Despite occasional setbacks, Canadian banks have a long track record of generating shareholder wealth.Fred Lum/The Globe and Mail
Canadian banks have withstood the recent selloff in financial stocks relatively well, but are still underperformers by domestic standards.
In the first half of this year, the Canadian bank index rose by 7.8 per cent on a total return basis, Sohrab Movahedi, an analyst at BMO Nesbitt Burns, said in a note.
"All the Canadian banks, relative to their global brethren, are in a thin minority with positive year-to-date returns," he said.
But the bank index is also trailing the broader S&P/TSX composite index by about 200 basis points over the last six months.
And the balance of probabilities would suggest that investors should be selective among the Canadian banks over the remainder of the year, Mr. Movahedi said.
Since 1970, the bank index has fallen short of the broader market in the first half of the year exactly half of the time. That underperformance then extended into the second half of the year also about half the time, suggesting that Canadian investors are facing even odds strictly by historical standards.
But history also suggests the margin of potential underperformance is greater than the potential upside, judging by years that started in a similar way to 2016, Mr. Movahedi said.
"The Canadian bank index 'expected' return profile, albeit based on historical performance, suggests a skew to the downside in the second half of calendar 2016 and argues in favour of individual bank stock selection."
One stock-picking method that has a strong track record is mean reversion – buying last year's worst-performing Canadian bank stock and selling the top performer.
Since 2000, that method has generated an average annual positive return of 27 per cent per year, Mr. Movahedi said. And this year is shaping up to be a confirmation of the pattern.
The two biggest laggards among the Big Six bank last year were National Bank Canada and Bank of Nova Scotia. This year so far, they are the best of the group, having generated total return of 12.4 per cent and 15.7 per cent respectively.
Meanwhile, Toronto-Dominion Bank has gone from first to worst with a total return of 4.3 per cent year to date.
There is, however, a caveat. The valuation spread between the more richly valued Canadian bank stocks and their cheaper counterparts has been shrinking in recent months. And when spreads decline below long-term average, that's a trend that historically has been persistent, Mr. Movahedi said.
In that kind of environment, portfolio management may require some qualitative comparison.
"In this regard, the differences in strategy and platforms, as well as track record in capital management become increasingly relevant," Mr. Movahedi said.
By those criteria, his top picks among the big banks are Bank of Nova Scotia and Toronto-Dominion Bank.