Tuesday, August 14, 2007

Banks Could Be Best Buy in Decade

Sean Silcoff, Financial Post, 14 August 2007

Canadian Imperial Bank of Commerce offered up a spoonful of sugar yesterday as it revealed its US$1.1-billion exposure to the U.S. subprime home-mortgage market: The third quarter will be a scorcher. Earnings are due from Canadian banks at the end of this month, and CIBC said that it will earn $2.30 a share, up 24% over last year. It was enough to lift the stock by 1.3% on an otherwise down day for the banks.

Canadian bank investors tend to be sanguine about the odd bit of bad news from their favourite oligopolists. Their sheltered status, strong retail businesses and general diversification mean the big banks consistently boast better returns on equity than their global peers. Their occasional missteps (Enron; losses from the telecom sector meltdown; Bank of Montreal's trading losses in the natural-gas market, for example) barely leave a scratch. If anything, they have led to greater risk aversion by the banks. The overriding mantra for their investors seems to be: Ignore the headlines, buy any Canadian bank stock and put the share certificates in storage. In the past five years even the worst-performing stock of the lot, BMO, was up 12% on average annually, while three of the other Big Five boasted 12%-plus returns over 10 years, not including dividends.

The banks may be a perennial "buy," but some times are better than others. And if you believe Nick Majendie, senior portfolio manager of Canaccord Capital Inc., we may be close to the best buying opportunity in a decade. "It's not there yet, but it's coming," he said yesterday. Until then, his portfolio is devoid of Canadian bank stocks.

The results from the first nine months of the fiscal year -- as CIBC indicated -- should be strong. But look at the timing: Q3 ended July 31. The markets started to go wonky in late July, but most of the carnage has happened since then. And the volatility will likely continue for months. Expect more bad news to trickle out from the banks about their subprime exposure. (CIBC is the first Canadian bank to disclose its potential damage.) Throw in a couple of scotched leveraged-buyout deals, a few hedge-fund meltdowns and some negative data points and markets should stay rocky.

Here's what Dundee Securities Corp. analyst John Aiken sees: a whole lot of trading into September, followed by a drying up of volumes, particularly if the sell-off chills the market for mergers and acquisitions and public offerings. "The worst thing that can happen is if crickets start chirping on trading floors," he said. That's bad for Canadian banks, which earn 20% to 30% of profits from capital markets. "If that dried up or receded, you'd see significant headwinds on bank profits over the next couple of quarters," Mr. Aiken said.

To Mr. Majendie, that smells a lot like 1998, when the collapse of hedge fund Long Term Capital Management roiled global financial markets. Stock charts for the Canadian banks in 1998 look like a big bungee jump. Their shares sold off sharply -- down 35% to 40% late in the year, though part of that factored in an end to speculation about mergers --but within 30 months they had mostly recovered, then kept growing.

As Mr. Majendie sees it, the bank stocks are standing on the platform, their harnesses tightly secured, the abyss beckoning. Stocks were down from their year-high peaks by 12% on Friday, reflecting a drop in multiples investors were willing to pay on earnings; now they're set to drop another 10% to 15%. "My view has been that when [the excessive liquidity situation in credit markets] was reversed it would be a particular crunch to the banks," he said. "All these trading revenues, which have gone straight up since 1998, can go into reverse," he said. "There will be a lot of nervous anticipation which will drive down banks."

Plus, if fund managers have to liquidate their holdings, bank stocks are likely to face inordinate selling pressure.

Soon after, expect to see Mr. Majendie jump back into the banks. For now, "I think it will pay to wait. The banks will be the leaders in the bounce off the bottom."