Is now the time to buy bank stocks?

By Jason Chow
Globe Investor Magazine Online, June 3, 2008

Can't blame you for wondering that exact question. With Canadian banks posting battered profit numbers, many investors may be wondering if this is the moment to buy low. After all, history shows us that bank stocks in this country rarely stay down long.

To tackle the subject of bank stocks, let's break it down.

1. Buy banks now?

The answer depends on the kind of investor you are. Are you a first-time buyer, a money-parker, or looking to add more to your portfolio?

Those without any exposure to the financial sector may want to look at now as a good time to buy. Valuations are relatively low and all the investment experts say Canadian investors should always have some of the big financial stocks in their core holdings. Besides, investors who are putting money in money-market funds or high-interest bank accounts might be better off with bank stocks and collecting the dividend cheque.

These days, bank stocks are so depressed that the dividend yield can vary from 3.5 per cent to as high as almost 6 per cent. The yield on the S&P/TSX capped financial index is at 3.7% but some, like Bank of Montreal, had a dividend yield Tuesday of 5.8 per cent. And remember, dividends are taxed lower than interest and history shows that bank dividends are among the most dependable on the market.

But for those who are seeking to add to their already existing bank stock holding in hopes for a strong rebound, this year may be too optimistic. There will likely be a better time to buy.

2. Why the wait?

To be safe, it may be best to wait until the conditions for a strong rebound are more certain. You don't have to look far back to be cautious: In the past six months, bank chief executives have constantly tried to assure investors the worst has already passed but there still remain a lot of clouds ahead for the sector. By no means is the subprime loan mess out of the forecast and the weakening U.S. economy doesn't instill much optimism either.

"Two things will help clear the air," says portfolio manager David Cockfield at Leon Frazer Associates in Toronto. "We really need to see a resolution to all the liquidity problems in the financial system. And to get really enthusiastic for the banks, we'd have to see prospects for better economic growth. We probably won't see that until at least the third or fourth quarter [this year]."

3. What would give the green light to buy?

A rosier economic forecast, for one. Also, Mr. Cockfield says he requires a sign that the liquidity problems in the financial system are over.

But how can we tell that the tide has changed?

"We need a quarter where there are zero writedowns and no surprises," says Mr. Cockfield. Given that the banks have had three quarters in a row of shrinking profits and missed forecasts, it's best to see the hard evidence before you get bullish on the sector. And he says that we may be six months away before we see a completely clean no-writedown quarter.

Last week, Canadian Imperial Bank of Commerce posted a $1.1-billion loss in the last quarter saying it took a hit on a credit-related writedowns. This was the second consecutive quarter that the bank posted a major loss and in its remarks, it hinted that more significant writedowns would be on their way.

4. When the banks do pop back to life, can we expect a massive rebound?

Well, probably not anything like Internet stocks in the late-1990s, but take a closer look at the numbers and you'll see it wouldn't take much for an investor to see double-digit returns on bank shares from their current levels.

George Vasic, portfolio manager at UBS Securities, broke it down: With the average dividend yield around 4.5 per cent, he says investors could bag a double-digit total return (dividends plus capital appreciation on the shares) even if the banks raise their profits by a modest 6 per cent to 7 per cent. Pedestrian growth is all we need.

Currently, the S&P/TSX capped financials Index is trading at a price-to-earnings ratio of 13.9, well below the 17.8 level for the overall S&P/TSX composite index.

However, like Mr. Cockfield, he cautions investors. If you were to buy stocks now, it would mean you believe that the credit problems that have affected bank stocks are past. He also forecasts Canadian markets to pull back a bit from the recent big gains that the S&P/TSX composite has made in the past three months.

Special to The Globe and Mail