadian banks could repurchase ~2% – ~5% of their outstanding shares in FY2021 if OSFI permits purchases in a similar manner to what the U.S. Federal Reserve permitted late 2020 for American banks.

While the economic and market disruptions stemming from the pandemic have abated and banks’ capital levels have been resilient, some “key vulnerabilities” remain in the economy, including elevated household and corporate debts. Furthermore, the recovery has been uneven with some benefitting more than others.

As noted earlier in this post, the current real estate market conditions in Canada have led to high household indebtedness and imbalances in the housing market. These vulnerabilities have intensified over the past year.

Although BMO could distribute a ‘special dividend’ or increase its quarterly dividend to reduce its excess capital, BMO could also entertain acquisitions or share repurchases. Naturally, BMO requires OSFI’s approval but OSFI likely wants to proceed cautiously to ascertain the severity of credit losses; I do not expect OSFI to render a decision on share repurchases and dividend increases until late 2021.

BMO – Current Valuation

BMO reported YTD adjusted diluted EPS of $6.19 and full-year guidance from 12 brokers is a mean of $12 and an $11.27 – $12.89 range. Using the mean value and a ~$125 share price, the current forward adjusted diluted P/E is ~10.4.

BMO’s Q3 FY2021 ends July 31 so we should also consider broker estimates for FY2022.

FY2022 guidance from 11 brokers is a mean of $11.86 and an $11.31 – $13.21 range. Using the mean value and a ~$125 share price, the current forward adjusted diluted P/E is ~10.5.

This level is within a reasonable range of the forward adjusted diluted P/E of BMO’s peers; Royal Bank of Canada (RY) and Toronto-Dominion Bank (TD) are marginally higher.

Regrettably, BMO’s share price has appreciated considerably over the last few months and, in my opinion, is no longer a ‘bargain’. If you are a long-term shareholder and periodically acquire additional shares on weakness, then an investment in BMO at the current valuation should generate a reasonably attractive return.

BMO – Dividend and Safety – Final Thoughts

The sudden interest in MEME stocks and cryptocurrencies, the modern-day version of tulip bulbs, by investors who make investment decisions on the basis of stock price movements and who define a long-term holding period as a few days, is alarming.

In my opinion, many investors are making investments:

• with little regard to the underlying fundamentals of the business;
• on the basis of a company’s stock price;
• in companies of poor credit quality;
• where the current valuation will make it difficult to generate an attractive investment return;
• in outright frauds;
• based on dividend yield or consecutive years of dividend increases;

Investment decisions made using the above may lead to success. These investment decision-making methods, however, typically expose investors to the very real risk of permanent impairment to capital.

I do not dispute some ‘home-based casino’ players are successful. The problem is investing in equities is a zero-sum game. If some investors are reaping millions in profits from highly speculative investments it means other investors are losing millions.

Investors may be willing to risk a sizable loss in exchange for the possibility of generating outsized returns. However, many people learn that risk tolerance changes once losses become a very real and present danger. You can gauge your tolerance for risk here.

Although I have an existing BMO position and BMO’s credit ratings, valuation, and dividend yield are acceptable, I consider TD and RY to be far, far superior franchises. Even though their dividend yield and valuation are slightly inferior to that of BMO, I have recently disclosed the purchase of additional TD and RY shares at Financial Freedom is a Journey.

If you feel BMO is sufficiently enticing, bear in mind that August 3rd is the dividend record date and the dividend distribution date is August 26th. You must already own shares at least two days before the dividend record date to be eligible for payment of stock dividends; this is one day before the ex-dividend date.