Why it’s time for a bank-stock checkup

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Investors love their Canadian banks – and with good reason.

They're massively profitable. They pay growing dividends. They have their fingers in lots of different pies: lending, insurance, investment banking, wealth management. And, in Canada, they enjoy a cozy oligopoly that limits competition.

As I've written before, some investors are so enamoured of the Big Five that they own nothing but bank stocks. As ill-advised as this strategy is from a diversification standpoint, it has worked exceptionally well: Using the BMO S&P/TSX Equal Weight Banks Index ETF (ZEB) as a proxy, Canadian banks have produced an annualized total return – assuming all dividends were reinvested – of 13.3 per cent over the past five years, compared with about 8.4 per cent for the S&P/TSX composite index.

But as the old saying goes, past performance is no guarantee of future results. That caveat is especially relevant now, given the convulsions at alternative mortgage lender Home Capital that triggered a mini sell-off of bank stocks this week amid growing fears that Canada's housing bubble may be about to pop.

Canadian banks are well-capitalized and would survive a sharp downturn in house prices, but they would not escape unscathed. In a report last year, Moody's estimated that – assuming a 25-per-cent decline in the average Canadian home price, and a 35-per-cent drop in the overheated markets of Ontario and British Columbia – losses to the financial system would total more than $17-billion, split roughly evenly between banks and mortgage insurers.

According to Moody's, banks could generate internal capital to recoup such losses "within a few quarters." But it's worth noting that house prices have only zoomed higher since the report was released last June. In the Toronto area, for example, prices leaped more than 30 per cent in the past year, which suggests the correction – if and when it comes – could be even more severe than the scenario Moody's examined.

What's more, just because our banks are likely to survive a housing crash doesn't mean everything will be hunky dory for bank investors. If the last financial crisis is any indication, bank share prices could take a hit, and those dividend increases investors have come to expect could potentially dry up – at least temporarily.

During the credit crunch of 2007-09, the average peak-to-trough decline of the Big Five banks was about 60 per cent. That compares to a drop of about 50 per cent for the S&P/TSX composite index, and a decline of 28 per cent for a portfolio of conservative pipelines and utilities, according to investment adviser Robert Cable in his book Inevitable Wealth.

Not only did the banks fall more than the broad market, but "most banks froze their dividend payments for two to three years. And it took the Bank of Montreal a full five years before it finally was able to increase its common share dividend," said Mr. Cable, president of Waterford Weir. The pipelines and utilities, on the other hand, kept raising their dividends as if nothing had happened.

Thursday's downdraft in bank stocks – triggered by Home Capital's dwindling deposits and decision to seek a $2-billion lifeline at a hefty interest rate – underscored investors' growing unease about the housing market and the potential fallout for banks should the bubble burst.

So how should investors prepare? Well, there is certainly no reason to panic, but it's probably a good time to check your bank exposure. After the runup in bank stocks over the past several years, they may account for a bigger portion of your portfolio than you realize. Also keep in mind that, if you own Canadian mutual funds or exchange-traded funds, you're probably getting a big helping of banks already.

Canada's largest ETF, the iShares S&P/TSX 60 Index ETF (XIU), for instance, has more than 30 per cent of its assets in banks – including its top three holdings, Royal Bank, Toronto-Dominion Bank and Bank of Nova Scotia. A more egregious example is the Vanguard FTSE Canadian High Dividend Yield Index ETF (VDY), which had a 50-per-cent weighting in banks as of March 31.

Renato Anzovino, lead manager of the Heward Canadian Dividend Growth Fund, says investors should aim to have no more than 20 per cent of their equity portfolio in banks. He doesn't expect a doomsday scenario to unfold in the housing market, but "you never know what could happen," he says. Oil prices could plunge, a spike in interest rates could trigger mortgage defaults or the economy could fall into a deep recession – all of which would be bad for the banks.

As wonderful as the banks have been for investors, "you need a properly diversified portfolio. It doesn't make any sense to have your entire life savings in one area," Mr. Anzovino says. "There are a lot of other great companies that people should invest in as well."