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Dollars & ¢ents

Let me first ask the question…

When was the last time any bank in North America had a six month return below 1%?

CM: -9.22%
RY: -1.10%
TD: -1.00%
BNS: -3.11%
BMO: -5.00%
BAC: -7.31%
C: -13.50%
WB: -13.75%
MFC: -1.70%
SLF: -1.90%

6-month return as of July 30th, 2007
Any investor might first look at those numbers and have given a loud “OUCH”. For many investors, they would run and hide from returns such as these in any category without ever giving them a second glance. We’ve all heard about the rising Canadian dollar hurting foreign returns, concerns about the inverted yield curve, rising interest rates or even the sub-prime fiasco that’s on going and appears to be snowballing for many involved.

But, it’s important to understand how a bank does business. Essentially they’re in the business of making money; not much has changed over the last 100 years in banking. They continue to pay out GIC’s at 4.5% and lend mortgages at 7.25% (arbitrary #’s). The spread is always there. Even with HELOC’s at prime minus 2, the banks ensure the safety of their loans through collateral (hence the discount). From time to time individuals will get greedy and lower the MoS as with BMO’s gas mishaps & CM’s recent sub-prime exposure. But for the most part the banks generate revenues by maintaining a widened spread between what they yield vs. what they can charge.

A mentor of mine once said that “If it don’t make dollars, it don’t make ¢ents” (future posts on this). What he meant is that a smart investor will always put their money where the money is. Banks might report losses against trading or risky activities, but never that they “lost” money from fundamental operations of their business. Similar to insurance companies; they may pay out higher premiums one year due to an unexpected natural disaster, increased mortalities or a higher number of claims, but they don’t “lose” that money. It’s either been paid for multiple times already through years of paid premiums or they’ll just increase rates the following year to cover their MoS.

Do I think that the market has overlooked this group? – Yes
Do I see value in some of these names at these levels? – Yes
Would I buy all of them at the moment on their recent weakness? – Not just yet

Remember that the market does behave efficiently at times, but emotion is the shadow that lurks within the market. We hear about exposure to so many risk factors and the market realizes that they need to be priced into the market in some form. What routinely happens though is that risk is exaggerated well beyond the true pricing of the company and a mispriced asset is left vulnerable for those who can identify it.

For myself, with an investing horizon of 25+ years ahead of me…I’m cautiously looking in the rearview mirror for a sign to “back up the truck”. I’ve already secured large initial positions in some of these names and understand that the volatility of the group may test my patience over the next six month period. But if you can get past the market sentiment here, look at the fundamentals, valuation and price in an adequate amount for the risk they’re all exposed to – you may come out a little on the giddy side that this opportunity has presented itself.

Sure, we might see another 5% come off…but if you include the after-tax dividends they each pay over the next 12-month period – you’re easily breaking even at these levels. They’ve almost all paid those dividends on a consistent basis and even increased them by large percentages over the years they’ve been in operation. If you could go back to late 2002 and you knew then what you do today…would you have done the same?

Some are exposed to more risk than others…that’s the nature of business. Some have better management, strategic focus, stable cashflows and opportunities for growth internationally. But the Canadian dollar won’t always be where it is today, interest rates still remain at historic lows and the market has already heavily priced in the cost of sub-prime exposure to most of the North American banks. Even if you don’t agree completely with my opinions, you’d be hard pressed to disagree where these stocks will be in the years to come. It might still be early, but I’m guessing that at some point the market will realize how far the mispricings have gone for this group & valuations may rise significantly due to that discount.

Where I have I been initiating positions & lining up the truck for:
MFC: You can’t get better international exposure to developing markets while gaining exposure to an established portfolio of products, impressive dividend growth & some of the most solid management around
SLF: I like to call it “Mini-me”. While they don’t deserve the same accolades as their larger competitor, some of the same criteria applies here as well
RY: No other bank has their strength, scale, experience or exposure to growth in North America. If or when the rules are ever changed, this one will grow in similar fashion to RBS has.
BNS: Offers the best international exposure and most consistent dividend growth of any Canadian bank. It’s often picked on as the “little guy” but the focus of management is “outside the box” which is right up my alley
BAC: Raised their dividend yearly forever, exposure to the American market like few others & functional management who understand the limitations & strengths of the business model. They might not be as large as Citi, but they will also be able to post higher annual growth above Citi’s because of their smaller scale and those limitations.
WB: Diamond in the rough IMO.

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{ 5 comments… add one }
  • moneygardener July 31, 2007, 7:55 am

    Good post. I agree.

    It will be interesting to see how low investors will take BAC down given it’s current 5.4% yield.

    BTW – Good numbers from SLF today, and a dvd. increase.

  • Nurse B, 911 July 31, 2007, 9:38 am

    Good numbers (although I have yet to read them all indepth) and you always have to smile when you get a “RAISE” – enjoyed that post.

    I’m still in another “cash accumulation” phase at the moment since I’ve pretty much gotten my fill of MFC & SLF – can’t throw my allocations TOO out of wack. But did you read my comments on TOC?

    I started more indepth research on the US stocks in the past few weeks. My only hesitation is that I’m already heavy in financials, but do you put BAC on the same undervalued level as BNS?

  • moneygardener July 31, 2007, 10:25 pm

    BAC is cheaper than BNS by a few percentage points.

  • moneygardener August 9, 2007, 11:14 pm

    I agree with your comments on TOC. Do you agree with me that it is looking like pretty good value here. It’s hard to get around that multiple though…

  • Nurse B, 911 August 11, 2007, 2:29 am

    My ACB on TOC is just under $44 now, so the next addition to my position would be taken in the $40-41 range if it drops there. The stock IMO underwent a mutiple contraction over the last few yrs, so I think we’re safe at the moment. I’m looking more towards forward earnings – which I feel are WAY undervalued once you add in the Reuters acquisition & cost savings from selling non-core assets recently. With the fitness of their current balance sheet & post Reuters, I’m willing to pay the small premium I see in the P/E knowing five years from now I’ll be laughing.

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