Skip to main content

In 2015, Scotiabank’s stock fell 15.6 per cent and lagged behind all of its big bank peers, which means it should outperform the index this year if history holds true.Darren Calabrese/The Globe and Mail

The best Canadian bank stock for 2016 is Bank of Nova Scotia.

That's a bold statement, and what makes it even bolder is that it has nothing to do with the bank's focus on the Pacific Alliance countries of Mexico, Colombia, Chile and Peru, where Scotiabank distinguishes itself from its Big Five peers.

Nor does it have anything to do with the bank's recent expansion into credit cards, its expected profit growth or the views of analysts and fund managers.

Instead, Scotiabank gets this stamp of approval because its stock was a dud in 2015. It fell 15.6 per cent and lagged all of its big bank peers, which is good news for 2016: Buying last year's underperforming bank stock, and holding it for a year, is a remarkably simple and effective stock-picking strategy.

Employing this strategy since the start of 2000 – a reasonably lengthy 16-year period that gets us through the tech crash, a bull market, the financial crisis and the recovery – would give you an average annual return of about 16 per cent, not including dividends.

That's considerably higher than the average return for the banking sector over the same period: The S&P/TSX composite commercial banks index delivered an average gain of 10 per cent a year, which lags the stock-picking strategy by six percentage points per year. And it wallops the mere 4-per-cent average gain for the broader, commodity-laden S&P/TSX composite index.

Why does this strategy work? Although the big banks are pursuing different growth strategies, particularly in international markets, they still get most of their profits from their home base in Canada. Similar operating conditions and an identical economic backdrop suggest that an underperforming bank stock shouldn't diverge from the pack for long. Bank stocks tend to revert to the mean.

As well, dividends provide support: An underperforming bank stock's dividend yield will start looking very appealing relative to a stock that is on a tear – which is an approach to stock-picking that underpins the popular Dogs of the Dow strategy.

Admittedly, buying the year's worst bank stock didn't work in 2015. Scotiabank was the laggard in 2014, and it ended 2015 as a laggard for the second successive year. Oops.

But over the longer term, the numbers are compelling. Since 2000, buying the worst-performing bank stock beat the bank index 11 out of 16 years, for a success rate of more than 68 per cent. The strategy has not misfired for two consecutive years, making 2016 look like a winner. And on six occasions, last year's laggard emerged as the top-performing bank stock in the next year, beating the index by an average of 17 percentage points a year.

Another benefit to this strategy: During the financial crisis, it saved you from some of the most severe declines, suggesting that it can provide a smoother ride when turbulence picks up.

In 2008, Canadian Imperial Bank of Commerce – a "buy" after it lagged peers in the previous year – fell 28 per cent. Sure, that's a big dip. But it was less severe than the 34-per-cent decline for the index and far less harsh than the sharp 45-per-cent decline for Bank of Montreal. (BMO, a "buy" in 2008, was the top performer in 2009 with a 79-per-cent rebound.)

Of course, there are easier ways to buy bank stocks. You can buy a favourite and hold on through thick and thin, saving you transaction costs. You can also take a diversified approach through an exchange-traded fund that holds all of the banks. As a reporter who covers the banking sector, I am prohibited from owning individual bank stocks, so I've taken this ETF route.

But stock-picking certainly looks compelling for anyone who aims for better-than-average returns.

In the case of Scotiabank, its decline in 2015 was more than double the decline for the commercial banks index and 13 percentage points worse than the leader, Toronto-Dominion Bank, leaving a sizable gap to close in 2016. Also, Scotiabank's dividend yield is now a robust 4.8 per cent, versus just 3.7 per cent for TD.

That's hard to pass up.

Follow related authors and topics

Authors and topics you follow will be added to your personal news feed in Following.

Interact with The Globe