Looking for a bank stock? Pick a loser

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There is a new contrarian strategy for investors who want to swing for the fences when it comes to the Big Six Canadian banks.

Forget about buying shares of the best bank. At the end of every year, invest in the one with the shares that have had the worst performance over the previous 12 months.

It's a simple approach that has earned investors surprisingly large returns over time, according to a note to clients by UBS bank analyst Peter Rozenberg.

Mr. Rozenberg has calculated that a portfolio made up solely of the worst bank stock held for a year, then replaced the following year with the newest laggard, would have chalked up impressive gains of 18.9 per cent a year over the past decade, compared with only 10.3 per cent for the six banks as a group.

The difference is huge when the magic of compounding over long periods is expressed in dollars. A $10,000 portfolio invested in the annual bank dogs would have risen to $56,500 over the past 10 years including dividends and capital gains, compared with only $26,700 for banks as a group. (The figures don't include transaction costs.)

As far as mindlessly simple investment formulas go, this is a new one when it comes to Canadian banks, although it does mirror the so-called Dogs of the Dow strategy, an approach that involves purchasing the 10 stocks in the Dow Jones industrial average with the highest dividend yields each year.

Mr. Rozenberg says buying the bank laggard works because investors tend to be too harsh in punishing share prices when institutions report earnings disappointments, large credit losses, or other problems. The beaten-down stocks then become compelling purchases for contrarian investors.

"Stocks that are underperforming tend to be cheap and so buying things that are cheap is a good strategy. It's really that simple," he said in an interview.

The strategy has outperformed the bank index in seven of the last 10 years. Last year was a case in point. CIBC had the smallest gain among the big banks in 2009, but this year it's up the most, according to the UBS note. It rose 23.3 per cent up to the end of October, compared with 12.8 per cent for the bank index.

In 2009, the biggest gainer, with a 90.9-per-cent rally, was Bank of Montreal which happened to be the laggard from the previous year.

Investors wanting to apply the formula next year should be looking to pile into shares of Royal Bank which have fallen 2 per cent in the year to date following weaker-than-expected trading profits.

UBS likes the bank and says it has more going for it than just the contrary indicator of performing poorly this year. It has a long term record of better-than-average growth and return on equity.

"We think [RBC]could be the best performer in 2011 as higher organic growth continues, trading revenues normalize, and capital is increasingly deployed," Mr. Rozenberg wrote.

Mr. Rozenberg says one reason the laggard strategy is successful in the Canadian market is because all six of the major banks are highly solvent. When one experiences a setback, the problem tends to be temporary and the share price usually recover quickly.

But buying laggards doesn't always produce big profits. For instance, the same approach wouldn't have worked in the U.S. because weak bank stocks there are often on their way to collapse.

Another approach that doesn't involve trading in and out of Canadian banks, and still offers superior returns, would be to buy those with good long-term growth records, according to Mr. Rozenberg.

Scotiabank exemplifies this approach. It has surged an average of 14 per cent a year for the past decade, well above the index.

* to Oct. 31