Are bank stocks cheap?

We keep hearing that stocks are cheap and if you compare today’s prices to those of six months ago, they certainly are. The S&P/TSX Composite Index is down 45 per cent from its all-time high, reached in early June. Many stocks have lost even more including such blue-chip companies as Manulife Financial, which is down an astonishing 55 per cent from this time last year.

So is this the time to buy? Are stocks really the screaming bargains they seem to be? The answer is yes – but they could become cheaper still in the coming weeks.

Financial insiders say that one of the main reasons for the depressed price levels we’re seeing is hedge funds. These largely unregulated investment vehicles make money in a variety of ways including short-selling, arbitrage, spread trading, leverage, and derivatives. They retain a core base of blue-chip stocks which provides liquidity and collateral for leveraged positions. The sudden market downturn caught many of these funds offside, forcing them to raise cash quickly to cover margin calls. The only way they could do this was by selling their most liquid stocks for whatever they could get, pushing prices down even farther. “We’re about two-thirds of the way through that cycle,” one knowledgeable money manager told me recently, suggesting that we could see more distress selling in early 2009.

Since hedge funds are notoriously opaque – nobody knows exactly what they hold at any given time – it’s impossible to predict which stocks may be most affected by the next wave of binge selling. What is clear, however, is that some of the prices we’re seeing now do not accurately reflect the underlying value of the companies. There are forces at work that are distorting the markets to a degree never seen before. Sooner rather than later, regulators are going to have to rein in the hedge funds but in the meantime investors are left trying to figure out what is a bargain and what is not and whether to buy or wait.

I’ve been receiving a lot of inquiries about the bank stocks so let’s take a look at them and see whether they are really good value at the current prices. Here are the bullish and bearish views on the outlook for Canadian banks.

The bullish case . As I write, the S&P/TSX Capped Financials Index is down about 45 per cent from this time last year. The Big Five banks, which make up a large part of that index, are all down by about the same percentage, with the exception of Royal Bank which looks like a winner having lost “only” 39 per cent.

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 per cent from these companies. As of the time of writing, Royal Bank was yielding 6 per cent, TD Bank was paying 6.1 per cent, Scotiabank was at 6.6 per cent, CIBC investors were getting 7.3 per cent, and Bank of Montreal shares were yielding an astounding 8.5 per cent. With the dividend tax credit taken into account, a 6 per cent dividend is equal to an interest rate of about 8.5 per cent in after-tax terms.

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, that is simply not going to happen, say some experts who watch the bank stocks closely. They point out that none of the Big Five Canadian banks has ever cut its dividend, at least not 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 manoeuvre. For example, in its recently-released annual report TD Bank showed an adjusted dividend payout ratio of 49.3 per cent, meaning that less than half of its 2008 profits were paid out to shareholders. “The banks are not going to cut their dividends. Period. Full stop.” That was the way one closely-connected investment manager put it to me.

If business conditions begin to improve in 2009, the bullish view goes, bank stocks will benefit and yields will decline as share prices rise.

The bearish case . Although all the big banks earned enough in fiscal 2008 to more than cover their dividends, some disquieting trends emerged. TD Bank’s payout ratio was below 50 per cent, but it was much higher than last year’s 36.4 per cent. BMO’s payout ratio came in at an alarmingly high 75 per cent. The bank reported net income of $1.978 billion and paid out $1.483 billion in common and preferred share dividends. That explains why BMO’s yield is so high. 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 we’re seeing from the banks as they move aggressively to build their Tier 1 capital. A strong capital base adds to investor confidence and helps the bank maintain a good credit rating. The downside is that 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.

In its December Financial System Review, published last week, the Bank of Canada warned that in a worst-case scenario, financial institutions could come under intense pressure.

“A deep, or prolonged, downturn in the economy could entail new challenges for Canadian banks in the form of higher credit losses, with potentially significant negative impacts on their capital ratios,” the report said. “The risk is that market forces could compel banks to restore their capital ratios, leading them to curb balance sheet growth more aggressively. This could result in a significant tightening of lending conditions for both households and businesses that would exacerbate weakness in the economy and increase difficulties for financial institutions.”

In other words, if things get worse before they get better, history will count for nothing. None of our major banks will fail – the government simply would not let that happen. If one of them appears to be teetering, Ottawa’s long-standing opposition to 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.

Last month, RBC Capital Markets issued a research report stating that it is still too early to be loading up on bank stocks. Analyst Andre-Philippe Hardy and associate Dave Munn cited three reasons for caution:

1. The continued deterioration of the economic situation.

2. The risk of dividend cuts.

3. The need for analysts as a group to reduce profitability estimates to more realistic levels. (RBC’s estimates are about 7 per cent below the average.)

The team does not give an “outperform” rating to any bank and warns sombrely: ” The likelihood of capital raises or dividend cuts for Canadian banks has risen in the last months, in our view.”

The bottom line : Although bank stock yields look extremely attractive at current prices, the risk level is higher than we would expect from these companies in normal times. If you want to add bank stocks to your portfolio, do so gradually and focus on the companies with the strongest balance sheets and the lowest payout ratios. Talk to a financial advisor about the best choices.

Gordon Pape’s new book is Tax-Free Savings Accounts: A Guide to TFSAs and How They Can Make you Rich . Reserve your copy now at