Canadian Banks: Don’t Invest for Yield Alone

Canadian bank stocks have become extremely tempting with dividend yields at levels that I cant remember. Bank of Montreal had a yield of over 11% yesterday while other banks are yielding in the 7% – 8.5% range.

On the surface, those looking for yield will choose Bank of Montreal. The next question one should ask after looking solely at yield is how safe the dividend is in the future.

Rob Sedran, Bank Analyst at National Bank Financial, discussed the outlook of the Canadian banks on a conference call today. He believes that the dividends are safe for now on all of the banks without any guarantees.

That being said, the dividend payout ratio should be looked at closely to determine how safe a particular companies dividend may be. We can just look at income trusts and how distributions get cut when cash flow or net earnings drop.

Bank of Montreal’s dividend is the highest but their payout ratio is also the highest as 75% of their net earnings right now go to pay dividends on their common shares. This leaves 25% of earnings to grow the business which is not a great use of capital in the long-term.

The other major banks have payout ratios in the 40% – 59% range of forecasted 2009 earnings giving them a greater cushion to maintain their dividend that will allow them to increase their dividends quicker when things turnaround.

What are your thoughts on the Canadian banks? Will they cut their common share dividends or will they maintain them going forward?

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A Repeat of Two Weeks Ago

A couple of weeks ago, I wrote a post “It’s Different This Time But it’s Also the Same”. The Canadian market is down 7% and the Dow is down 6% with under 10 minutes left in the trading day. The markets were jittery from the outset as some participants didnt believe the financial bailout would come to fruition.

We can panic and sell as account values shrink with each day. However, looking at individual securities, there are many companies that will carry on who have limited debt, excellent cash flow, but are down tremendously with this month’s losses. 

Canadian Natural Resources is down 16% today. Suncor is down 11%. CIBC is down 7% while some Real Estate Investment Trusts are down 10% in one day. Are these numbers justified? One could argue that it is as oil prices dropped $10 today. However, these oil companies had their estimates based on $90 oil, less than where it is right now.

When this will end, no one knows, but I do know that the valuations get more compelling by the minute. For more information on our company, you can visit us at http://www.rothenberg.ca

Your comments are greatly appreciated.

Market Update – August 27, 2008

The S&P/TSX composite traded higher today, up 231.58 points at 13,530.65, as oil prices continued to rise on worries that Tropical Storm Gustav may disrupt oil and gas operations in the Gulf of Mexico while CIBC reported a huge drop in profit from a year ago.

 

CIBC reported that net income fell to $71 million for the third quarter, down from $835 million for the same period last year as the bank was hit with more losses connected with the American housing sector. Diluted earnings per share were 11 cents, down from $2.31 a year ago. In other news, Scotiabank says it will pay US$15 million for 33 percent of a new mutual fund company in China that will be formed with the Bank of Beijing.

 

U.S. stocks on Wednesday stepped higher as investors found reason for economic hope in a July rise in orders for U.S. durable goods, with a spike in the price of crude viewed as temporary in light of storm conditions in the Gulf of Mexico. The Dow Jones Industrial Average was climbing 107 points to 11,520, while the S&P 500 was gaining 12 points to 1283. The Nasdaq rose 30 points to 2392.

 

General Motors plans to reduce its vehicle output in Spain to account for flagging demand, Reuters reported. GM will shutter its Figuerelas auto plant for two days in September and four days in October, lowering production by 12,000 vehicles. ConocoPhillips plans to exit the gas station business, selling off the last of its 600 stations to PetroSun West for $800 million, The Wall Street Journal reported. The deal is part of a growing trend among oil companies, which are exiting the business to concentrate on energy exploration. The firm’s Conoco, 76 and Phillips 66 stations will retain their branding.

 

TiVo, the company that whose little black box allows users to watch what they want when they want, is now letting its customers sample other people’s tastes, namely those of the staff at Entertainment Weekly. The company is entering a deal with the magazine, which is owned by Time Warner, which will allow users to configure their TiVo devices to automatically record programs recommended by EW, The Wall Street Journal reported.

 

On the data front, Statscan reported Wednesday that the average weekly earnings of employees were $789.23 in June, up a moderate 0.1 percent from May and 2.5 percent from a year ago. Down south, orders for big-ticket manufactured goods jumped for a second straight month, the government reported Wednesday. Orders rose 1.3 percent in July, easily outpacing the 0.1 percent gain economists were expecting, on average. The rise was in line with the upwardly revised 1.3 percent increase reported in June. Separately, the Federal Housing Administration said it would increase the price of its insurance of mortgages to 1.75 percent of the loan amount from 1.5 percent. The new rate takes effect on Oct. 1. And early Wednesday, the Mortgage Bankers Association reported a week-over-week rise of 0.5 percent in mortgage applications for the week ending Aug. 22.

 

The Canadian dollar, meanwhile, was trading up 0.19 cent at 95.57 cents US. Crude oil settled up $1.88 at $118.15 US a barrel after the Energy Department said that stockpiles of unused crude fell by 100,000 barrels and gasoline stockpiles fell by 1.2 million barrels last week.

All I want is 10% Guaranteed!!!

With the markets as volatile as ever, it can be difficult to stomach the ups and downs as you try and have  a portfolio generate enough income or growth to last a lifetime. I know of many clients who talk about the days when they could get 19% on Canada Savings Bonds, 20% or more on Term Deposits, and those lucky few who annuitized and locked in 16% for life.

Of course inflation was running rampant in double digits and with higher tax rates, you were lucky to break even. Over the last year, while the Fed and the Bank of Canada have lowered rates to stimulate the economy and try and avoid recession, rates on corporate debt and preferred shares have gone up significantly. The spreads between bank debt and government debt are the widest they have been in over 20 years.

You could argue that Canadian banks are going to collapse so the risk of investing in a bank guaranteed bond or preferred share is too high. Looking at things objectively, the likelihood of one of our banks going bankrupt and the common share price going to zero are remote.

If you are on the same page as me and believe that a bank failure in Canada is not likely, there is an interesting opportuntiy that awaits. Preferred shares issued by corporations in Canada are eligible for something called the dividend tax credit. Because Canadian corporations have already paid tax on their earnings, the dividends that flow through to individual investors are subject to a reduced level of tax.

As I look at my stock screen today, I see that CIBC and Laurentian Bank have perpetual Preferred shares currently yielding approximately 7.25% per annum with the dividends paid quarterly. So, how do I come up with 10% when they are paying 7.25%. Interest earned on GIC’s is fully taxable. The preferrential tax treatment on dividends and preferred shares equates to just under 10% for a Canadian in the highest marginal tax bracket on an interest equivalent basis.

Some would argue that there are further write downs to come and that interest rates in Canada are going to rise since inflation is going up. I would agree that government bond rates will probably rise over the next 12 months. Nobody knows how much, but, I would argue that while government rates go up, the spread between government and corporate bonds could fall which means that you wont be able to get 8%, 9% or 10% on these preferred shares next year and that this deal will look like the annuity that we should have locked in at 16% for the rest of our lives.

What are your thoughts on interest rates and corporate debt? Your opinions are more than welcome.