Canadian banks have delivered great returns for investors, and anyone who wants to invest in the sector can easily buy an exchange-traded fund that tracks all five of the big lenders. But is there an even smarter way to invest in Canada's leading oligopoly – a way to squeeze not just the average return from the sector, but to focus on the one or two bank stocks most likely to perform best over the year ahead?
In fact, there is. And the best part: If history is any guide, you don't have to be that clever to find these exceptional performers. Yet they can add an impressive dollop of profit to your portfolio.
The numbers are eye-catching: If you had owned all of the Big Five banks over the past five years, in equal dollar amounts, you would have gained an impressive 80 per cent including dividends. But your results would have been even better if you had chosen the best single performer over that entire period–Toronto-Dominion Bank, which delivered a return of 98 per cent. And you would have fared better still by picking the best-performing bank in each of the five years. A perfect stock-picker would have achieved a return of more than 120 per cent, or 40 percentage points better than the average.
Okay, perfect is a tough goal. But achieving pretty good isn't so difficult. We looked at three easy ways to size up the big banks and were surprised to discover that the simplest approach worked best. Equally surprising: what didn't work.
Buying the bank with the biggest dividend yield at the start of January, and holding it until the end of the year, looks like a tempting strategy. Theory says you should collect a bigger quarterly payout while benefiting from the strong probability that the share price will rise to reflect the lush dividend.
Sadly, though, this approach only works in theory. In each of the past five years (including 2015 so far), the highest-yielding bank stock usually went on to underperform the average big bank over the course of the year. You would have been better off with that sector exchange-traded fund.
A strategy based on cheap valuations also disappointed. The bank stock with the lowest price-to-earnings ratio–that is, the lowest share price relative to its 12-month trailing earnings–underperformed the average bank in three of the past five years. Again, you were better off with an ETF.
So what worked? Simply buying the bank stock that had been the worst performer in the previous year gave you a very good chance of delivering better-than-average gains in the next year. Indeed, this approach worked in four of the past five years. If the pattern holds up, last year's laggard, Bank of Nova Scotia, has a good chance of outperforming in 2015.
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