Canadian Bank Stock Investor

Maybe Now is Not the Best Time To Buy Banks...

2011-09-22T23:48:00.002-04:00

The fed's decision to implement "operation twist" has, as expected, flattend the yield curve (the curve that shows the change in interest rates against time to maturity). Conventional wisdom says a flatter yield curve is generally bad for the economy and usually that means it's not so good for the banks either. It's also supposed to hurt bank earnings as loans typically have longer maturities than deposits so the net interest margin earned by the banks will be lower when yield curves are flatter.

The empirical evidence for the past 16 years supports this view. The graph below plots the spread between the 10 year Bank of Canada benchmark bond yield and the 3-month T-bill Auction Yield monthly over the past 16 years vs. the subsequent 1-year price appreciation of the average (price-weighted) Canadian bank stock (big 6).

While it's certainly not a clear-cut relationship, there does seem to be a correlation here, with the yield spread seemingly responsible for about 25% of the subsequent 1-year return. As of today, the 10-year Bank of Canada bond is yielding about 2.02% and the 3-month bill yields 0.83% for a spread of 1.19%. On a monthly basis, this is the lowest spread since August 2008. The banks did appreciate 9% over the subsequent 12 months at that time, so by no means a catastrophe. But these interest rate trends are certainly not a bullish indicator either.

A Technical Trading Article

2011-09-19T23:26:00.000-04:00

In this article from the Globe, the author points out the banks have performed well for the Oct to Dec period. I would also note that the March to May period has also been a good time for banks, positive 15 of the past 17 years with an average return (excluding the dividend) of 6.1% on a price-weighted index.

2 Views on Canadian Household Debt

2011-09-19T22:46:00.001-04:00

A couple of interesting articles following Statscan report last Tuesday that Canadian household debt had reached a record high.

Canadian debt levels no cause for alarm, economist says - according to the article, Canadian debt levels are not as high as they seem relative to the U.S. because the majority of our health care costs come off the top through taxation, while in the U.S., Americans must spend 20% of their disposable income on health care. Interesting point.
Rising household debt a threat for Canadian banks: Moody’s - this article argues that the banks have grown profits via rising consumer debt but with household debt at record highs and storm clouds on the horizon (economic downturn, housing price correction) there could be some trouble in future.

Price-to-Book Strategies

2011-09-11T00:20:00.002-04:00

Okay, so obviously I love the price-to-book ratio when it comes to valuing Canadian bank stocks and deciding whether or not it is a good time to invest. But so far I have looked primarily at the combined values of all 6 "big" banks.

But how does price-to-book (PB) do on an individual bank share basis?

As it turns out, pretty well, though it's not as clear as I would have hoped. The chart below shows the results of ranking quarterly the 6 banks by PB ratio and investing in either the lowest PB, 2nd lowest PB, 3rd lowest PB, etc. up to the highest PB, starting with $1 in Dec 1995. Dividends are re-invested.

Clearly, investing in the 2 "cheapest" bank stocks, appears to be a pretty good strategy. Investing quarterly in the lowest PB bank would have increased your investment nearly 20x over the ~16 years in the study. The number 2 bank improved almost 14-fold.

Oddly, though, the 3rd cheapest is a dud. It would have increased in value only 4.7x, beating only the results of investing in the highest PB bank shares, which increased 4.5x. The 2nd and 3rd highest PB banks both come in at around 9x and overall the big 6 increase in value about 9x.

So investors might be wise to weight the 2 cheapest banks a little heavier in their portfolios. Based on current prices, these would be BMO and TD.

Note that these results exclude any transaction costs, bid-ask spreads etc. Also please note that while I have endeavored to ensure the data used is accurate I make no guarantees.

Note: this post was edited Sep 15th; the final point in the 'average' series was incorrect.

Scotiabank Invests in Chinese Bank

2011-09-10T21:30:00.000-04:00

Scotiabank announced this week they purchased 20% of a Chinese bank for $719 million. The price implies a total value for the equity of $3,595 million. The bank is government-owned and I wasn't able to easily track down financial statements. I did find a KPMG report on Chinese banks which had data from 2008 and 2009. According to the report, earnings at the Chinese bank in '09 were 508 yuan and in '08 they were 814 yuan. At today's exchange rate of .1545 yuan per CDN$, that works out to earnings of $78 million and $126 million. So BNS is paying 46x '09 earnings and 29x '08 earnings.

The same report shows equity at the bank of 8,376 yuan, about CDN$1,294. While presumably the equity has grown since then, the purchase price was 2.8x 2009's equity value.

So definitely not a rock bottom price. Possibly they overpaid, but it's not a terribly big investment for the bank and I doubt it will have any material effect on BNS's value.

Caveats On Price-To-Book as a Measure of Future Returns

2011-09-08T23:30:00.003-04:00

When analyzing the past record of banks share performance vs. the price-to-book ratio at time of purchase one needs to be cautious about the underlying assumptions.

At a high level, the returns over the past decade and a half break out more or less like this: The banks return about 16% on their equity (ROE) and pay out about half of that in dividends. They tend to trade around 2x book. So your expected return at any time is the 8% annual increase in book value (the 16% ROE less half paid out as dividends) + the dividend yield (calcualted as the 8% of equity paid in dividends divided by the price-to-book valuation, so at 2x book, the yield would be about 4%; at 2.5x book the yield would be about 3.2%, etc.) + change in market value as the shares move back to their average p-b ratio of 2. So buying at a high price-to-book means receiving lower dividends and also lower return as the bank shares move to their long-term equilibrium valuation of 2x book.

Here's an example...you buy at 2x book value. Your expected return would be the 8% growth in book value + the 4% yield. So that's 12% per year.

If you buy at 3x book, then you would still expect the 8% growth in book value but your dividend yield is now only 2.7%. In addition, over the next several years we expect the price-to-book to return to a more normal 2x, so you would actually see a -7.8% return on valuation over 5 years. Your net return is about 3% annually.

If you buy at 1.5x book, then you earn the 8% + 5.3% dividend + 5.9% in increased valuation. Your expected overall annual return is 19%.

These numbers aren't far from what the regression of the past 16 years' results actually predict.

But in this age of increased credit requirements, the important assumption of a 16% return on equity may not be so secure. What if ROEs fell to say, 14%? If we assume investors still want the 4% dividend from the banks, then we would see the equilibrium price-to-book fall to 1.75.

Now buying at 2x book leads to returns of 7% in increased book value + 3.5% dividends - 2.6% in lower valuation over 5 years. Our 12% expected return is now a mere 7.9%.

Of course I can't say for sure what future returns on equity will be. In 2010 the simple average ROE of the big 6 was 16.1%, so it would appear that 16% isn't an unreasonable target, especially given the still relatively high provisions for credit losses reflected in that number. But regulations around capital requirements are tightening. We should keep a close eye on its impact to returns.

5-Year Returns vs. Dividend Yield

2011-09-02T21:09:00.001-04:00

I'm always going on here that price-to-book appears to be a good indicator for predicting future returns on Canada's big six banks. But what about dividend yield? Surely buying banks when yields are high should be a good strategy?

And of course the answer is yes, it has just not been as good a predictor as price-to-book. The chart below shows 5-year total returns (dividends reinvested) vs dividend yield at time of initial investment.

The relationship here is not nearly as strong as we've seen with price-to-book ratios. The r-squared is only about 30% vs. 80% for the price-to-book relationship.

Some may note that the chart shows yields in the neighborhood of 4% predict 25% annualized returns and current bank yields are in the same neighborhood. The period reflected above though is from the mid-90s, when price-to-book ratios were in the 1.25x range and payout ratios were lower (banks retaining more of their earnings theoretically could have led to greater growth).

