Buy the banks!

It’s a rare occasion when a team of senior analysts does a complete about-face on one of the major sectors of the Canadian economy. But that’s exactly what happened earlier this month when the bank analysts at RBC Capital Markets changed their tune on the sector, raising a lot of eyebrows in the process.

It was just two months ago that analyst Andre-Philippe Hardy and his associate David Mun came out with a 67-page report (that’s right, 67 pages) in which they highlighted the risks facing the Canadian banking sector and went so far as to suggest that they suspend dividends to protect their capital base. Sure, such a move would be seen as “negative” by the markets, they admitted, and some investors would be “disappointed”. But it would be worth it because the result would be to “increase internal capital generation and thereby reduce the need for banks to raise capital” if conditions deteriorated. Needless to say, some investors were rattled and bank stocks remained out of favour.

This month, in a much shorter report, the RBC duo switched gears saying it is “time to buy Canadian banks on weakness rather than sell on strength”. In a May 4 analysis, the team said: ” We are turning more positive on Canadian bank shares as indicators of future profitability have improved, and the banks have enough capital in our view to handle the negative impact of challenging economic conditions on loan losses over the next 6 to 12 months”.

In explaining this reversal, the pair said that they still expect bank earnings will be depressed in the near term but that investors with a longer time horizon will profit as the economy recovers and profits rebound. “W e are comfortable that 12 months from now, investors will be talking about an economic recovery/earnings potential under a recovery scenario/how much earnings estimates might rise. In that context, we believe that it is reasonable to anticipate higher share prices 12 months from now,” they wrote.

How much higher? Somewhere in the range of 40 per cent to 80 per cent which would be on top of annual dividend yields in the 5 per cent to 7 per cent range. Sounds pretty tempting, doesn’t it?

But wait! We will likely see a sharp correction in current share prices, perhaps on the order of 20 per cent, before the real run-up begins, they suggest. “Negative news flow on the economy and credit is likely to continue, and consensus earnings expectations still need to decline in our view. As a result, a pull back in bank shares is quite possible (20 per cent is not unimaginable) so our change of view is not a trading call, but we believe that fundamentally a pullback should be viewed as a buying opportunity, so long as key indicators of future profitability trend in the right direction”.

In other words, don’t rush. Let the stocks come to you rather than chasing them.

When the original report came out, I strongly disagreed with its conclusions writing at the time: “I do not expect the banks to cut their dividends as long as the financial situation does not continue to deteriorate.” In fact, at just about the same time we were recommending the purchase of shares of TD Bank (TSX, NYSE: TD) in my Internet Wealth Builder newsletter. They were trading at $35.36 when we made the call on March 9; the shares were trading in the $50 range at the time of writing.

That said, I tend to agree with the RBC analysts on their current call. The bank stocks have been on a great run and it would not be at all surprising to see them retreat in the next couple of months. If you have not taken a position yet, you may wish to wait until that happens to make a move.

Active traders who have already profited from the bank run-up may want to take some profits at this stage with a view to re-entering at lower levels. Otherwise, we are advising our newsletter readers to maintain current positions. Talk to your own financial advisor about appropriate action.

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