Wednesday, July 30, 2008

Genuity CM's Analyst on Banks

The Globe and Mail, Tara Perkins, 30 July 2008

A top analyst at Genuity Capital Markets has caught some investors' attention with a method he uses to determine when to trade bank stocks in volatile times.

Three or four times since the credit crisis began last summer it has looked like the stocks of financial institutions were poised to recover, analyst Mario Mendonca wrote in a note to clients this week. "In each instance, certain observers stated that the worst was over."

But he believes that some recent rallies were not evidence the market was improving. Instead, they were simply a belief among investors that the stocks had fallen enough to make them worth the risk.

"This last rally was particularly telling, as the financials rallied violently in the face of [JPMorgan Chase & Co.'s] warning about a deteriorating prime mortgage book," he wrote. "In our view, the only absolute evidence that investors should focus on to support the belief that the worst is over is price stability in the U.S. housing market," he added. "Until there is evidence that U.S. housing supplies are declining (that is, resale activity is catching up with the pace of foreclosures) such that price declines will shrink, the environment will be one of trading around extremes."

With that in mind, Mr. Mendonca's tool of choice is the price-to-book to excess return framework: the Canadian banks' forward price-to-book ratio is compared with the excess of return on equities over the 10-year government bond yield. "Our analysis suggests that at a 20-per-cent discount or greater, the banks are cheap enough to support buying the group, particularly the underperformers, [Canadian Imperial Bank of Commerce and Bank of Montreal]," he wrote. "At a 10-per-cent or smaller discount, the model supports selling the group. There is less conviction in the calls between a 10-per-cent and 20-per-cent discount."

At the current discount of 18 per cent, he advocates an "add if underweight and hold if overweight" strategy.

In an interview, the highly ranked analyst said the concept is very theoretical, but investors are always surprised when he tells them it has an 80 per cent R-squared, meaning that it is correct about 80 per cent of the time.

"Really, it's a substitute for the bank to bond yield, because everyone agrees now that the bank to bond yield has no explanatory power whatsoever," he said.

Target Price and Rating

BMO $49 Hold
BNS $52 Hold
CM $78 Hold
NA $55 Hold
RY $52 Hold
TD $73 Buy