Thursday, December 07, 2006

For Bank Stocks, Worst Becomes First Before You Know It

The Globe and Mail, Derek DeCloet, 7 December 2006

Less than two weeks after becoming grand-fromage-in-waiting at Bank of Montreal, Bill Downe is already a genius. Really. And if he's not recognized as one, he will be soon enough. Just wait a couple of years.

Don't misunderstand: It's not that we're bowled over by his intellect or charm. Mr. Downe, who takes over for retiring Tony Comper in March, seems like a reasonably smart guy with the charisma of drywall. He may turn out to be the right guy to run BMO, or he may not. But he's got one important thing going in his favour. Like a Bay Street version of St├ęphane Dion, BMO is the first choice of very few, and totally underestimated.

What follows could be titled Why Bank Analysts are Useless. That last word is a little bit strong, perhaps, because we can think of several good uses for analysts. They can be amusing company, enjoyable to have lunch with. They tend to be dedicated husbands and mothers and so on.

It's just that, as a group, when it comes to picking the best bank stocks -- uh, did we mention that they're good company?

For sure, they are knowledgeable. Canadian bank analysts can churn out lucid 100-page reports full of facts about credit cards and mortgages and TD's market share in southwestern Saskatchewan. But who's got time to read it all? Most people have better things to do than worry about Bank of Nova Scotia's net interest margin. Besides, the Canadiens are on TV.

No, what we want is an investment strategy that maximizes profits while minimizing effort. Most investors are familiar with the Dogs of the Dow strategy, which involves buying the 10 highest-yielding (and, theoretically, most out of favour) stocks in the Dow Jones industrial average at the end of every year. We'll call our version the Dogs of the Street.

The concept is so easy, a child could have invented it (you may conclude that one did). You buy the bank that gave you the worst return in the previous two years, dividends included. Every two years, you switch. Total time consumed: about 10 minutes biennially. No fuss, no reports, no thinking -- and terrific performance, at least over the past two decades.

Suppose you'd started our Dogs strategy on the last day of December, 1986. The worst performing big bank of 1985-86 was Royal Bank, with an 18-per-cent total return. So you bought it, then held on for a couple of years before switching to the new laggard, Scotiabank, and so on, until today.

Net result: a $1,000 investment became almost $41,000, an annual return of more than 20 per cent. That was a much better idea than buying the top-performing bank of the period, RBC, which turned $1,000 into about $29,000. It killed the strategy of chasing the hottest bank, which would have made your initial investment worth about $12,300. Who needs analysts to tell us what to buy? Buy the dog.

The reason is simple. Canadian banks are never quite as good as they look in prosperous times, and never quite as bad as they look when they're troubled. (Finance geeks would put it differently: Canadian bank stocks revert to the mean.) Buying the Street's resident basket case -- even if the analysts despise it -- often means buying a bank that's underrated and cheap.

Like the Dogs of the Dow, it doesn't work every time, but it works often enough. Look at the outsized returns of Scotiabank shareholders in the early-1990s after the Third World loans scare, or TD's rebound after the telecom debacle of 2002. Last year's scandal was CIBC's $2.4-billion (U.S.) legal settlement in the Enron affair. That was in August. By early September, CIBC became one of the lowest-rated stocks in the S&P/TSX composite. Guess who's got the best-performing bank stock this year? CIBC. For bank investors, catastrophe equals opportunity.

At BMO, Mr. Downe faces no big crisis. But the financial community is unimpressed. The bank's latest financial results were so-so. Its return on equity, a key yardstick for bankers, lags well behind RBC's and Scotiabank's. Privately, some investors complain that the culture is lacklustre and the place seems overrun with consultant-speak (remember Mr. Comper's "three concentric circles"?) It was also the worst performer among the five largest bank stocks since Jan. 1, 2005, and if that continues, it's next in line for our Dogs strategy. Fourteen analysts cover it, according to Bloomberg, but only one rates it a "buy." For Mr. Downe, the expectations are incredibly low. These are bullish signs. You read it here first.

Two-year bank roll; value today of $ 1,000 investment made on 31 Dec 1986*

Dogs of Bay Street Strategy$40,910 20.5%
Royal Bank of Canada$29,170 18.4%
Bank of Nova Scotia$26,170 17.8%
Toronto-Dominion Bank$21,940 16.8%
Bank of Montreal$19,940 16.2%
CIBC$19,460 16.1%
Chase the hottest bank strategy$12,330 13.4%

Sources: The Globe and Mail, Bloomberg