Darko Mihelic says success in analyzing bank stocks over the past three years has had more to do with the banks you didn’t pick than the ones you did.
“Frankly, the past three years have been about financial crisis,” says the Cormark Securities analyst, who sits atop StarMine Corp.’s rankings of Canadian commercial-bank analysts in terms of outperformance of his stock picks for the past 12-month and 24-month periods, and ranks second for the past 36 months. “A lot of my success has been simply avoiding stocks with potential earnings downside.”
Data compiled by StarMine, a stock market analytics service owned by Thomson Reuters, show that the bank stocks that Mr. Mihelic has recommended have generated excess returns of 9.8 per cent above the overall Canadian commercial banking sector over the past 12 months, and excess returns of 13.8 per cent over the past 24 months. Over 36 months, his excess returns are 9.9 per cent, second only to Jason Bilodeau of TD Newcrest (10.4 per cent).
But Mr. Mihelic says his years as a sell-side analyst have made him humble about his successes.
“My style may have worked for the last three years, but we’ll see about the next three,” he says. “The next three years will be more about identifying the stocks with the best earnings growth potential.”
StarMine’s formula for measuring excess returns uses each analyst’s stock recommendations to mimic a “long-short” investing strategy – emulating the effect of going long on stocks the analyst rates as “buy” and selling short the stocks he or she rates “sell”. The analyst not only gets credit for returns that exceed the industry-wide benchmark for all “buy”-rated stocks, but also gets credit for “sell”-rated stock returns that underperform the benchmark. (Stocks rated “strong buy” or “strong sell” are awarded double credit.) Ratings of “hold” or “neutral” receive no score under this system.
Tim Gaumer, director of fundamental research at Thomson Reuters, says there was more to Mr. Mihelic’s outperformance over the past few years than merely staying out of the way of falling stocks.
“He not only made good picks, but his timing was good,” he says.
He points to Mr. Mihelic’s call on National Bank of Canada as an example. StarMine’s data show that over the past two years, the stock rose 28 per cent during periods when Mr. Mihelic rated it a “buy”, compared with gains of just 4 per cent in periods when he rated it “hold” or “sell”. Over the past year, Toronto-Dominion Bank was up 10 per cent when the analyst rated the stock a “buy”, but was down 5 per cent when he rated it a “sell”.
Earnings Potential and Valuation
StarMine also tracks analysts’ accuracy in earnings forecasts, and while Mr. Mihelic doesn’t top this ranking, he does score well above the median among Canadian banking analysts (he ranked fourth for the past fiscal year). But in terms of his stock recommendations, the analyst says he actually finds it very useful when banks miss their earnings targets.
“There are two things I always try to triangulate. One is the potential for earnings surprises, and the other is valuation,” he says.
He says he looks for stocks where analysts are forced to revise their estimates upward after the bank comes out with a financial report, as that speaks both to shifting market sentiment and potential for positive earnings surprises. He also examines the banks’ businesses for pockets where they might see strong earnings growth.
“I know that sounds very simple. There’s not a lot of magic to it.”
His top pick at the moment is Bank of Montreal , Canada’s fourth-largest bank. He believes the bank has potential for better-than-forecast earnings growth, in part because, as he puts it, “it’s over-capitalized.”
That excess of capital, he believes, could fuel its share value and its per-share bottom line by paying for share buybacks, financing modest-sized acquisitions, and allowing the bank the freedom to increase its lending.
The strong capitalization could also fuel an improvement in the valuation levels the market has traditionally assigned to Bank of Montreal, because it looks less risky and better positioned for earnings growth than in the past.
“There’s a potential for its valuation to improve relative to its peers,” he says.
One factor with the banks that has been gaining a lot of attention lately, but that Mr. Mihelic doesn’t put much stock in, is the prospect for dividend increases. National Bank recently came out ahead of the other Big Six banks with a dividend hike, while the others remain in their post-financial-crisis holding pattern. But Mr. Mihelic doesn’t believe the dividend question should play a significant role in identifying the most attractive stocks in the group.
“I see the dividend phenomenon as a market sentiment that’s likely to be short-lived,” he says, predicting that within the next six months all the Canadian banks will be signalling a return to their normal patterns of regular dividend increases.