Is Now a Good Time to Buy Banks?

2011-09-01T00:06:00.000-04:00

While we're still waiting for TD to release their results tomorrow, so far results have been pretty good with BMO leading the way in terms of book value growth, rising over 10% in Q3 vs. Q2. This was driven by their acquisition of Marshall & Ilsley which was paid for through the issuance of 67 million common shares. Since these shares were valued at about 1.7x book value, their issuance improves book value per share. Conservative types might be concerned that $1.8 billion of the $4.0 billion purchase price was made up of Goodwill, and accounted for $2.78 (about 3/4) of the $3.67 quarterly increase in book value per share. But as Warren Buffett students know, some Goodwill is worth a lot, some isn't. It remains to be seen if M&I's goodwill is worth what BMO paid.

In any event, sticking to our simple model of price-to-book, the banks overall, despite rising about 7% so far this week, still appear to be reasonably priced at about 1.9x book. We forecast a 5-year total return of about 14% per year at this valuation, based on the historical results of the past 16 years.

I'll remind readers that past performance is no guarantee of future results. Past relationships, especially of the kind being discussed here, can sometimes break irrevocably. Any investors in US financial institutions over the past few years will be especially aware of this point. Never invest more than you can afford to lose!

Latest Quarters Numbers Almost All In

2011-03-03T22:24:00.000-05:00

With TD and Royal reporting today, only one more bank remains to report Q1 results for 2011 and that's Scotiabank. Thought I would take a look at valuations right now anyway and see what the model says. Current average share price is $70.31 and current average book value per share stands at 32.73, for a price to book ratio of 2.15. Comparing that to a regression of monthly price-to-book values against subsequent 5-year returns (including dividends, reinvested) shows an expected 5-year return for the banks of 9.96% per year.

The formula comes from the equation for the line of best fit in the graph below.

Note that while the r-squared number in the graph implies that 80% of your return is dependent on the price-to-book ratio at which you invest, this is an historical relationship and there is no guarantee it will hold into the future. Also it is obvious from the graph that there is a significant variance from the line. For example, those data points where price-to-book was around 2, similar to today's valuations, are all below the line of best fit, meaning returns were less than the model would have predicted.

All in all though, Canadian banks appear to be reasonable, but (given the inherent risks in all investments) not spectacular investments at current valuations.

Price-to-Book and 5 Year Returns

2010-09-20T20:40:00.000-04:00

A while back I put up a chart showing the average price-to-book of Canada's biggest 6 banks and their subsequent 5-year returns. Thought I would update that with the past few months' data. The results show an even stronger relationship (r-squared is .8213 vs. .8123).

The model predicts that at the current average price-to-book ratio of around 2x, the expected 5-year return on Canadian banks is about 8% per year (0.4235 - .1695*2 = .0845), compounded, before dividends. With yields currently around 4%, overall returns are expected in the 12% range, or perhaps higher if, as expected, bank dividends are raised over the ensuing 5 years.

Not a bad return for sure, but not without its risks. Remember this model is based on past performance and is NO guarantee of future results. The future can, and often does, hold unexpected surprises.

Share Price and Book Value Chart

2010-09-12T16:59:00.000-04:00

Thought I'd throw up a chart showing the average share price (blue line) and average book value (pink line) of Canada's biggest 6 banks since October 1995. Where the lines intersect, the price-to-book value is 2.

As you can see, since 1995, the share price has risen in tandem with book value. Sometimes the shares get considerably higher, such as in April 1998 or May 2007, sometimes considerably lower, such as in October 2002 or February 2009, but has always, at least during this 15-year interval, returned to the mean.

Will Banks Be Able to Grow Book Value

2010-09-11T22:30:00.000-04:00

Back in January a reader posed the question:

Seems to me that going forward banks will have a difficult time growing their balance sheets. I suspect that much of the recent growth has been on the back of the Canadian real estate boom (mortgages, home equity loans, etc). This will be ending soon I believe with lower real estate prices and higher default rates. Some time later the banks will have to recognize the losses. I wonder if you've noticed that the quality of their balance sheets has noticeably gotten worse. I mean that "other assets" has become a larger component of the balance sheet compared to the pre-boom years (before '04). What do you think? I'm pretty sure bank stocks will not perform well over the next few years. Collect the dividend...that's it, IMHO.

This is a great observation and raises some very interesting questions. But after examining the evidence, I don't think the thesis holds. Since the 2009 year-end, the most recent financials available when the question was asked, the banks have increase book value at an annualized rate of 8%, which is pretty good. And as for the balance sheets deteriorating due to more 'other assets', I created consolidated common-size balance sheets from the most recent quarter, Q3 2010, and from October 2003 ('pre-boom'). The results below show that other assets actually declined as a % of total assets, from 3.3% to 2.6%. Goodwill, sometimes considered a lower-quality asset, did rise by 0.5%. Perhaps most concerning is derivatives rose 1.3%. Derivatives can be a time bomb, as discussed frequently by Warren Buffet.

Overall though, the balance sheets, at least on the surface, do not seem all that different today than they did 7 years ago, before the real estate blow-up. It's possible the quality of the loans is lower today. But I'm not sure how much evidence there is to support that conclusion. Real estate values have not collapsed like they have in the U.S., and Canadian banks have followed more conservative credit policies than their American counterparts.

At current prices and assuming no major economic upheavals, Canada's banks are likely to offer reasonable returns for the long-term investor.

Best of the Banks the past 15 years

2010-09-09T22:45:00.000-04:00

Since banks share prices tend to trade at a multiple of book value (around 2x book, on average) an important determinant of your stock returns will be how quickly the bank can grow its book value. A bank that has a flat book value over time will likely provide meagre returns, while one that grows its book value at a steady 8-10% per year clip will provide much better results. Dividends are generally well correlated with book value over time as well, so rising book value generally means rising dividends, which would further improve returns.

Since I now have about 15 years' data on per-share book values, I thought it would be interesting to look at how well each bank grew its book value over the first half of that 15-year period and again in the second half. Would the best performers in period 1 be the best performers in period 2? If they were, it might be evidence that we can predict future performance by past results, and we can say certain banks are consistently good performers.

Of course, this isn't the whole story. A bank can increase its book value by paying lower dividends. In this case a rising book value would not be a function so much of better management but more the result of a different strategy. The exact impact of this is beyond the scope of the current study, but is probably not terribly significant as all the banks tend to have similar payout ratios.

Here are the results:

So there does appear to be some consistency, although it's not perfect. CIBC (CM) wins as most incompetent bank for finishing dead last in each period. RBC (RY) performed the best, finishing first, then second. TD Canada Trust (TD) fared well also, ranking 3rd then 1st. Using average rankings over the two intervals, the 3, 4 and 5 positions belong to Scotiabank (BNS), National Bank (NA) and Bank of Montreal (BMO).

Average growth in the first period was 92% while in the second it was 74%.

So no earth-shattering conclusions here. But some evidence that it might be acceptable to pay a small premium to invest in RBC or TD, but it's probably best to steer clear of CIBC altogether!

Price-to-Book the Key Indicator

2009-12-22T16:46:00.006-05:00

Thought I would post some charts that show the realtionship between the banks' price-to-book ratios (calcuated here as the simple average split-adjusted prices of the six largest Canadian banks divided by the simple average split-adjusted book values per share) and the subsequent 1-, 2-, 3-, 4- and 5-year annualized returns, excluding dividends. The data is monthly from Oct '95.

