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The background

Yesterday we examined the performance of Canadian bank stocks over the past year. Even with the credit crisis, all but one of the Big Five delivered a positive total return including dividends, and three posted double-digit returns.

But investors could have enjoyed superior returns by buying the bank with the worst trailing 12-month performance, and repeating the exercise every three months. That's because banks that lagged the pack tended to rebound.

Similarly, buying the bank with the highest dividend yield every quarter also generated outsized gains. That's not surprising, given that a high dividend yield is often a sign of a sagging share price. The worst strategy over the past year was buying the bank with the highest trailing 12-month return.

What are we looking for?

Today we'll see how well these and other strategies fared over a longer period. We'll turn once again to CPMS, an equity research and portfolio analysis firm owned by Morningstar Canada. CPMS back-tested 10 years of data to determine what attributes predicted strong stock price performance.

What we found

The data are consistent with the one-year results in that the most beaten-up banks tended to perform best going forward.

For example, if you'd bought the bank with the worst trailing 12-month return every quarter over the 10-year period (while selling your existing stock, assuming it no longer had the worst 12-month record), you would have made an annualized return of 12.3 per cent, including dividends. That's nearly double the 6.5-per-cent annualized return of the S&P/TSX composite index.

Buying the bank stock with the highest dividend yield would have worked even better, generating a total return of 15.9 per cent. And focusing on stocks with the lowest price-to-book and price-to-earnings ratios would have generated returns of more than 16 per cent.

Of course, trading commissions from all that buying and selling would have eaten into your returns.

The conclusion

But the lesson is clear: If you buy the top-performing bank stock, you could end up grumpier than one of those guys in the TD ads. In fact, by buying the bank with the highest trailing 12-month price change every quarter, you would have made just 5.8 per cent annually. "If nothing else, don't chase the one that's done the best over the last little while. That by far was the worst factor out of all the ones we saw here," said Jamie Hynes, senior account manager with CPMS. "The big caveat would be that this is obviously past performance and there are no guarantees, but this has been the trend."

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