The ongoing credit crisis has unearthed some rare gems for investors, but whether some of these gems turn out to be fools gold remains to be seen. It is no surprise that one of these opportunities has appeared in the Canadian banking sector, as these stocks lie near the heart of the ABCP fall out and the credit crisis mess. BMO's share price has nearly been chopped in half since around this time last year. Due to this massacre in share price, BMO's yield has crept up to a staggering 7.2%. This yield level is absolutely unprecedented for a Canadian bank. You could buy BMO shares today and receive 7.2% annually back on your investment even if the stock flat lined for years. Combine this with the favourable tax treatment of dividends for Canadian residents and many would be satisfied with that investment return. Of course this is assuming they don't cut their dividend. That unfortunately is the $700 million dollar question. If BMO did happen to cut their dividend in half, they could instantly have about $700 million extra to work with annually. Whether the bank feels they would need this capital to compensate for write-offs or investment losses remains to be seen. There are also several other factors at play including the eventual true value of written down assets, as well as the banks reputation, culture, and dividend policy.
Several months ago BMO was being used as an example of a stock that one could buy by employing some leverage in a Smith Manoevre type strategy by using a home equity line of credit (HELOC) to essentially make mortgage interest tax deductible. People saw BMO shares as a prime candidate for this type strategy given their high, stable yield, and dividend growth history. At this time BMO was yielding around 4 - 4.5%. It is interesting to look back at this now. Are all of the pieces of the puzzle still in place for BMO as a candidate for leveraged investing? The yield is certainly high, there is no arguing that, but I'm not sure how stable it is, and I don't have the utmost confidence in their ability to grow dividends from the current level in the short to mid term. This just goes to show how quickly and dramatically change can occur in markets and thus stocks. If BMO cuts their dividend dramatically you would have to say this is a worst case scenario for those who bought it last year in leveraged accounts. Not only do you lose precious income that would have gone to interest expense but the value of your investment will have roughly coincided with the dividend drop. For those who factored many possible negative scenarios into their strategy in the planning phase, and assuming they've diversified appropriately they will likely still stand a good chance of mid to long term success using this strategy.
So should we buy BMO now? Should it be bought now that the yield is 7.2% and maximum negativity in the name seems to be close at hand? I would argue, like many others have, that the yield is a bright red flag indicating a warning of a dividend cut. If a high dividend yield is the only thing attracting me to the stock, then I don't want it in my portfolio. BMO's recent performance and short term outlook are murky at best, and I don't really think the bank has much going for it when compared to their Canadian competitors. Currently there is no shortage of attractively valued Canadian banks with reasonable pay out ratios, strong recent performance, good management, and solid balance sheets. A yield over 4% in BNS, RY, and TD is nothing to sneeze at when you consider some of their other fundamentals, outlook, and market position. All three also look reasonably valued using earnings growth models.
Although some would say that the most successful long term strategy has been to just close your eyes and buy the current worst performing Canadian bank. You can judge this buy simply buying the one with the highest dividend yield. For me, this just doesn't feel right....I'd rather keep my eyes open...