While the images may not be the clearest (sorry, if anyone knows a better way to copy graphs from Excel I'd like to hear!), I think the picture is still pretty clear. As the timeline increases in each graph, the importance of buying bank shares at a good price also increases. On a 5-year timeline, the r2 is 0.8123. What that is saying is that 81% of your return over a 5-year period is determined by the price-to-book ratio you pay. That's a pretty important indicator. Buying at ratios of less than 1.5 resulted in returns of 14 to 23% per year over the next 5 years. Admittedly, price-to-book ratios haven't been this low that often, since Oct-95, only during the following periods: Oct-95 to Oct-96; Sep-99; and again during the recent financial crisis, from Dec-08 to Apr-09. Obviously 5-year returns are not available for any purchases made during the last interval. But with the index up 36% since April and 72% since February, I'd say it looks promising that those brave investors who purchased bank shares back then will look back contentedly on their investment decision in another 4-and-half years.

Please note that these results exclude dividends. Since dividend yields are generally negatively correlated with price-to-book ratios (though not perfectly), the slopes of these graphs would be steeper were dividends included; in other words, low price-to-book ratios are even more important to future returns than indicated by the charts above.

Currently, price-to-book ratio of the index is just under 2, indicating it's not an especially good or bad time to invest for the long term.

The usual caveats and disclosures apply: past relationships do not always hold in the future. This article is for informational purposes only. I do own shares in some Canadian banks. I've done my best to ensure the data is correct but make no guarantees.

Pat Was Right, Oh So Right

2009-12-10T17:41:00.002-05:00

And I guess I gotta' give credit where it's due. Pat left a comment here asking if it was true the price-to-book value for the banks goes to 1 in a recession. I said I didn't think that was a hard and fast rule and that banks hadn't been valued that low in years and would not likely get there again.

Well guess what? The banks hit their low point on February 23rd. The average bank stock was priced at 29.43. The average book value at the time was 29.32. A price-to-book value of 1.00.

Bang on! A perfect call on the bottom. Pat, if you're still out there, let me know when these babies are gonna' peak!!

Well I'm Back and It Was Quite A Year

2009-12-08T14:29:00.004-05:00

I guess in retrospect I'm glad I was out of the blogosphere for the past year. I can just imagine my posts all through the horrible slide, day after day, month after month: "The banks represent good value at these prices. Doubt they'll get much lower from here." The first sentence might have actually been true, but the second would be tortuous as the index kept sliding, finally reaching bottom on Feb 23rd. Of course, if I were Jim Cramer I would forevermore cite my Feb 23rd post calling the bottom with pinpoint precision (even if it was for the 80th consecutive day) as evidence of my genius.

Do Banks Typically Fall to Book Value During Recession?

2008-10-28T22:03:00.003-04:00

A reader left a comment the other day. Pat asked:

"I remember reading an article about the level at which Canadian bank book values bottom during downturns....was it at about 1xbook? If so we have some further down to go. Do you have stats on this?"

Answer:

Hi Pat,

The banks haven't traded at 1x book since the early 1990s. National Bank was trading at 1x book as late as October 1996, but since then, none of the big six have traded that low. However, one might argue we haven't had a real recession since the early 1990s. At that time, some banks did touch the 1x book value. But it's important to bear in mind that the banks of today are different from the banks of that time. In 1990, RBC and BMO (sorry, these are the only two that I have reports for on hand) derived 30% of their revenue from non-interest income; today they derive over 60% from such sources. Returns on equity have stabilized somewhat since that time, perhaps justifying a higher price-to-book value. More importantly, interest rates are much lower today. It makes sense that lower interest rates lead to higher valuations for all assets, including bank equity values. Therefore I don't think any such rules of thumb are necessarily relevant in today's market. I believe that so long as the banks don't cut their dividends, they likely won't go much lower from here. But predicting short-term price movements is truly a sucker's game; anything could happen.

I will put together some more detailed research around the change in bank income sources and its effect on returns on capital and also on the effect of interest rates on bank valuation, and present it in a future post.

Thanks for reading and thanks for the question!

Perfect hindsight

2008-10-28T21:44:00.004-04:00

Analysts are reducing expectations for Canada's big banks

"TORONTO — Analysts are slashing their ratings on Canada's big banks in anticipation of discouraging results in the coming quarters.

John Aiken of Dundee Securities believes disappointing results from the financial services giants will stretch into next year as capital market revenues moderate and credit quality weakens."

Comments - forgive me for being cynical, but boy, those analysts really earn their pay. Let's see, the average bank stock has fallen 30% from its high, and now we learn we should sell. That's timely information. No doubt after the banks recover 30% from their current lows, these same brilliant analysts tell us it's now time to buy. Does anyone actually make money listening to this kind of advice?

Nobody can predict the future, but there's an awful lot of pessimism already built into today's bank stock valuations. Dividend yields are the highest they've been since the early 90s and price-book hasn't been this low since the market crash of 2002. Share prices could continue to fall, of course. A dividend cut by any of the banks would likely have a significant negative impact. But doesn't it make more sense to buy things when they're cheap, rather than when they're expensive?

CI Rights Plan is Bill Holland's Protection Plan

2008-10-23T20:01:00.005-04:00

Scotia deal spurs CI rights plan

"CI Financial Income Fund has adopted a unitholders rights plan in an effort to prevent Bank of Nova Scotia, its largest unitholder, from undertaking a 'creeping takeover.'

Two weeks ago, in a deal done without CI Financial's knowledge, Scotiabank agreed to buy Sun Life Financial Corp.'s 37-per-cent stake in Canada's third-largest mutual fund company for $2.3-billion."

Comments - Bill Holland strikes me as one of those "capitalists" who give capitalism a bad name. He heads a publicly-traded company, then acts all concerned when someone buys those shares? That's how the free market works, Bill. If you don't like, don't go public. "Any company in the country which woke up one day and had a [new] 37-per-cent shareholder with no pre-arrangements in place ... would have one in place," he laments. How about any investor who woke up one day to discover the managers he hires to run his company were conspiring against him would make arrangements to fire the whole lot! This is outrageous. Shareholders' rights? Isn't Scotiabank the biggest shareholder? What about their rights?

Shareholder rights plans are NOT about protecting shareholders' rights; they are all about protecting management's jobs.

"But many that are first shall be last; and the last first"

2008-10-23T19:24:00.002-04:00

BNS downgraded, stock falls

"Four of the five biggest banks in Canada are enjoying modest gains on the Toronto exchange on Thursday morning but Bank of Nova Scotia isn't one of them.

Shares in Scotia are down more than 2% approaching the afternoon trading session, after an analyst downgrade of the stock by BMO Capital Markets. "

Comments - long the darling of bank analysts, it looks like BNS' lustre has been tarnished. Actually, we've commented on these pages already that price-to-book appears to be the key metric in valuing Canadian bank stocks and BNS has had the second-highest ratio (after RBC) for some time. So we tend to agree with the BMO Capital Markets analysts. CIBC and BMO are recommended in the article (isn't that a conflict of interest, BMO Capital Markets recommending BMO shares?) and BMO currently has the lowest price-to-book. While CIBC is also trading at a moderate valuation, it also has a much spottier history. A long history of mis-management seems to be the story there. Perhaps things have finally turned around, but I'd be hesitant to place a big bet on CIBC.

The Roller Coaster Ride Continues

2008-10-15T18:46:00.004-04:00

Well, after jumping over 9% yesterday, the bank index was back down 2.4% today. Which is actually a pretty good performance, given the TSX/S&P index was down over 6%.

Since dividend yields are so high, I thought I'd show a couple of graphs that plot bank yields against future 4 year returns.

