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Why you should pick up banks stocks even if they’re down

As the financial crisis continues, don’t worry about what the banks have done lately, says this advisory, look at their long-term strengths.

The chairman of the U.S. Federal Reserve Board now admits that a recession is “possible.” Many of the newsletter editors we survey were telling him that months ago… and not always in the kindliest terms.

But it is not the debate between Mr. Ben Bernanke and his critics that is our chief concern, entertaining though it may be. Our concern is how to invest when you’re not sure what tomorrow will bring, or when another Bear Stearns may tumble down to blaring headlines and panicked markets.

Investing for safety has usually meant stocking up on banks and utilities. But wait, surely the banks are not the best investment at the moment. They’re in the middle of a credit crisis, right?

Don’t be too hasty, says one of Canada’s leading advisories for income investors, the Money Reporter. Look carefully at what you get when you invest in the big Canadian banks, and you will see a glass half-full at the very least.

The holy grail

“Every serious income investor makes a solid allocation to bank stocks as a core part of his or her portfolio,” says this advisory. “History tells us over and over again that Canadian bank stocks have given income investors everything they have been looking for.”

That is, the banks offer a steady price base, and steady, predictable income flowing from that base. It’s even better if that price base rises over time and the dividends rise with it, making the income stream even richer.

“In that context, the banks have been a veritable holy grail,” says the advisory. “Historically they have provided a steadily rising income on a steadily rising price base.” When you add in the benefits of compounding, the value rises exponentially.

“If you look at what a particular bank is paying in dividends today,” explains the advisory, “and calculate a yield based on the bank’s trading price five or seven years ago, you will see what a tremendous current yield can be had by simply buying and holding a bank stock for that term.” And you get a hefty price gain to boot.

No wonder income investors — and many not-so-conservative investors as well — tend to have bank stocks as fundamental core holdings in their portfolios.

Utilities vs. banks

But don’t ignore utilities, either, says the Money Reporter. “Both banks and utility stocks are good investments for the income investor, especially because their returns don’t correlate well.” In 2007 utility stocks bested financial stocks (no surprise there, as the credit crisis reared its ugly head). The year before, financial stocks had the upper hand. In 2005, utilities posted the higher returns.

Does that mean you should alternate them every year? In a word, no. “Own both,” states the advisory, “because we wouldn’t want to bet that financials will outdo utilities this year, just because last year they didn’t.”

OK, but why shouldn’t investors just stick with utilities now? Banks stocks have not been doing well, as we all know. But look a little deeper, says the advisory. Start with the bad news, and you’ll find some good.

How far have they fallen?

The advisory devised a measuring stick for the performance of the banks. It weighed the banks against their 52-week highs. How far have they fallen?

The banks fall into four groups. Lowest on the totem pole are Bank of Montreal (TSX-BMO) and Canadian Imperial Bank of Commerce (TSX-CM). Both are a rather large 36 per cent off their highs.

Next is a group in the low to mid-20 per cent range: National Bank of Canada (TSX-NA), Canadian Western Bank (TSX-CWB) and Royal Bank of Canada (TSX-RY).

The third group consists of a pair of banks off about 15 per cent: Toronto-Dominion Bank (TSX-TD) and Bank of Nova Scotia (TSX-BNS).

Finally, in a group by itself is Laurentian Bank of Canada (TSX-LB), which is down just 2.4 per cent.

None of these banks, by the way, has had a significant shift in its share price in the week since this issue went to print last week, so the percentages look pretty much the same today as they did then.

Out of favour, but still a buy

Now the advisory takes one more measurement: how far are the banks off their highs in the year to date? With this yardstick, it finds two banks out of favour with the market: Bank of Montreal and Canadian Western Bank, respectively 17 and 23 per cent off their highs this year.

Not daunted by the Bank of Montreal’s big drop-off, the advisory still has it as a buy — “but there’s no rush.” It does not follow Canadian Western Bank regularly and has no specific recommendation on it shares. The same holds true for Laurentian Bank. Its shares are the only ones that are above their 52-week high year-to-date (by a tidy 30 per cent), but the advisory does not monitor the stock regularly.

All the rest of the banks are buys. In fact, the advisory has just restored National Bank to a buy. The smallest of the big banks, it was put on hold while it divested itself of $2 billion to assume responsibility for asset-backed commercial paper.

$2 billion means a lot more to National than it does to its big five rivals. And the advisory was waiting for another shoe to drop. Sure enough, National has committed $815 million to a backup line of credit that will keep it out of the courts. That means “the crisis is much closer to the end than the beginning.” So National is a buy again.

So are Bank of Nova Scotia, CIBC, Royal Bank of Canada and Toronto-Dominion Bank. “If we had such a thing as a ‘best buy’ among our banks,” concludes the Money Reporter, “Royal Bank would be it.”

Bigger banks in bigger markets than Canada have suffered far more than our banks. Maybe it’s because they’re Canadian and they like to keep something in reserve. But according to this advisory, the banks’ glasses are half-full even when they look half-empty.