Are Canadian Banks Cheap?

12/22/2008 12:01 am EST

Focus: GLOBAL

Gordon Pape

Editor and Publisher, The Income Investor and the Internet Wealth Builder

Gordon Pape, editor of The Canada Report, says Canadian banks look to be in pretty good shape, but there are no guarantees.

The S&P/TSX Composite Index is down 45% from its all-time high, reached in early June. Many stocks have lost even more.
 
So, is this the time to buy? The answer is a highly qualified yes. The problem is they could become cheaper still in the coming weeks.

Financial insiders say that one of the main reasons for the depressed price levels is hedge funds that retain a core base of blue-chip stocks for liquidity and collateral for leveraged positions. The sudden market downturn forced them to sell their most liquid stocks to raise cash quickly to cover margin calls. That pushed prices down even farther.

As a result of the price drops, bank stocks are offering eye-popping yields right now. In normal times, we expect dividend returns of around 3% from these companies. Currently, Royal Bank (NYSE: RY) is yielding 6.9%; TD Bank (NYSE: TD), 6.1%; Scotiabank (NYSE: BNS), 6.6%; CIBC (NYSE: CM), 7.3%, and Bank of Montreal (NYSE: BMO) shares are yielding an astounding 9.0%.

Yields this high suggest that investors are worried the banks will cut their dividends in 2009, with BMO and CIBC viewed as the most vulnerable. However, some experts point out that none of the Big Five Canadian banks has cut its dividend in living memory. To do so would shatter investor confidence, and bank directors just won’t let it happen except in the direst circumstances.

Even after a lousy year, bank profit margins are well in excess of dividend payouts, leaving plenty of room to maneuver. If business conditions begin to improve in 2009, the bullish view goes, bank stocks will benefit and yields will decline as share prices rise.

However, BMO’s payout ratio came in at an alarmingly high 75%. If any of the banks is going to cut, investors expect BMO to lead the way.

Another worrisome sign is the flood of new common and preferred equity issues from the banks as they move aggressively to build their Tier 1 capital. More shares mean that more money will have to be paid out in dividends. If profits are squeezed further in 2009, that could spell trouble.

None of Canada’s major banks will fail—the government simply would not let that happen. If one of them appears to be teetering, Ottawa’s longstanding opposition to bank mergers will vanish in an instant. But if we do find ourselves in a Depression-type scenario in 2009, some dividends will get cut and today’s seemingly cheap share prices will look mighty expensive.

So, although bank stock yields look extremely attractive at current prices, the risk is higher than we would expect from these companies in normal times. If you want to add Canadian bank stocks to your portfolio, do so gradually and focus on the companies with the strongest balance sheets and the lowest payout ratios.

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