The first graph shows data for the period Oct 99 to Dec 03 (currently, I've only compiled data back to Oct 99):

Clearly there was a very strong relationship between dividend yield and subsequent stock price appreciation over the period studied. A higher yield led to a higher annualized return.

Before we get too excited over that graph and rush in to buy banks solely on that basis (after all, the graph predicts annual returns of well over 25% given today's >5% yields), let's take a look at the next graph:

This is the relationship between dividend yields in 2004 (to October) and subsequent four year returns. This graph reflects the meltdown we've seen in share prices this year. And here the once strong relationship breaks down completely.

What does it all mean? Well, both data samples are relatively small, so any conclusions drawn have to be taken with a grain of salt. But the graphs do show the dangers of assuming that previous relationships will hold true indefinitely. It's my belief that there is a logical, common-sense connection between dividend yields and future returns and that the recent aberration in that relationship will right itself in the long run. When that will actually happen though is anybody's guess. Another factor making any predictions difficult is the very real and rising threat that banks may cut their dividends -- how long will governments allow banks to hand out billions of dollars in the form of dividend payments through the front door, while taxpayers shove billions in through the back door?

Biggest Advance since Jan 1998

2008-10-14T16:42:00.002-04:00

Today the bank index rose 9.6% as the Canadian market played catch up to the U.S. market, which was down slightly today, but up over 11% yesterday. The gains follow more quasi-socialist government bailout plans.

This was the biggest one-day advance for the bank index since it jumped 10.3% on January 23rd, 1998, following the announcement that Royal Bank and the Bank of Montreal planned to merge (a plan that was ultimately scuttled by the government).

Frankly, based on the lessons of history, I don't believe that these bailout programs are in the best interests of the long-term health of the economy. They'll just spread the pain around so that everyone feels it, at the same time undermining future economic growth. Read here for more on this line of thought.

However, investors, particularly those with shorter timelines, should be pleased. While long-term growth will certainly be sacrificed, short-term, these programs will prop up equity values.

What a Week!

2008-10-10T16:44:00.004-04:00

Well, a brutal week comes to an end, with the bank index down 13.6% over the 5 sessions. On the bright side, the index was up 0.3% today, handily beating the S&P/TSX Composite index’s 5.6% decline.

The optimism may be related to the announcement by Jim Flaherty that the CMHC will be purchasing $25-billion in mortgages from the banks. We are assured of course, that this is not a bailout and Canadian banks are perfectly sound. That may or may not be true, but could we expect our government to tell any other story? In a related item, banks used the ~~bailout~~ liquidity measure as a pretext to lower their prime rates, after the much anticipated (by us anyway) backlash over the commercial banks’ failure to match the central bank’s interest rate cut reached a crescendo (there is a federal election coming up next week, after all).

All of this may or may not be bad news for Canadians, depending on who you believe, but it's probably good news for investors. The banks will take a small hit on interest margin but will be able to increase their loans.

As an aside, BMO has handily beat the other banks' stock performance these past four days, falling only 4% vs an average of 10% for the other 5 banks. Could it be that BMO's heavy U.S. exposure, at one time such a drag on the bank's performance, is now propping it up in the face of a rapidly falling loonie?

Banks down a record 7.2%

2008-10-09T17:02:00.004-04:00

Let's see...this morning I woke up to hear on the radio that Canada's banks are the soundest in the world, according to a survey by the World Economic Forum.

By the end of the day though, our Bank Index had fallen by a whopping 7.2%, to 44.24, its lowest level since May 2004. The current price-to-book value of 1.62 is the lowest since October 2002 and the dividend yield of 5.68% is the highest its been since the early 1990s.

Either these are great prices or a real financial collapse is coming!

No one can say for certain what the future holds here. It could be asset values on bank balance sheets will continue to fall and there may be significant write-downs, insolvencies, domino-effect repercussions, etc.

But given all the money and guarantees being offered up by governments throughout North America and Europe, it seems likely the Canadian banks will survive. It's been said many times before that times of crisis often present incredible investment opportunities (e.g. the American Express salad oil scandal)

As an aside...all the extra cash being pumped into the system will undoubtedly lead to inflationary pressures (unless it leads to deflation). It seems that today's inflation though, is not exactly like yesterday's. With technological advances and cheap third-world labour making prices of many common goods deflationary, inflation these days seems to appear in more tightly focused markets, and not so much in measures such as the Consumer Price Index.

If inflation is "too much money chasing few goods," as economists tell us, it might be that the goods we're chasing these days aren't your basic food, clothing, shelter, transportation, electronics. Our desire for these items is satiated, and increases in the money supply do not drive these prices especially higher. Rather, the inflation is in luxury goods and specific asset classes, such as stocks, bonds and real estate. This sort of inflation is not picked up in CPI (technically the cost of housing would be picked up through higher mortgage costs, but this has been offset in recent years by lower interest rates, due in part to increased demand for bonds).

So, the question I think is...where will this next batch of cash end up? I like to stick with fundamentals in my investments, but it might be worth keeping an eye on the markets to try and catch a piece of the next bubble (and let's hope it's in Canadian Bank stocks).

Whew...finally some relief!

2008-10-08T16:28:00.003-04:00

The bank index rose 1.3% today, ending a painful 2-day, 8.3% slide, but lagging the broader Canadian S&P/TSX index, which rose 2.3%. This followed a dramatic 50 basis-point rate cut by several central banks, including the Bank of Canada.

Here are a couple of today's bank headlines:

Banks trim prime but lag BoC cut

"OTTAWA — Major Canadian banks said they would lower their prime rates by just a quarter of a percentage point, refusing to pass along all of the Bank of Canada's half-point decline.

The rebellious move is a departure from the past, when the big banks have fully matched central bank rate cuts, despite complaints they couldn't really afford it."

Comments - well, this is bad for PR, but good for the bottom line. As a shareholder I applaud the move. As a borrower, I guess I'm not too happy. We'll see if there is any public outcry. If the banks can get away with this, it's a good thing for share prices!

RBC to buy back US$850,000 in auction-rate securities

"The Royal Bank of Canada will pay a fine and reimburse customers as part of a settlement with U.S. federal and state authorities over its role in the collapse of the auction-rate securities market that left many Americans unable to access savings they had set aside for short-term needs like college tuition and medical expenses.

The largest bank in Canada said it will buy back about US$850-million of auction rate securities from more than two thousand retail clients in the U.S. and pay a US$9.8-million fine as part of an agreement with the Securities and Exchange Commission and New York Attorney General's Office."

Comments - that RBC was likely to pay around a billion dollars to buy back auction rate securities had already been reported in the Financial Post back on Sep 24th. So this isn't a surprise. It's a marginal hit to earnings right now, maybe 2 or 3 cents per share, although it does reduce RBC's liquidity somewhat. The bigger concern is there may be further write-downs on the securities in the future. Even this will likely not be too signficant - a further 30% write-down on these assets will have an impact of about 20 cents per share.

Yet another brutal day...

2008-10-07T21:52:00.002-04:00

Well, the bank index was down another 3.8% today, to 47.07. When will the bleeding stop?! On the bright side, we're still above July's low of 45.25.

I continue to suspect that these current prices will look cheap four years from now.

Unless of course, this really IS Armageddon.

On an unrelated note...here's a link to an interesting web site that features, among other things, Warren Buffett's letter to shareholders for the period 1969-1976: http://stableboyselections.com/. The Buffett fans (of which I am one) will enjoy these.

2008-10-06T19:57:00.005-04:00

Scotiabank buys CI stake in wealth management coup

"The worsening turmoil in financial markets Monday altered the balance of power in Canada's wealth management sector, as one of the country's largest insurers was compelled to sell off a highly-prized stake in the third-biggest mutual fund company for $2.3-billion in cash to Bank of Nova Scotia.
The sale of a 37% stake in CI Financial Income Fund by Sun Life provides the insurer with a capital injection as the costs of bad bets on financial markets climb for the Canadian insurance sector as investment portfolios bleed cash."

