Tuesday, March 18, 2008

the last temptation of BMO

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...


Traciatim said...

Why not instead of just closing your eyes and buying the biggest yield you sort them by yield and buy them all? How likely is it that all 5 big banks go under, or all cut their dividends.

So for today it's
BMO 7.05%
CM 5.76%
RY 4.33%
BNS 4.18%
TD 3.65%

So you take your money and split it up to:

30% BMO
25% CM
20% RY
15% BNS
10% TD

So say you take 20K and invest it you now have:

6K @ 7.05% = 423
5K @ 5.76% = 288
4K @ 4.33% = 173
3K @ 4.18% = 125
2K @ 3.65% = 70

For a total of 1079 / 20000 = 5.3% . . .

That's a pretty darn great yield, and you can do the same thing after each yearly earnings come out and the dividends for each year are known. You'd probably do pretty well for yourself over the long haul. Perhaps someone (not me, preferably) should back test that one and see how well a person would do over the last 50 years in rolling 5, 10, 15, 20, and 25 year periods.

MG said...

Probably not a bad way to dollar cost average into the cheaper banks but it would take a lot of money to implement. I'm sure if you back tested it the return would be very good.

Sami said...

Hi Mg

How is BMO fundamentally different than RY or TD? Most Canadian banks have so similar operations and assets.

I think BMO decline is somewhat exaggerated by sheer panic in this market.

MG said...

How is BMO different from TD and RY?
- lower ROE
- weaker canadian retail business
- weaker u.s. business
- higher pay out ratio
- weaker balance sheet
- weaker management
The list goes on, if you actually looked deeper into it.

Traciatim said...

I'm not so sure you would need a ton of funds to implement this. Say for example you did 2400 per year, it would be 720, 600, 480, 360, 240 in to whichever bank. You would open up a ShareOwner Investments account and pay 36 bucks for one trade a year, or 1.5% in transaction costs.

Plus they have free DRIPs on any dividends in the account. Though after a while I wonder if you would really want to be DRIPing or just taking the income.

I think this would probably snowball to a rather large amount over time. Though you'd be at the mercy of what the banks are doing at any given point in time, you'd probably make out better than most.

Do this inside a TFSA, and you even have all the growth/dividends tax free. I wonder if ShareOwner will be offering TFSA accounts.

Canadian Capitalist said...

BMO might sport an unprecedented dividend yield for a Canadian Bank and while a high yield might be a warning sign, it may also signify a great bargain. Example: Spring of 2003, MO (Altria Group) was yielding more than 9% when investors were worried that it could go bankrupt due to an adverse court decision. So, it's all about risk versus reward. Yes, there is risk but if the bet pans out in your favour, there is a commensurate reward as well.

PS: Having said that, I wouldn't bet the farm on BMO. I'm mostly indexed anyways.

MG said...

I agree that a high yield is a good example of risk vs. reward and the market being 'the market'. There is a point though, where the consensus is saying 'cut' as with C and WM. Whether that means the company will cut or not remains to be seen in every individual situation.

BMO could turn out to be the buy of the decade in Canadian large cap stocks.....right now it feels a little risky, but once again with risk comes reward sometimes...

Nurse B, 911 said...

I won't touch it until the management is "torched" as I've said before. But remember that this yield isn't unprecedented - only new to recent memory.

There are two periods in my historical analysis where BMO has yielded around the same: 1990(7.8%) & 1988(7.0%). Both of which were hard times

It will definitely be interesting to see what options they go for when the rest of their stinky poop hits the fan. I'm still standing by my $36/share based on historically low P/B (and that's only an average)

Thicken My Wallet said...

In a non-mature business, like BMO, a dividend yield over 5% really begins to scare me especially if they have indicated they will not do an equity infusion to prop up the balance sheet (still think they will have to change this position soon).

My key question going forward is will they dip into their cash flow to pay out dividend or will their retail operations be strong enough to attract cash? Keeping up the dividend is one thing but if you have to do it by dipping into cash, BMO is going to have a rough future relative to its peers with not as much free cash to expand.

Frog of Finance said...

I think that the weakest aspect of BMO is currently the management. Everything else stems from there.

I was at the annual assembly on March 4th, and the picture management painted seemed overly optimistic. When asked about the likelyhood of the bank raising its dividend in 2008, they said that their current payout ratio was within their target range (which is true *only* if you ignore "exceptional events") and that they still have room to increase the dividend.

That kind of attitude does not inspire confidence.

Nevertheless, I believe there may be an opportunity there, although I wouldn't bet too much money on it. That's why I like DRiPs -- I am only sending small amounts of money to add to my position in the bank. And to me, BMO is my secondary investment in the canadian banking sector -- I like BNS much more.


Freedom 45 said...

Check out what Mark Mcqueen over at Wellington Financial noted in a comment today.

Looks like the banks, BMO included, are rebuilding the capital base so the div may be safer than you think.

Disclosure...Long BMO.