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Inside the Market For bargain hunters, these two small Canadian banks offer big potential

Laurentian Bank of Canada is down 28 per cent in 2018

Christinne Muschi/Reuters

Some of Canada’s smaller banks are having a terrible year, but there is a bullish case for these stocks that rests on cheap valuations, attractive dividends and a history of recovering from sell-offs.

Brace yourself though: Laurentian Bank of Canada is down 28 per cent in 2018 and Canadian Western Bank is down 30 per cent, opening a horrendous performance chasm with the Big Six – which are also struggling this year – that is now 22 percentage points wide, on average.

The banks’ fiscal fourth-quarter results this week may provide some hints about whether these two banks can close the performance gap.

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On Wednesday morning, Laurentian will report its results for the three-month period ended Oct. 31; Canadian Western Bank will follow on Thursday, concluding the reporting season for the banking sector.

Admittedly, most analysts are cautious, arguing that there’s little chance the quarterly results will spur a relief rally. Their lukewarm “hold” recommendations outnumber “buy” recommendations by a ratio of about two-to-one. And they’ve been trimming their target prices, or where they believe the shares will trade in 12 months.

But the low bar in expectations implies that the downside is limited for bargain-hunting investors who are willing to wait for better days ahead.

Given previous rebounds, the payoff can be big if you get the timing right: Canadian Western Bank rose 104 per cent between February, 2016, and January, 2018, outgunning the Big Six as the prior collapse in energy prices eased. Laurentian Bank rose 42 per cent over a similar period and now offers a 6.3-per-cent dividend yield as a sweetener.

What’s the problem with these banks today?

Investor sentiment toward Edmonton-based Canadian Western Bank is being weighed down by the economy in Alberta, where an oil glut kept oil prices pinned down at multiyear lows last month. On top of this, the bank is struggling with weak deposit growth – a nasty headwind given that deposits fuel lending activities.

Analysts expect the bank will report a quarterly profit of 78 cents a share, after adjustments, up 5 per cent over last year.

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Montreal-based Laurentian, which largely operates mostly in Quebec, is suffering from a shrinking loan book, declining efficiencies and continuing labour strife as it attempts to streamline its branch network and recover from the discovery a year ago that some of its mortgages had been underwritten with false income statements.

Rather than becoming leaner and meaner, the bank’s efficiency ratio (which compares expenses with revenues) went in the wrong direction last quarter, rising to 66.4 per cent from a recent low of 64.3 per cent in the fourth quarter of 2017 (a higher ratio is bad). Short-sellers have been particularly enthusiastic about betting against this stock.

Analysts expect the bank will report a fourth-quarter profit of $1.27 a share, after adjustments, down 20 per cent from last year.

If weak or declining quarterly profits leave you cold, fair enough. But the case for Laurentian and Canadian Western Bank rests on the idea that neither bank is broken: The stocks are simply more volatile than the bigger banks, and look particularly attractive when they are underperforming.

The way out of their difficulties isn’t overly complex.

Canadian Western Bank has been diversifying its lending activities outside of Alberta. It now has a strong base of operations in Ontario, which accounted for 21 per cent of its loan portfolio in the fiscal third quarter. And giving up on the Alberta economy seems silly, given the political will to ease the oil glut with additional rail capacity and production cuts.

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As for Laurentian, a lot of the bank’s problems are related to its attempt to merge physical branches as more consumers pay bills online. It’s a messy process, partly because 37 per cent of the bank’s work force is unionized and have been without a contract since the end of 2017.

It’s not easy to call a bottom on this one – but Laurentian’s commercial loan book is growing and any sign of a stabilizing mortgage book will surely be greeted as a bullish sign. In the meantime, the shares trade at just 7.3 times estimated earnings, according to Bloomberg. That’s a significantly cheaper valuation than the Big Six, and implies that there’s a lot of upside here when things start to go right.

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