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It's been said that the trick to making money on Canadian bank stocks is simple: Buy the worst-performing bank and wait for it to rebound.

We'll put this theory to the test with the help of CPMS, an equity research and portfolio analysis firm owned by Morningstar Canada. Today, we'll examine bank stock returns over the past year. Tomorrow we'll look at 10-year performance to see how the strategy stands up.

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Banks made a comeback

Even with the credit crisis, it was hard to go wrong with bank stocks in the past year. Three of the Big Five - Bank of Montreal, Canadian Imperial Bank of Commerce and Royal Bank of Canada - delivered double-digit returns (including dividends) for the 12 months ended July 31, lifted by the powerful rally this spring and summer. The only bank stock with a negative total return over the past year was Bank of Nova Scotia.

Investors could have improved their returns dramatically with some well-timed buying and selling.

Buying the worst was best

Buying the most beaten-up bank was indeed a good strategy.

An investor who selected the bank with the worst trailing 12-month price change on July 31, 2008 (namely CIBC), and repeated the exercise every quarter thereafter (selling their existing stock and then buying the worst performer, which at various times was CIBC, TD, BNS), would have made a hefty 27.6-per-cent return as of July 31, 2009. That compares with a return of 8.7 per cent for an equal-weighted portfolio of the Big Five.

High yield = high returns

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Similarly, buying the bank with the highest dividend yield at July 31 and every three months thereafter - and simultaneously selling the existing stock - was also a profitable strategy. That's not surprising, given that a high yield is often a symptom of a lagging share price. According to CPMS, the highest-dividend-yield strategy delivered a total return of 18.6 per cent. One bank - BMO - had the highest yield for most of the past year, but CIBC briefly held the honour.

An investor's actual return would have been slightly smaller in both of the above scenarios, after taking into account trading commissions.

Don't chase winners

The worst strategy? Buying the bank with the best trailing 12-month price change. Just as stocks that have lagged tend to rebound relative to the group, those that have outperformed often run out of gas.

The comedown for the top performers was dramatic. If you had purchased the best-performing bank (based on 12-year trailing returns) every quarter over the past year, you would have lost 23.3 per cent. "There tends to be a reversion to the mean," said Jamie Hynes, senior account manager with CPMS.

The lesson for investors? "It speaks to not chasing performance," he said.

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About the Author
Investment Reporter and Columnist

John Heinzl has been writing about business and investing since 1990. A native of Hamilton, he earned a master's degree from the University of Western Ontario's Graduate School of Journalism and completed the Canadian Securities Course with honours. More

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