Bank on the big five banks as cornerstone stocks

The big five Canadian banks pay much higher dividend yields than the overall Canadian stock market. They increase their dividends each year. The big five are all blue chip stocks that trade at attractively-low price-to-earnings ratios. That’s why you should make them cornerstones of your portfolio.

Warren Buffett has said that his favourite holding period is “forever”. We feel that way about the big Canadian banks. They should serve as long-term cornerstones of your portfolio.

The big five pay attractive dividends, of course. Indeed, Bank of Montreal, or BMO (TSX—BMO), yields 3.6 per cent. Bank of Nova Scotia, or Scotiabank (TSX—BNS), yields 3.8 per cent. Canadian Imperial Bank of Commerce, or CIBC (TSX—CM), yields 4.5 per cent—the most. Royal Bank of Canada, or Royal (TSX—RY), yields 3.5 per cent. Toronto-Dominion Bank, or TD (TSX—TD), yields 3.3 per cent—the least. This is well above the average dividend yield of the S&P/TSX Composite Index (or the Canadian stock market).

Even better, the big five banks are what’s known as ‘dividend aristocrats’. That’s because they raise their dividends every year. In fact, in recent years some have raised their dividends more than once a year—albeit by more modest amounts. Growing dividends enable you to beat inflation. Growing dividends also attract income-seeking investors who bid up the price of your shares.

The banks may beat expectations this year

The big five banks almost always earn more. Rising interest rates in the U.S. are likely to exert upwards pressure on Canadian interest rates. This is positive for banks. That’s because it widens their ‘spreads’. That is, they earn more interest on assets, such as loans, than they pay on liabilities, such as deposits. Growing ‘net interest income’, their traditional banking business, may raise their earnings more than expected.

In fiscal 2017 and 2018, (fiscal years end on Hallowe’en), BMO’s earnings are now expected to rise to $7.63 and $7.99 a share, respectively. This gives the shares attractive price-to-earnings, or P/E, ratios of 12.9 and 12.3 times, respectively.

Scotiabank’s earnings are now expected to rise to $6.35 and $6.74 a share, respectively. This works out to appealing P/E ratios of 12.2 and 11.5 times. CIBC’s earnings are now expected to slip to $10.10 a share, then rebound to $10.43 a share. This bank, too, has fine P/E ratios of 11 and 10.6 times. Royal’s earnings are now expected to advance to $7.11 and $7.44 a share. This gives the shares improving P/E ratios of 13.2 and 12.7 times. TD is now expected to earn a better $5.11 and $5.95 a share. This also gives it improving P/E ratios of 13.1 and 12.3 times.

The big five banks’ forward P/E ratios are significantly below the Canadian stock market’s average forward P/E ratio. Low P/E ratios give you what Benjamin Graham (the father of fundamental security analysis) called a ‘margin of safety’. Low P/Es expose you to low chances of losing a lot of money.

Why argue with success?

A critic might sniff that the banks have always paid generous and growing dividends, plus trade at attractively-low P/E ratios, Our view is that as long as this is the case, the big five banks should remain cornerstones of your portfolio. Why argue with success?

The consensus recommendation of four analysts is that BMO, Scotiabank and CIBC are ‘holds’. The consensus recommendation of five analysts is that Royal and TD are ‘buys’. But each bank outperforms the others from time to time. So rather than trying to guess this year’s winner, hold them all as a package.

Year over year is best comparison

When you examine the banks, it’s best to compare their year-over-year results. Otherwise, you may draw erroneous conclusions.

A few years ago, one observer fretted that the bank’s second-quarter earnings had fallen from their first-quarter earnings. What he failed to grasp is that the first quarter is usually three days longer than the second quarter.

The first quarter of the banks’ fiscal years (November, December and January) lasts 92 days. The second quarter (February, March and April) lasts 89 days, except for leap years. The banks are highly profitable. So even just three extra days can make the first-quarter’s results much better. Compare the banks’ first fiscal quarter results with those of the year before. In both cases, the results are for 92 days.

 

This is an edited version of an article that was originally published for subscribers in the January 27, 2017, issue of The Investment Reporter. You can profit from the award-winning advice subscribers receive regularly in The Investment Reporter.

The Investment Reporter, MPL Communications Inc.
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