Why I love down-on-their-luck bank stocks

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All Canadian bank stocks are moving up, but Canadian Western Bank stands out: Its share price is surging, and its spectacular gains in recent months offer another example of why underperforming bank stocks can make ideal investments.

Consider these numbers: Since May, when Canada's banking sector was in the doldrums, the S&P/TSX composite commercial banks index has rebounded 13 per cent as investors applauded stronger economic growth, two Bank of Canada rate hikes and easing concerns about the country's housing market.

But Canadian Western Bank has bounced 44 per cent over the same period, three times the gain of the banks index and more than double the gain for the best-performing of the Big Five, Bank of Nova Scotia.

CWB's recent outperformance follows a difficult few years for the Edmonton-based lender. The stock's six-month gain really only closes a wide performance gap with other banks. But the closing of this gap highlights an important investing strategy for bank-loving investors: Down-on-their-luck bank stocks are bargains.

I've made this point before, but only in regard to the biggest five banks: Buying last year's worst performer tends to be a good investment strategy, because big banks have an uncanny ability to catch up with their peers.

Turns out, smaller banks can do the same thing.

In the case of CWB, the source of its problems was oil – or, more specifically, the impact falling crude-oil prices had on the oil-dependent Alberta economy.

From June, 2014, to February, 2016, the price of crude oil fell 75 per cent. CWB's share price fell 54 per cent over a similar period, amid worries about its loans to businesses and individuals in Alberta. Other banks also struggled during this time, but their greater diversification tended to protect them from bigger slides.

Short-sellers, who profit when share prices decline, jumped all over CWB, betting that the bank would suffer bigger problems ahead as loan losses bolted higher. As recently as September, more than 30 per cent of its shares were sold short. While this figure is down to about 20 per cent, CWB remains the third most-shorted Canadian stock.

How has CWB managed to rebound so impressively?

Recovering oil prices have certainly helped. Investors likely imagined all kinds of horrific scenarios when West Texas intermediate oil fell to 13-year lows in early 2016. CWB's decision in June of that year to offer new shares after the stock price had tumbled only underscored the apparent financial threat.

But oil prices have been rising, trading above $50 (U.S.) a barrel for most of the past five weeks, easing concerns about loan losses and helping Alberta's economy. Now, economists predict last year's economic contraction – the province's worst in 50 years – will morph into Canada's strongest economic growth, driven by the energy sector.

But CWB has also been diversifying beyond Alberta and observers are upbeat about these efforts. Earlier this week, after CWB agreed to buy the Canadian commercial-and-vendor finance loans and leases of ECN Capital Corp., a portfolio that stretches across the country, analysts were supportive.

"We view the acquisition positively as it is in line with CWB's existing strategy to improve geographic diversification, improves the scale of CWB's existing equipment finance businesses, and is immediately accretive to earnings," Darko Mihelic, an analyst at RBC Dominion Securities Inc., said in a note.

So where does the stock go from here? Clearly, the deep discount relative to other Canadian banks has been closed. CWB shares trade at 14 times analysts' estimated per-share profit, according to Bloomberg. That's higher than most other banks. Royal Bank of Canada, for example, trades at a lower 13.4 times estimated profit and RBC pays a considerable larger dividend, too.

This full valuation could weigh on CWB's rally as the year winds down.

But the bigger takeaway is the broader trend: When a Canadian bank stock is trailing its peers, investors should push aside the market's concerns and accept the underperformance as a gift.