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Why it’s time to invest in banks and real estate when they hit bottom

Before the most damaged sectors of the economy start to recover, says a top Canadian analyst, get the best stocks while they’re down.

“Did you ever feel like you were a passenger in an out-of-control bus that had just lost its brakes on a mountain road?”

That’s the sensation Mr. Gordon Pape got from just one day’s worth of headlines. Such as: “Warren Buffett says U.S. is in recession.” “Bank of Canada slashes rates; says situation deteriorating.” “Bank profits slump.”

We’ll spare you the rest. But Mr. Pape isn’t just bemoaning the bad news. He has a few remedies to propose for investors. Writing in The MoneyLetter, he suggests you look squarely at the unhealthiest sectors in the economy and see which stocks are due for a recovery.

Fishing for value

“Certainly, we’re going through a rough period,” says Mr. Pape, “and Warren Buffett predicts it will get worse before it gets better.”

After a series of yet more subprime shocks, poor year-end financial results and interest rate cuts, only strong prices in commodities like oil and gold have kept the TSX from sinking like a stone. And those high prices owe a good deal to a weak U.S. dollar, notes Mr. Pape.

“I expect the turmoil to persist for most of 2008,” he adds. “Stock indexes will stage periodic rallies but will remain in a downward trend until at least the summer.”

That’s why it’s time to go fishing for value, he says.

“Bear markets — and I believe that’s what we are now experiencing — create tremendous bargains for those who have built cash reserves and are alert to opportunities that may be available only for a short time.”

Thriving on adversity

Mr. Pape points to a pair of value-fishing fund managers who seem to do better in bad times. Mr. Francis Chou rolled up double-digit profits with the Chou RRSP Fund in the bear market of 2000-2002, but gained just less than 10 per cent in the bull market of 2006 and lost money last year. He appears to thrive on adversity.

Mr. Richard Howson, veteran manager of the Saxon Stock Fund recently told Mr. Rob Carrick of the Globe & Mail that he’s not going to change horses and bring in resource stocks even though his fund is down. They’re too volatile, he says, so he will stick to his philosophy and hope his unitholders stay with him.

In the end, says Mr. Pape, this stick-to-your-guns approach has paid off for these fund managers. “Of course, it works only if you pick good securities,” he adds. “If you buy junk cheap, it’s still junk.” If you want to emulate these successful value managers, look for the best companies in the asset classes that have taken the worst beating.

“Decide which ones you’d like to own, and then watch the price movements closely,” explains Mr. Pape. “You’ll get the best value on a day when the indexes are plunging. That’s when the pros move, and so should you.” Right now, you can’t go any lower than real estate.

A bargain-hunter’s paradise

In the wake of the housing crisis and mortgage debacle in the U.S., any security associated with real estate has been hammered. Even those companies with no proven exposure to subprime mortgages are pronounced guilty by association.

“It’s a bargain-hunters paradise,” states Mr. Pape. And the biggest bargains are Real Estate Invesment Trusts, or REITs. During the year ended March 3, the REIT Index lost a thumping 25 per cent of its value. We may have already seen the low point in January when the index was down over 31 per cent from its 52-week high.

“But if that low is retested, be ready to move,” says the analyst. He suggests you start with one of his favourites, RioCan REIT (TSX-REI.UN). RioCan’s earnings fell sharply in 2007. But there’s a catch. The company booked $144 million for future income tax liabilities, as required by law. But REITs are exempt from the trust tax in 2011 if they meet certain conditions, so all that money will come flowing back in.

RioCan’s low was $18.10. It traded around $19.35 when this issue of The MoneyLetter was released last week, and it opened today at $20.26. Put it on your watch list and grab it if it goes below $19, says Mr. Pape.

The strongest Canadian bank

Not quite as low on the list of losers, but still pretty far down, are the banks. All of Canada’s chartered banks except one were caught with subprime junk in their pockets. Only Toronto-Dominion Bank (TSX-TD) appears to have avoided it altogether. Canadian Imperial Bank of Commerce (TSX-CM) was the worst offender.

CIBC shares fell to as low as $60 this month, an astonishing 44 per cent freefall from their springtime high. “Much as I dislike CIBC’s corporate policies (the bank also took a huge hit over Enron),” says Mr. Pape, “the shares appear to offer strong upside potential at this level.” They were sitting at $67.25 today.

As the analyst penned this article, Royal Bank of Canada (TSX-RY) was down 28 per cent from its 52-weel high, Bank of Montreal (TSX-BMO) had fallen 31 per cent, and Bank of Nova Scotia was off 21 per cent. Even the innocent are suffering: TD Bank was down 17 per cent.

“If you want to invest in the strongest Canadian bank,” says Mr. Pape, “I suggest you keep an eye on TD.” If the shares pull back below $62, “swoop in,” he recommends. They opened at $64.37 this morning.

But you can also spread your bet across all five Canadian chartered banks with one investment. 5Banc Split Inc. Capital Shares (TSX-FBS.B) is a split-share arrangement with two classes of units — one for common stock and another for preferred shares. Unlike other financial index funds, Capital Shares invests only in the five major banks, so it’s a pure bank play. No insurance companies or fund companies included.

“I think they’re good value right now,” concludes Mr. Pape (they were at $6.24 when The MoneyLetter went to press), “but we’re looking for big-time bargains right now, so I suggest you watch for an entry point below $5.90.” And move quickly, the window may not be open for long. The opening price today was $6.15.

Buy low. Sell high. It’s at times like these that you have opportunity to reach that Holy Grail of investing. The secret, claims this analyst, is to have the fortitude to buy on those panic-stricken days when the bus is roaring down the mountain road out of control.