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Bank stocks are as close to a sure thing as there is in investing, but every so often one hits the skids. Savvy investors live for these moments.
As Summer 2007 wound down, investors were treated to a unique spectacle: two wounded banks stocks at the same time. Bank of Montreal, stung by commodity trading losses, was down 9 per cent for the year through the first week of September. National Bank of Canada, punished for its dip into the market for asset-backed commercial paper, was down 20 per cent. Why would any sensible investor be interested in these losers, especially when other bank stocks have done comparatively well?
There are two simple answers, one of them we’ll informally call the Rule of Big Banks. It stipulates that big bank stocks in Canada all have their own cycles of boom and retrenchment, but that all of them ultimately are excellent long-term investments. The upshot here is that a slumping bank stock is an opportunity to buy quality merchandise on sale. It wasn’t too long ago that Royal Bank of Canada was the laggard bank stock because of troubles in its U.S. division. TD was the laggard early this decade because of its heavy lending to the troubled telecommunications sector. Most recently, Canadian Imperial Bank of Commerce hit some turbulence resulting from involvement in the Enron debacle. All three are now healed. RBC is the best performer of the Big Five banks in the past three years, while CIBC is tops in the past 12 months. The second-ranked bank stock over both timeframes is TD.
The second reason to look at BMO and National Bank is their dividend yield. BMO’s yield was 4.4 per cent as of early September, while National Bank’s was 4.5 per cent. Those are exceptionally high dividend yields for bank stocks. So high, in fact, that they’re a bit alarming because only when a stock is under selling pressure does its dividend yield soar. BMO’s dividend yield has averaged no more than 3.5 per cent over any year this decade, while National Bank has topped out at 3.60 per cent. The risk here is that either bank would have to cut its dividend - you can’t rule this out entirely, but the history of recent decades suggests banks faced with troubled operations simply won’t slash the amount of money they shovel out to shareholders each quarter.
The near-term outlook for all the big banks heading into the autumn was uncertain because of the volatility in stock and bond markets. All the banks earn a substantial amount of income from financial market trading activities and this pipeline appeared vulnerable. But worrying about things like this is for professional money managers who must account for their results each quarter. Longer-term investors can afford to take be more patient, even with the lingering uncertainties surrounding National and BMO.
National actually reported a better than expected increase in third-quarter earnings, but its future is clouded by its decision to buy $2-billion in asset-based commercial paper held principally by its in-house money market funds. Spooked by the subprime mortgage mess in the United States, investors put the ABCP market into a deep freeze this summer. National Bank bought the ABCP holdings from its funds to forestall the possibility of devaluations in the value of its money market funds, which would have been a calamity for investors who purchased these funds for safety. BMO’s problems are related to difficulties in its natural gas trading activities, which caused a $149-million pretax hit in its third-quarter earnings. Looking ahead, BMO still faces the threat of lawsuits and inquiries from law-enforcement agencies.
To put BMO’s problems in perspective, the bank recently increased its dividend by 2 cents to 70 cents a share, and announced a share buyback. Neither action is earth-shattering, but they do suggest the bank recognizes that shareholders need something to keep them happy until such time as the overall business is high gear. Keep your eye on National when it next reports its quarterly earnings. The bank hasn’t raised its dividend in the past two quarters, and its historical patterns suggest it is due for an increase. If one is forthcoming, it’s a sign of management’s confidence in the future. If not, then pressure mounts for the sort of turnaround that Canada’s banks always seem to pull off when they flirt with trouble.
Rob Carrick has been writing about personal finance, business and economics for more than 12 years.