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Two Canadian bank stock buying strategies that have produced amazing returns

Staying loyal to one Canadian bank stock has its advantages. So does owning them all. But if you want to get the most out of an investment in this sector, try buying a fresh bank stock each year.

Which one? That depends upon which of two stock-picking strategies you employ. But number crunching for both strategies, going back to 2000, points to market-beating annualized returns of 20 per cent or more.

Not bad for something that is dead simple to employ. And if the strategies work in 2018 – and there is a good chance they will – then Canadian Imperial Bank of Commerce or Bank of Montreal should be on your radar today.

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But before discussing these picks in greater detail, let's look at the underpinning strategies that are producing them as top prospects.

The first strategy, discussed in these pages frequently over the past couple of years, selects last year's worst-performing stock among the Big Five banks and holds it for one year.

Using 18 years of data, this strategy has delivered an average gain of 17 per cent a year (not including dividends) versus an average gain of 5 per cent for the S&P/TSX Composite Index and 11 per cent for the S&P/TSX Commercial Banks Index (a decent proxy for the Big Five). Add dividends to this strategy, and you're looking at an average total return of more than 20 per cent a year.

In other words, you're not just beating the benchmark index; you're beating other banks.

The laggard strategy

YearPick: Worst performer in previous yearPick's performance in current year
2000BMO (1999)59%
2001TD (2000)-5%
2002BMO (2001)16%
2003CIBC (2002)47%
2004RBC (2003)4%
2005RBC (2004)41%
2006CIBC (2005)29%
2007BMO (2006)-18%
2008CIBC (2007)-28%
2009BMO (2008)79%
2010CIBC (2009)15%
2011RBC (2010)-1%
2012BNS (2011)13%
2013CIBC (2012)13%
2014CIBC (2013)10%
2015BNS (2014)-13%
2016BNS (2015)34%
2017CIBC (2016)12%
2018BMO (2017)TBD

Source: Bloomberg and author's calculations

It's not foolproof, but it works more than 75 per cent of the time, including a seven-year winning streak between 2008 and 2014. Nearly 40 per cent of the time, the previous year's laggard turned out to be the current year's top performing bank stock.

Dismiss the strategy as data-mining if you want. But there is a compelling reason supporting the pattern: Banks are very good at closing the competitive gap with their peers, lifting the outlook for an out-of-favour stock relatively quickly.

BMO is the top pick for 2018 under this strategy. It lagged its peers in 2017, gaining just 4 per cent compared with a gain of 11 per cent for the bank index.

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The bank has a couple of other things going for it this year, though. Expectations are low as the bank gets ready to report its fiscal first quarter financial results later this month, suggesting that the share price could rise if BMO exceeds expectations. RBC Dominion Securities estimates that BMO will report an operating profit of $2.02 a share, down 3 per cent from last year.

At the same time, BMO should benefit more than its peers from U.S. tax reforms. According to the bank's estimates, it should save about US$100-million in tax savings per year, boosting profit on a per-share basis by 2 to 2.5 per cent in 2018.

The second strategy for selecting outperforming bank stocks is also simple, and effective. It involves picking the stock with the highest indicated annual dividend yield in the fiscal fourth quarter of a given year, and holding the stock for a year.

For numbers going back to 2000, this strategy delivered a return of 20 per cent a year, after including dividends, outperforming the S&P/TSX Composite Index and the bank index.

The yield strategy

YearBiggest DividendTotal return

Source: Bloomberg and author's calculations

At the end of 2017, CIBC's indicated yield was 4.6 per cent, the only Big Five bank with a yield above 4 per cent at the time, making the bank the clear stock pick for 2018.

What's underpinning this strategy? Banks don't cut their dividends, so higher yields are rarely a sign of danger. A higher yield also suggests that a bank stock may be undervalued next to lower-yielding peers.

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But this dividend approach to stock-picking has a few notable flaws. For one, BMO and CIBC have been the top yielding bank stocks for 16 of the past 19 years, meaning that investors are usually jumping from one to the other, while ignoring the other banks. It's hard to argue with the results, but it doesn't look like a strategy that draws from the entire family of big bank stocks.

Another flaw: While the average return is strong, the strategy often misfires. The success rate at beating the bank index stands at just over 60 per cent – good, but not great.

And finally, the average annual gain of 20 per cent lags the first strategy – picking the previous year's laggard – by a bit after dividends are included. Add dividends to a 17 per cent average annual return for the laggards, and you're at 21 per cent.

This is by no means a deal breaker, though. Indeed, both investing strategies are compelling, and we will continue to track them.

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