Bank stocks have had such a fantastic run it is difficult to imagine they could ever go out of favour. But they have been out of favour — many times. On those occasions, investors have saved themselves from capital losses by selling or, if holding, accepted low returns.

With valuations for bank shares so high, it is timely to review portfolio holdings of banks and look hard at their prospects for continued large gains.

The question of whether banks ever lose ground is answered by the accompanying chart. This shows the performance of Canadian bank stocks relative to the broad market for 85 years. There were times when banks were stocks to avoid.

The numbers start with indices produced by the Dominion Bureau of Statistics, predecessor of Statistics Canada. DBS published bank stock price index numbers beginning in 1919. Bank subindex data starting in 1956 from Toronto Stock Exchange has been sliced to the relative strength ratio of the DBS bank index, which then picks up with the current S&P/TSX GICS bank index beginning in 1987.

These show there have been six or seven major downturns in bank stocks relative to the market, and seven or eight upturns (the banks’ upturn in the 1950s could be considered two separate upward moves or one interrupted long rise).

In the upturns, rising relative performance has meant bank shares gained more than the broad market. There is a notable exception: in the post-1929 crash, bank stocks outperformed the market all right, but only by dropping less than the market.

Banks’ recent outperformance started in 1988. The first wave lasted 10 years. The TSX bank index gained 403% in value, while the TSX composite index gained 121%. After a 24% drop in 1998-2000 (when the broad market gained 24%), banks climbed 56% from the relative strength low to a relative strength high in April 2003. The TSX composite index dropped 28% while this happened.

Since April 2003, banks have performed worse than the market, though whether this is the start of a new long wave of underperformance is not yet certain.

The long business expansion has enabled the “Big Six” banks to improve their balance sheets and therefore their quality.

Balance sheet risk has diminished since 1998. In that year, common equity averaged 3.8% of assets. For fiscal 2004, the ratio is 4.3%. Bank of Nova Scotia stands highest, with a 5.3% ratio, and CIBC lowest, at 3.7%.

The banks’ liquidity has improved in the past five years. Cash and securities account for an average of 30.8% of assets, down a percentage point from 2003, but up from the 28.4% average of fiscal 2000. For fiscal 2004, National Bank of Canada’s liquidity stands highest at 38% of assets. Bank of Montreal is lowest, at 25.8%.

What lends credence to the idea banks are overvalued and are starting downhill is another fundamental valuation, price to book value. For banks, whose only real asset is money, book value is a credible and useful measurement.

In the mid-1990s, bank stocks traded at less than book value. In 1994, the average price/book ratio was 0.66. Comparing 2004 calendar yearend stock prices with fiscal 2004 yearend (Oct. 31) book values, bank stocks trade at an average 2.45 times book value. Scotiabank ranks highest, at 2.8 times book value, and National Bank is cheapest at 2.17 times.

A rise of four times in valuation in a decade seems extreme. This example shows what happened: in 1994, you could have bought $26 worth of BMO net assets for $13. Now, to buy $24 worth of net assets you pay about $58.

Two stock valuation formulas published in 1979 but not, to my knowledge, publicly used are useful in assessing bank stocks.
The formulas have proven to be over-conservative in valuing other stocks in the past bull market.

The virtue of the formulas is they avoid dependence on stock prices or earnings estimates. They use solid fundamentals:
book value, return on equity, dividends and earnings per share.

The capital value formula, measuring a stock’s worth as a source of income, suggests bank stocks are fairly valued only if you assume a 15% opportunity cost. At an 8% opportunity cost, they are worth only about half their recent prices.

The second formula, to measure potential capital growth, yields similar answers.

@page_break@A well-known stock valuation formula by Graham and Dodd indicates the intrinsic value of most bank stocks is higher than recent market prices, if you assume continued strong earnings growth.

The notable example is Scotiabank. Its five-year compound earnings growth rate has been 12% and its three-year average earnings are $2.27 per share. At a 10% compound earnings growth rate, the indicated intrinsic value is near $65, compared with a recent share price of $39.

For TD Bank Financial Group, with a recent loss year, a least-squares compound growth rate cannot be figured.

The remaining four banks have recent earnings growth rates of 10% to 11%.
Based on three-year average earnings and
projected continued 10% earnings growth, the Graham and Dodd formula suggests BMO is worth $100 a share (recent price, $56), CIBC is worth $114 (recent price, $74), National Bank $92 (recent price, $52) and Royal Bank of Canada $119 (recent price, $75).

At lower growth rates, however, the valuations are lower and close to recent stock prices. At a projected 5% earnings growth rate, the highest estimated price growth are for BMO and National Bank, with intrinsic values of $65 and $60, respectively ($10 and $8 above recent share prices). At 5% earnings growth, Scotiabank’s
estimated intrinsic value is only $42, or $3 higher than its recent price. IE