Comments - this looks like a good deal for BNS to me. CI Financial made $2.14 over the past 12 months and BNS is buying it for $22/share. Admittedly that's a substantial premium over the market price $16.20. But it's only 10x earnings, and should prove to be a lucrative investment for the bank.

The obvious investment idea here is -- why not invest in CI Financial? You can get it for 25% less than the Bank of Nova Scotia just paid for it. At just 8x earnings and currently yielding a whopping 13%, it certainly warrants further research, at the very least. This site is devoted to banks, so I leave that research to others.

Another Bad Day.

2008-10-06T19:20:00.002-04:00

Well, the markets were down big time today. In Toronto, the TSX/S&P Composite was down 5.3%, and in New York, the Dow was down 3.6%. Canadian banks were certainly not immune, although they performed a little better than the Toronto index, finishing down 4.7%. This puts them at their lowest level since mid-July.

There is obviously an overhang of uncertainty here, but it's times of adversity that create the greatest opportunity. With yields north of 5% and a price-to-book value of 1.8, the average Canadian bank is looking like it could potentially pay off for the long term investor.

A prudent, risk-averse investor would probably want to wait this one out. On the other hand, October has been the best month for bank stocks the past 13 years, with an average share price appreciation of 3.7%. November and December are the second and third best months, respectively.

I don't put a whole lot of stock into those numbers. It's only 13 years of data and last year the index fell 13% between the end of September and the end of December. But if history is any guide, we could be seeing a rebound in Canadian bank stocks soon.

Book Value since Oct-95

2008-10-05T21:47:00.004-04:00

I've put a lot of emphasis on the banks' book value at this site. This is based on analysis of the past 13 years' data which shows a pretty strong correlation between banks' price-to-book ratio and subsequent stock returns. This relationship has been described in previous posts.

What's also interesting about the book value of the Canadian banks is its very consistent, steady growth. The chart below shows the growth in book value per share (using the simple average of the split-adjusted book values of the six banks followed here, referred to as the Bank Index).

Note the exponential trend line shows a coefficient of determination of 0.9802. That's a pretty high value, and implies that the passage of time is an excellent predictor, at least over the 13 years in this study, of book value. By the way, this period includes the telecom/tech bubble, the $2.4billion Enron write-off by CIBC, and at least the first leg of the subprime credit crisis that has rocked U.S. financial markets for the past year. So there are quite a few significant events accounted for here, yet the trend is strong.

The formula for the trend line shows e to the power of 0.0061x. What this tells us is the rate of growth in book value has been around 0.61% per month, which works out to 7.5% per year (note that this is a higher growth rate than I discussed previously due to the addition of data from 1995-1999, which exhibited a higher rate of growth in book value).

So clearly there appears to be a pretty stable growth rate in book value per share. Over any four year period it has ranged from an annualized rate of 4.6% to 10.9%, and has averaged around 7.5% per year. Assuming this long-term pattern continues to hold, we can use it to help us predict the future returns we might expect from our bank stock investments.

2008-10-03T17:11:00.003-04:00

CIBC gets $1-billion cash injection from Cerberus

"Canadian Imperial Bank of Commerce has turned to a U.S. vulture fund to protect the capital base of the country's sixth-largest bank with an infusion of $1.05-billion to help the institution get through the credit crisis.

The extraordinary deal will see Cerberus Capital Management will pay cash and take on risks linked to CIBC's exposures to toxic U.S. mortgages in return for an exceptionally high rate of return expected to reach 20% or $200-million."

Comments - CIBC has essentially taken out an expensive insurance policy on its U.S. mortgages. Given the highly-leveraged nature of the banking business and the potential for disaster should U.S. real estate prices collapse further, it's probably not a bad idea. The market seems to have liked the news, bidding CIBC up 1.2% today, while 4 of the remaining 5 banks declined.

While odds are good that the impact of this transaction will ultimately prove to be negative, in hindsight, on CIBCs net worth, say, four years from now, it does improve the chances that for CIBC there actually IS a "four years from now."

Ahhh, kids....

2008-10-01T23:12:00.002-04:00

From the terrific site, Seeking Alpha:

Bank of Montreal: Should You Be Tempted?

"The ongoing credit crisis has unearthed some rare gems for investors, but whether some of these gems turn out to be fools gold remains to be seen. It is no surprise that one of these opportunities has appeared in the Canadian banking sector, as these stocks lie near the heart of the ABCP fall out and the credit crisis mess. Bank of Montreal's (BMO) share price has nearly been chopped in half since around this time last year. Due to this massacre in share price, BMO's yield has crept up to a staggering 7.2%. This yield level is absolutely unprecedented for a Canadian bank. You could buy BMO shares today and receive 7.2% back annually on your investment - even if the stock flat lined for years.

Combine this with the favorable tax treatment of dividends for Canadian residents, and many would be satisfied with that investment return. Of course this is assuming it doesn't cut its dividend. That unfortunately is the $700 million dollar question. If BMO did happen to cut its dividend in half, it could instantly have almost $700 million extra to work with annually. Whether the bank feels they would need this capital to compensate for write-offs or investment losses remains to be seen."

Comments - a fine analysis. But The Moneygardener is showing his youth with statements like "This yield level is absolutely unprecedented for a Canadian bank." In fact, BMO was yielding over 8% back in 1990. I'll admit that was 18 years ago, but a 7% yield is hardly "undprecedented."

Are Canadian Banks a Good Investment?

2008-10-01T21:23:00.005-04:00

Probably the biggest question people have right now is, are Canadian banks a good investment? The short anwer is yes. But of course, there are caveats.

First of all, a good investment does not in any way imply a guaranteed investment. When it comes to investing in equities, there simply are no guarantees. Any company can collapse into bankruptcy, leaving shareholders with nothing. What differs is the probabilities. Banks, based on a fractional reserve system that any Austrian school economist will tell you is destined to ultimately fail, probably face a higher probability of disaster than many industries. However, a conservatively run bank is probably about as good a bet as any. Canadian banks, CIBC aside, have a pretty good reputation for safety and soundness (here's a page from the World Bank showing national rankings on bank soundness. Canada ranks 5th in the world, while the U.S. is 27th).

So, before you make any investment, understand that there is a probability, albeit small, that you could lose everything. It's important to diversify.

Secondly, a good investment does not mean a great investment. At current valuations, and based on past history, as discussed in a previous post, banks look poised to return anywhere from 3% to 21% annual returns over the next four years, with an expected return of 13.5%. While 13.5% for four years would be a mighty good return (your investment would increase by about two-thirds over that time), this model implies there is a 50% chance returns would actually be lower, perhaps significantly. There is a very real possibility any bank stock investment will simply have tread water four years from now.

The fact is, bank shares have traded at cheaper valuations than where they are currently, although it's been a while. Price-to-book ratios are back down to 2003 levels, while we haven't seen dividend yields this high since the early 1990s (when interest rates were significantly higher). Likely those fat yields are keeping a floor on the price-to-book valuations, so unless we see a dividend cut, it's not likely valuations will get much lower.

The line between good and great is, admittedly, subjective and somewhat arbitrary. But given that it hasn't been that long since we've seen better price-to-book ratios, and price-to-book ratios have proven to be the best predictors of future returns, I'd have to put today's values in the "good" category.

For the record...I own interests in Royal Bank (because I consider it to be the best managed of the banks) and Bank of Montreal (because I consider it to be the best value currently among the banks).

