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Don’t give up on Canada’s big banks now

Thanks to fear and greed in the credit markets, Canada’s big banks may actually be better value for your money now, says this advisory.

Sorry to keep on about this credit thing. Some believe an infusion of cash is restoring the financial system to health — while others think throwing cash at the current problem will simply cause greater problems (inflation? recession? stagflation?) down the road.

The object of this story, however, is not to re-hash the slimy succession of subprime mortgages and structured investment vehicles that have brought us to this pretty pass. And we’re not here to discuss the motives and machinations of the world’s central banks as they try to keep the whole mess under control.

But we are here to talk about banks. Our banks. The big Canadian banks we’ve been going to since we got out first job and opened our first bank account.

Most of those banks were caught with their fingers in the asset backed commercial paper jar. Several appear to have avoided the worst effects, but at least one bank appears to be stuck in up to the elbow.

To which Mr. Richard Croft responds: So what? Yes, the banks made some credit missteps, he writes in the latest issue of The MoneyLetter. Yes, their results suffered following their last quarterly reports. They may suffer again after their next quarterly reports.

Does that mean you should avoid investing in the banks? Not at all, says this analyst. In fact, this may be the best possible time to put more bank shares in your portfolio.

Pressure beats fact and logic

“You have to think that speculative pressure trumped fact and logic when you view last November’s performance numbers of shares of Canadian financial institutions,” begins Mr. Croft.

Look closer, and the actual figures in the reports were not uniformly bad. Yet most banks and insurance companies hit 52-week lows. In short, the big bad headlines overpowered the poor little facts.

Mr. Croft turns to the figures. Two of Canada’s largest insurance companies, Sun Life Financial (TSX-SLF) and Great-West Lifeco (TSX-GWO) reported increases in income of 9 and 17 per cent, respectively, in their third-quarter reports in November. No damage there.

“No question the banks were hit by the much-publicized credit crunch,” adds the analyst, “but the impact was far from corporation-crippling.” Bank of Montreal (TSX-BMO) took the worst hit, with a 20 per cent drop in earnings. Oddly enough, Toronto-Dominion Bank (TSX-TD), which appears to have stayed away from asset-backed securities, saw a 13 per cent drop in net income for the year, although its fourth-quarter figures were up from the year before.

Royal Bank of Canada (TSX-RY) had a 16 per cent improvement in year-over-year earnings. Bank of Nova Scotia (TSX-BSN) saw its net income rise 6 per cent from the year before, and its earnings climb 13 per cent.

Canadian Imperial Bank of Commerce (TSX-CM), generally held to be the biggest sinner in the credit markets, actually showed a $2.6 billion increase in earnings, although there was more bad news to come after those results were studied carefully.

Looking over all of these figures dispassionately, “What a disaster!” is not liable to be your first reaction.

“But as we know,” says Mr. Croft, “market reaction has very little to do with actual reported numbers. Rather, the market’s focus was on the uncertainty about potential future writedowns.” The glass, in other words, was half-empty and then some.

The market abhors uncertainty

The classic case study, the analyst points out, is CIBC. In November, its numbers were better than expected. The stock jumped to $90 a share. Then analysts began looking closely at the numbers.

It appeared that the bank had $11 billion worth of “hedged” exposure to U.S. subprime debt. Even that was as clear as mud. “No one is really sure what ‘hedged’ means in this context,” says Mr. Croft. “What we do know is that the market abhors uncertainty. Particularly if it has the potential to significantly affect the value of the company.” $11 billion is a lot of money to write off, even for a very big bank.

So uncertainty got to work and kicked the share price down by more than $10 in short order. (At the close of yesterday’s trading it had gone all the way down to $69.80, a $21 drop from the balmy days of November.) Subsequent to Mr. Croft’s article, some desks have been cleared out in the executive suite at CIBC as the bank tries to stop the bleeding.

Those singularly unsentimental market operatives, the option traders, helped set the tone when they pegged CIBC’s volatility at 40 per cent, well above Scotiabank, at 22 per cent, or BMO, at 28 per cent.

“What this means,” explains Mr. Croft, “is that long-term investors must again come to grips with the concept of liquidity, which is to say the ability to purchase and sell shares quickly.”

And liquidity is a double-edged sword, the analyst explains. To help his readers in The MoneyLetter get hold of the right end of that sword, he turns to one of the legends of the investment world, Mr. Benjamin Graham.