And finally...this blog is just my opinion. It is meant to be a starting point for readers to do their own research. Please do not make any investment decisions based solely on what you read here (or from any other individual source). Get a variety of opinions, read the annual reports, talk to the experts. Remember, you are responsible for the decisions you make.

Good luck! And if anyone would like to share their investment experiences with the banks, please drop me a line at cdnstock@hotmail.com or leave a comment. I'd love to hear from you.

2008-09-30T22:30:00.002-04:00

Lipstick for the bailout pig

"U.S. politicians looking to tart up Washington’s plug-ugly Wall Street bailout bill to make it more appealing to Main Street voters may have found just the right shade of lipstick to do the job: Deposit Insurance Red. Within a brief run of the news cycle yesterday, the entire political class —from John McCain to Barack Obama to Congressional leaders — popped up in media reports supporting a plan to raise U.S. deposit insurance from $100,000 to $250,000.
The idea could get rolled into the bailout bill, or appended to it somehow, giving the Federal Deposit Insurance Corporation the authority to raise the limit. Former capitalist T. Boone Pickens endorsed the idea. 'People have to know they are not going to lose money if they have it in banks.' From gas to wind to solar and now to banks, Mr. Pickens’ current speciality appears to be advocating for more government control."

Comments - nothing to add here. Just thought I'd link to yet another insightful piece by my favourite writer over at the National Post, Terence Corcoran.

September 2008 Review

2008-09-30T20:55:00.004-04:00

Well, it was a heck of a roller coaster ride. September 2008 was the most volatile month for bank stocks since at least Jan 1995 (as measured by the standard deviation of daily % price changes for the Bank Index). In five of 21 trading days the index had a move of 5% or more, including today's impressive 6.1% gain. That's pretty volatile!

Incidentally, the second most volatile month since Jan 1995 was almost exactly 10 years ago -- August 1998, during yet another financial crisis, the Russian bond/Long Term Capital Management (LCTM) crisis (for an excellent account of LTCM read Roger Lowenstein's When Genius Failed).

Of course the volatility is a result of the uncertainty in the financial markets. There seems to be new bank or insurance failures almost daily; government bailout plans are certain one day, voted down the next.

Of course, this will all resolve itself eventually, government plan or no. Certainly there will be some pain, but that's the cost of decades of government intervention in financial markets. What the impact to Canada's banks will be remains to be seen.

Despite all the volatility, the actual change in the Bank Index for September was a slight decline of only -0.7%. RY (Royal Bank of Canada) was the best performer, gaining 3.6%, while CM (CIBC) was the worst, falling 4.8%, most likely indicative of a "flight to quality," as investors move capital out of Canada's worst performing big bank into Canada's best performing big bank. At month-end, the Index price-to-book ratio was 1.96, making the banks reasonably valued, based on past history. Not bargains of course, especially given the possibility of future writedowns, but a reasonable bet as part of a portfolio for the enterprising investor.

Ouch!

2008-09-29T17:00:00.002-04:00

The Bank Index (that would be the Bank Index used here at this site, a simple average of the six largest Canadian bank's share prices) fell a whopping 7.1% today. That's a record for this index, which goes back to Jan 1995 (over 13 years). The previous record was a 6.9% decline back on August 27th, 1998. At that time, the Bank of Canada raised short-term interest rates a full 1oo basis points in an effort to halt a rapidly falling Canadian dollar.

While today's setback is painful for investors, it's important to keep things in perspective. The index, currently 49.99, is back where it was on Sep. 17th, and was as low as 45.25 back in July. The current price-to-book ratio is 1.83, which is firmly in the reasonable range. These aren't bargain valuations and the price is not at a 52-week low.

Looking back, of the 7 times since Jan 1995 that the index has fallen more than 5% in a single day, it has risen the following day 5 times and fallen twice. The average increase on the up days has been 2.7%, and on the down days -2.1%. The overall one-day average change in the index following a 5% or greater one-day fall is +1.4% (as a benchmark, the average change in the index for all the days since Jan 1995 has been +0.1%).

So based on history, it seems more likely we'll see a bounce back in prices tomorrow. But who knows -- there is terror on the streets!

Bank Index and Book Value Index

2008-09-26T21:52:00.007-04:00

I'm presently developing an index of "big six" bank prices. Currently I'm just using a simple average of daily historical closing prices, adjusted for splits. This is similar to how the Dow Jones Industrial Average is calculated. While the Dow Jones methodology has some legitimate criticisms leveled against it, the fact is, it correlates quite strongly with market-weighted indices such as the S&P 500 (if this doesn't make any sense to you, don't worry -- the bottom line is the index will allow us to get an idea of how the six largest Canadian banks are performing in aggregate).

I calculate an index book value the same way -- a simple average of split-adjusted book value per share (BVPS).

I currently have complete book value and share price data only back to July 30, 1999, so it's just over 9 years' worth. I will be expanding that over time.

Here are some interesting, initial findings:

the index BVPS has risen around 6.9%, compounded, per year (calculated from the end of July each year) during the study period
the BVPS growth has been fairly stable, ranging from a low of 1.8% for the 12 months ending July 29, 2005, to a high of 11.3%, for the 12 months ending July 31, 2006.
the index price-to-book value has ranged from a low of 1.43 (Sep '99) to a high of 2.83 (Jan '07)
the average price-to-book over the range studied is 2.15
the current price-to-book (Sep 26, 2008) is 1.97

And here's a graph plotting price-to-book vs. subsequent 4-year returns (dividends excluded). Note that the price-to-book-value axis extends only to 2.60 though I refer to a price-to-book high of 2.83. This is because it has been less than 4 years since that high was reached.

So what does all this mean? Well, in all honesty, this sample is a little small to make any firm predictions. Also, past performance is no guarantee of future results. But based on the graph, current price-to-book values predict a return of around 10-15%, annually for bank stocks, in aggregate.

However...since book values grew only about 6.9% per year during this period, the growth shown on the graph is the result of both book value growth AND expansion in the price-to-book multiple. It is probably not realistic to expect price-to-book to expand beyond the upper limits we have already seen, i.e. 2.83.

Perhaps a better way to predict future bank returns is to assume the historical growth rate in book value of 6.9% per year continues over the next four years, and that the price-to-book ratio will be at its average value at the end of the period. Then the predicted return over the next four years would be about 9%. If price-to-book is at its high end though, then our returns would be 17%; if it were at its low end, our returns would be -1% per year. Add dividends to that (around 4.5%) to get your total return.

That's quite a range (3.5% - 21.5% per year, average 13.5%), but probably a pretty good estimate.

Once again, this is no guarantee. Anything can happen, particularly now with bank and insurance failures seemingly happening daily in the U.S. Big portions of bank book values could be wiped out, reducing the book value growth rate, possibly rendering some banks insolvent (I think that's a long shot). Or banks may be so out of favour 4 years from now that their price-to-book values are significantly less than the 1.43 low we used above.

Be careful. Diversify. And never invest more than you can afford to lose.

2008-09-25T22:07:00.003-04:00

A Crisis of Global Statism

"The current financial turmoil is a 'crisis of capitalism,' said a spokesman for Britain's Socialist Workers Party, as good Marxists have been repeating for more than a century. '[A]n unregulated financial system is a disaster,' echoed Sheila Rowbotham, professor of gender and labor history at Manchester University. Added a leftist London mayoral candidate, 'Capitalism has had its chance and failed; now it's socialism's turn.'
I wonder what they have been smoking."