Liquidity for the intelligent investor

Even before Warren Buffett, there was Benjamin Graham and his much-quoted book, The Intelligent Investor. Mr. Croft quotes from it to explain the importance of liquidity:

“Liquidity means that the investor has the benefit of the stock market’s daily and changing appraisal of his holdings, for whatever that appraisal may be worth, and second, that the investor is able to increase or decrease his investment at the market’s daily figures — if he chooses. Thus the existence of a quoted market figure gives the investor certain options that he does not have if his security is unquoted. But it does not impose the current quotation on an investor who prefers to take his idea of value from some other source.”

In short, you don’t have to take their word for it. Here is how Mr. Croft states the proposition:

“When it comes to value investing, the key lies in dissecting the news; separating the wheat from the chaff, as it were. The market too often values companies on the basis of fear and greed, something prudent investors must overcome.”

Value vs. fear and greed

Mr. Graham had further thoughts on taking the market’s meanderings with a grain of salt. “You may be happy to sell out when [the market] quotes you a ridiculously high price, and equally happy to buy when [the market] price is low. But the rest of the time you will be wiser to form your own ideas of the value of your holdings, based on full reports from the company about its operations and financial position.”

What this boils down to is a chance to keep your head when many around you are losing theirs. There’s a link, says Mr. Croft, between uncertainty, the role of liquidity and the real value proposition of a stock.

Because markets react badly to uncertainty, liquidity quickly translates fear and greed into a stock’s price. As Mr. Croft puts it: “Value judgments allow investors to take their own view, which means buying on fear and selling on greed.”

And now Canada’s big banks have become value plays. In an accompanying chart, the analyst sizes up the recent share price, earnings per share, price/earnings ratio, dividend yield and market cap for each of the big five and comes to the following conclusion:

“Beaten-down bank shares now represent good value. But it takes guts to buy when things look the grimmest.”

A reasonable economic recovery

Of course, the banks are a good buy if you can assume that they will survive and prosper, adds Mr. Croft. It’s hard to see them not surviving, but is prosperity just around the corner?

The link between the banks and economic activity is more acute than in other sectors, of course. The uncertainty we face is the degree to which the credit crunch will affect U.S. homeowners and consumer spending.

Mr. Croft believes the U.S. government’s plans to temporarily freeze the rate charged on subprime debt will cut down on foreclosures and bankruptcy filings. That will alleviate pressure on housing prices and help consumer spending rebound, “adding more fuel to house prices and ultimately to a reasonable economic recovery.”

This will require economic stimulus from the U.S. Federal Reserve Board in the form of lower interest rates, which Mr. Croft believes we will see by the end of the second quarter of 2008.

Banks typically lead this type of recovery, he points out. They should benefit in two ways: from stronger earnings created by an increase in quality consumer loans fuelled by low interest rates, and from a reduction in the size of writedowns flowing from the current credit crunch.

“Moreover, because the stock market tends to be a leading indicator, I would expect to see the market buying into this view as early as January, but certainly during the first quarter of 2008.”

Good then, even better now

Thus, Mr. Croft, who has steadily recommended bank stocks in The MoneyLetter, has no hesitation in doing so now, “on the classic value investor’s argument that if they were good then, they’re even better now.”

The specifics: Bank of Montreal is a buy, ideally “at any price below $60 per share. My target is $70 per share.” It closed yesterday at $56.52.

Bank of Nova Scotia is a hold/buy. “The market likes BNS for its low profile in the subprime crisis. So while it may not be as beaten down as the other banks, it’s still a good buy, with its $1.88 dividend and 3.9% yield.”

CIBC is also a hold/buy. “I am recommending you hold what you have and buy more CIBC at current prices.” His target is $100 per share, which leaves plenty of room at the current price. In the meantime you earn a little over 5 per cent in dividend income.

Royal Bank of Canada earns a hold/buy on the simple proposition that you “can’t go wrong with Canada’s biggest bank.” The current dividend yields 4.0 per cent.
Mr. Croft does not include a specific recommendation for Toronto-Dominion Bank, by the way. But he does have two more interesting calls.

One is the U.S. bank faced with the deepest cuts in the subprime crisis, Citigroup Inc. (NYSE-C). The bank is cleaning house with a new CEO, which may restore investor confidence. It still remains to be seen how effective the Fed’s bailout plans prove to be. In the meantime, with the shares trading around $28, the 7.47 per cent yield is hard to ignore. It’s a hold/buy.

Finally, you might want to own a piece of the entire financial sector without picking and choosing. In that case, says Mr. Croft, opt for iShares CDN Financial Sector Income Fund (TSX-XFN), which holds all the big banks and many other financial leaders, like Manulife Financial, SunLife, Power Corp., Fairfax Financial Holdings, Onex Corp. and CI Financial Income Fund.

So it has come to this. You can buy shares in Canada’s five big banks and hope to watch them run up the ladder like some hot small cap or junior miner that just struck it rich.

The mind boggles.