Comments - excellent article from our friends at mises.org by Pierre Lemieux, an economist at the Université du Québec en Outaouais, that points out, correctly, that those who blame the U.S. banking crisis on capitalism are either ignorant or dishonest. The U.S. mortgage market has been regulated and guaranteed by the government for decades. Americans should be saying, "Socialism had its chance and failed; now it's capitalism's turn." But I suspect it won't turn out that way.

Banks up today

2008-09-25T21:44:00.003-04:00

Okay, so I guess my prediction yesterday about Royal Bank was a little off as the shares were up 0.49% today. I'm going to claim partial credit though as RBC was the smallest gainer among the big six, which rose an average of 1.12%.

2008-09-24T22:54:00.002-04:00

SEC plans action against Royal Bank

"U.S. federal enforcement officials are turning their sights to the Royal Bank of Canada as they crack down on financial institutions amid mounting public anger over a plan to bail out banks exposed to the credit crisis at the expense of taxpayers, according to officials.
Canada's largest bank is at the top of the list for enforcement agents at the Securities Exchange Commission who are pursuing financial institutions implicated in the collapse of the $330-billion auction-rate securities market, according to two federal officials."

Comments -- this doesn't sound too good. A billion dollar payout is about 4% of the bank's common equity. Depending on how much of a surprise this is to the market, and how much the market agrees with the billion-dollar estimate, expect a decline in Royal shares tomorrow.

2008-09-24T21:50:00.003-04:00

Merrill challenges view that Canada is immune to U.S.-style housing downturn

"TORONTO - Merrill Lynch is challenging the prevailing view that Canada's housing and mortgage markets are more stable than their U.S. counterparts, warning that households in this country are so indebted that it's only a matter of time before we see a major downturn here as well.
In a report issued Wednesday, Merrill Lynch Canada economists said many Canadian households are more financially overextended than their counterparts in the United States or Britain."

Comments - it's quite likely Canadian housing prices will retreat; they're definitely on the high side. Check out this report from RBC Econmics, which clearly shows price-to-rent ratios are abnormally high (admittedly the report is year old but things haven't changed that much in the past year) . Note also how the report indicates the historic highs are "partly justified." Possibly, but I doubt it. All too often when prices deviate from known markers of value for extended periods, economists start searching for justifications. Think of the Nasdaq frenzy of the late 1990s, when all conventional valuation metrics were thrown out the window. There were no shortage of pundits explaining that things were different now, in the "new economy."

That said, the subprime mortgage market, which has been a huge catalyst in this crisis, is much smaller in Canada than in the U.S. Here's an interesting report from Benjamin Tal over at CIBC World Markets that compares the Canada and U.S. mortgage markets. Tal shows just how insignificant the subprime market is in Canada vs. the U.S.

So while I do believe there is likely to be some pain in the Canadian mortgage market, I don't believe it will be anywhere near the level seen in the U.S. And it will hardly, on its own, cause the failure of any Canadian banks. They've pulled through big problems in the past -- the corporate failures of the early 2000s, the commercial real estate bust of the late 1980s, the LDC (loans to developing countries) crisis of the early 1980s... (noticing a pattern here? Every 8-10 years there seems to be some crisis or another...)

2008-09-23T17:14:00.005-04:00

TD faces backlash if it snares WaMu

"If perceived long-shot Toronto-Dominion Bank actually wins the race for troubled Washington Mutual, expect the Canadian bank to be hit with a flurry of downgrades from analysts and a nasty sell-off by shareholders.
With TD Bank one of five reported contenders for Seattle-based WaMu, which formally went up for sale last week, National Bank Financial analyst Robert Sedran published a note Tuesday saying that it would be surprising to see the Canadian bank emerge with this prize - if a busted U.S. thrift can be described as a prize. He went on to say that in the unlikely event TD wins, “a transaction for the whole firm would be viewed negatively.”"

Comments - more on the negative aspects around TD's interest in WaMu's assets. Doesn't seem like anyone thinks it's a good play. Which makes the contrarian in me interested. If TD is successful in its bid and the stock does get severely punished, it might be time to consider buying.

2008-09-23T16:53:00.003-04:00

TD shows interest in WaMu, but there are risks

"TD Financial Group was flirting with danger by moving to raise its high-risk bet on the U.S. consumer in the midst of a deepening economic downturn, financial analysts said as the Financial Post confirmed the Canadian bank had entered the auction process for Washington Mutual, the sixth largest U.S. lender.
The auction for the distressed U.S. lender is being run by Goldman Sachs, which has solicited interest from a number of U.S. and foreign banks, including TD, according to a person familiar with the auction process."

Comments - looks like the temptation to pick up assets on the cheap might be too great for some Canadian banks to resist, even if it does entail some risk. Congress will need to finalize the details before anything gets done anyway. As to whether this is a smart move or not is anyone's guess at this point. If TD does its due diligence properly this could be a great opportunity.

But if banks in general actually did their due diligence properly, none of this would have happened in the first place!

2008-09-22T23:24:00.003-04:00

Unintended consequences: No-short rules hurts bank investors

"Canadian regulators, by following along with U.S. regulators on the no-shorting crusade, appear to have inadvertantly hurt retail investors trying to buy into bank stocks.
For the big banks that are on the no-short list - TD, CIBC, Royal Bank - bid/ask spreads on the TSX have yawned to unprecedented levels. At times Monday the difference between the asking price and the bid price on the big banks has jumped from its traditional level of about a penny or two to 20 cents or more. "

Comments - perhaps not terribly significant to the retail investor, but it's always interesting to analyze the unintended impacts of government intervention. Particularly ridiculous government intervention, like this recent ban on short selling.

2008-09-22T22:42:00.005-04:00

Nearly 25% of National Bank's book value

"National Bank Financial’s purchase of a 12.5% stake in Wellington West Holdings Inc. comes at an important time given that operating profit from National’s wealth management business has been flat for the past seven quarters.
National will pay $35.8-million and an additional $35-million if Wellington meets certain earnings targets over the next three years. It also has the right to buy an additional 5% of the company and has been granted right of first refusal if Wellington decides to pursue an outright sale or of a substantial block of shares."

Comments - Whenever one company buys another, it's a good idea to try and figure out if they paid a reasonable price. A quick, back of the envelope analysis tells us if National is paying $35.8 million for a 12.5% stake, then that works out to a valuation of $286.4 million for the entire company. Since Wellington West is not publicly traded, I wasn't able to quickly find earnings data, but according to Canadian Business, they had revenues of $134 million in 2007, with profit margins of 0 - 10%. So that would give us a range of $0 - $13.4 million in earnings for 2007. If Wellington West's earnings are closer to the top end of that range, then National paid just over 20x earnings. Given Wellington West's impressive growth rate, that doesn't seem unreasonable. Could be a good deal for National.

The headline about 25% of book value refers to analyst Michael Goldberg's assertion that National Bank stands to lose 25% of its book value if its Asset-Backed Commercial Paper (ABCP) exposure is not successfully restructured. Things are looking good right now after after the Supreme Court of Canada denied a challenge to a proposed restructuring.

So all in all things were looking good today for the National Bank, which could explain why it's the only one of the "big six" that was actually up for the day -- all the rest were down by at least 2.8%.

2008-09-22T21:56:00.006-04:00

Canadian firms reportedly hunt for opportunities in wake of U.S. financial crisis

"TORONTO — Canadian financial institutions are reportedly exploring opportunities in the battered American financial sector but should probably just sit back and enjoy possible relief under the U.S. government's massive rescue plan, several observers said Monday.
Canada's banks and financial services companies would be ill-advised to consider picking up the crumbs of failed U.S. insurers and other firms that liquidate assets to pay down debt, said Craig Fehr, a financial services analyst with Edward Jones in St. Louis."

Comments - there may be some deals available in the U.S. right now, but hopefully Canadian banks will remain prudent. The fact is, many savvy investors, including Warren Buffett, have declined to enter the fray and purchase these "opportunities", so Fehr's analysis is probably a good one. Still, if a Canadian bank in which you own stock starts buying U.S. assets, you'll want to be careful. Check back to this blog for updates and analysis.

Prophetic Words!

2008-09-19T22:43:00.002-04:00

Looks like my post on Wednesday was prescient -- the U.S. government has made it quite clear it has no qualms whatever about forcing U.S. taxpayers to foot the bill for Wall Street's greed.

And the impact to the Canada's bank stocks has been impressive. In just two days, the average big six bank stock has risen an astounding 11%; the big five (which excludes the National Bank) has risen more than 13%. RBC closed today at its highest level all year.

So it looks like the storm has passed (for now) for our favourite stocks. I'll say again that their share prices are not cheap, but, on average, reasonable. It would be well worth sitting down with your financial advisor and determining if these stocks, with their excellent dividend yields, should become a bigger part of your investment portfolio.

Wow, it's been a tough week!

2008-09-17T19:10:00.006-04:00

The big six Canadian banks (BMO, BNS, CM, NA, TD, RY) have fallen an average of 9% over the past week, with the biggest losses coming today in the wake of the financial crises in the U.S.

Hard to say what the final impact of all this turmoil will be on the Canadian banks, but given the U.S. government's willingness to intercede in financial markets, as demonstrated by the bailouts of AIG, Fannie Mae and Freddie Mac, it appears it probably won't be devastating. Any potential devastation is being distributed amongst U.S. taxpayers -- bad for them, good for us.

I think the important thing to keep in mind through all this is that the big Canadian banks have survived well over a century of crises, including the Great Depression of the 1930s. Historically, if Canadian bank shares have been purchased at reasonable or better prices, they have provided reasonable or better returns over the long term. While none of the banks are trading at what I would consider "cheap" prices right now, most are at least in the reasonable range.

In the short term the banks could certainly fall further still. However, this is likely to be a buying opportunity. Remember the advice of the world's greatest investor, Warren Buffett - be fearful when others are greedy, and greedy when others are fearful. If credit fears from the U.S. hammer Canadian bank stocks, it might be a good time to turn greedy!

BNS - a Stable Investment

2008-09-14T21:33:00.003-04:00

Most stock market investments are wild rides, with bull runs lasting months or even years, only to be followed by bear runs that can cause sleepless nights and wipe out years of gains.

BNS, (Bank of Nova Scotia aka Scotiabank Group), has not been one of those investments.

I looked at the quarterly closing prices of BNS stock back to September 1987 (yes, before the crash of October 1987) and calculated the subsequent four year returns from the end of each quarter, assuming the reinvestment of all dividends.

And the results...?

Not once in the past 17 years has an investment in BNS returned less than a 10% annual compound rate of return over a four year period.

Remember...this includes the crash of October 1987, the bear market of 1990, the bank "merger-mania" of 1998, the tech crash of 2000; even the recent credit crisis in 2007-08.

Oh, and by the way, that 10% was the minimum return. In fact, the average return was closer to 20%.

Of course, buying when BNS was "cheap" offered better returns, in general, than buying when BNS was "dear."

So, is BNS cheap right now?

Well, my two favorite valuation measures for the Canadian banks are price-to-book and dividend yield. BNS currently has a price-to-book ratio of 2.5, and based on historical levels, that ain't cheap.

From a dividend persepctive, with a current yield of around 4%, the valuation is pretty good. That's the highest it's been since about 1996.

It's a mixed result, but price-to-book has historically been the better predictor, so I would rate BNS as being fair-to-slightly-overvalued.

Based on the past, then, it's probably best not to expect spectacular returns from BNS. But I'd be pretty surprised if their 10% per year record wasn't still intact four years from today.

Double Your Money in Just Four Years?

2008-09-12T20:01:00.007-04:00

According to BMO Financial Group’s latest quarterly report, the company's book value per share is $30.15. Today I see BMO stock trading around $49. If we divide the market price by the book value we get what’s called the price-to-book ratio. So for BMO, that’s $49 divided by $30.15 = 1.63.

So what? you’re probably asking yourself.

Well, I happened to look at the price-to-book ratios of BMO every day between Jan 31, 1996 and September 2, 2004 and plotted it on a graph against the subsequent 4 year annualized compound return. The results are shown in the graph below.

You might notice that as the price-to-book ratio increases, the subsequent four-year return declines, and that the relationship between the two is pretty strong. In fact, statisticians have a way to measure the strength of that relationship, known as the “coefficient of determination” and it’s shown on the graph as R² ("R-squared"), and in this case is equal to 0.6734. The highest number it could be is 1, and that would mean a perfect relationship between the two variables. The lowest number it could be is zero, and that would mean there is no relationship between the two variables.

In this case, though, the number is 0.6734, and that’s indicative of a pretty strong relationship. The graph appears to be telling us that BMO's current price-to-book ratio is a pretty good indicator of future returns.

There’s also a formula on the graph y = -.1721x + .4241. That’s the formula for the straight line on the graph, which is the line of best fit. It’s the straight line that best incorporates all the price-to-book / 4 year return data pairs. We can use that formula to make rough predictions of our future returns, given the current price-to-book ratio.

So let’s plug our current price-to-book ratio of 1.63 into the formula and see what it tells us. According to the formula, we should expect annual returns of -.1721 * 1.63 + .4241 = 0.143. That’s 14.3% per year.

Keep in mind this is just the capital appreciation, i.e. the amount the shares are expected to increase. BMO is currently paying better than a 5.5% dividend yield. Throw that on top and our expected returns are nearly 20% per year.

Don’t know about you, but if I could earn 20% per year on an investment, I’d be pretty darn pleased! In four years, that would more than double an investment made today.

Of course, that's just an average expected return. If you look closely at the graph, it's clear that price-to-book values in the 1.6 range have (at least over the 8+years reviewed here) led to annual returns of around 6% to 18%. That's quite a range, but it's still a very attractive one. Again, remember these results exclude dividends. Assuming BMO doesn't cut their dividend (and they haven't in many years), you can add another 5.5% to those numbers. So you're looking at a downside of 11%. That's right -- an 11% return is the downside!

Of course past history is no guarantee of future results. Relationships that once held true can suddenly cease to exist. If BMO’s exposure to subprime loans turns out to be greater than expected, then a big chunk of that book value could be wiped out overnight and the price-to-book ratio could rise substantially. If BMO is forced to cut their dividend, this will have a very negative impact to the stock price. Obviously no investment is without its risks.

However, I think the graph tells a compelling story.

The Best Investment for Canadians

2008-09-11T22:22:00.001-04:00

Do you want an investment with good, tax-advantaged, cashflow, excellent capital appreciation potential, and a long history of steady performance?

Then look no further than the stocks of the six largest Canadian banks, currently offering an average dividend yield of 4.6%, and trading at their lowest valuations on a price-to-book basis since 2003.

And if you're a Canadian investor, those dividends are subject to a reduced tax rate, meaning more money in your pocket compared to an equivalent interest rate (and good luck finding an interest rate of 4.6%!)

Still, investing in Canadian banks is not without risks and pitfalls you should be aware of. Investors who bought shares last spring probably aren't too happy -- the average Canadian bank stock has fallen over 20% since then!

This site will show you how to avoid those pitfalls and maximize your returns on Canadian bank stocks. We'll look at indicators that tell us when to buy and when to sell and what strategies we can use to leverage those signals for even greater returns -- meaning more cash for you!