Financial Jungle

I’m loving BMO right now too. I got pre-approved for a nice mortgage, so I’m leaning towards real estate, but a big part of me is tempted to just dump everything into BMO and take advantage of (what seems to be) a buying opportunity.

Whoa….careful with that strategy.

Personally I don’t think BMO is that compelling at this price. The yield is nice but there is better growth elsewhere.

“Currently, BMO is sporting an attractive 4% dividend yield and a cheap P/E ratio of 13. In other words, for every $100 invested in BMO, the stock earns $7.70. Contrast that to only $4.68 for the 10-year bond.”

Can you go over how you arrive at this $7.70 and why you think 13 is a cheap P/E?

Sorry, I should have written it clearly. BMO has an earning yield of 7.7%. Out of which, 4% is distributed to shareholders.

($100/$7.7 = PE 13)

PE of 13 is cheap because $7.70 > $4.68 from the 10-year bond, especially when we assume no growth over the long haul.

Note this is a strictly a comparison between BMO and the 10-year bond.

Fair enough.

It would be interesting to see a similar analysis using ROC. Also maybe BAC in the U.S.

ROC has dropped a nice little bit too. Its actually scaring me a little bit, that’s the price you pay if you’re a long-term investor who insists on watching the markets I guess…

Is anyone buying ROC right now? If I hadn’t already expanded my position on it (right now its a bit more of my portfolio then I’d really like) I’d be wanting to grab some more…

I haven’t done too much with ROC, but managment seems to get excited when the fiscal 2007 results are on par with 2006.

This leads me to believe the 6% dividend will remain relatively flat or even decline over the long haul.

I may be in the minority but I am not a big fan of BMO. As compared a 10 year bond, its a great investment but compared to its peers, I am not a fan.

As Middle Class Millionaire points out, its dividend payout ratio is the highest among all major banks which means it has little room to increase its dividend. Harris Bank is also under some pressure if BOA ends up acquiring LaSalle.

RBC stock has dropped back to near where it was at in Jan. ‘07. It may be a better bargain if it continues to drop in price over the summer.

I am off topic to your post but just my 2 cents. Great analysis.

Thanks for you comments, Thicken.

I’ve always been perplexed by this payout ratio argument before. I know you’re into Canadian banks, so maybe you can help clarify my thinking.

Are you implying because RY has a payout ratio of 40% and BMO 55%, RY has the possibility of raising its dividends by raising its payout to be on par with BMO? Assuming RY will pursuit this avenue, that would only raise the yield to 3.9% which is still below BMO’s 4%.

I feel that BMO is a more conservative play on two counts. Unlike RY, they have been paying down their long-term debts, while RY doubled theirs over the past 10 years. Also, Unlike RY, BMO has been buying back its own shares, which means over time, BMO shareholders own more of the business.

The losses due to derivative trading may have risen the risk profile of BMO, but it’s largely a self-inflicted pain, which the new CEO quickly corrected by shutting the door to Optionable; they were (partly) responsible for the fiasco.

You mentioned RY is trading near the January 2007 level, but BMO is trading near the January 2006 level.

Thicken, you are not alone, I agree with you.

Some facts:

RY certainly is buying back it’s own shares. Over 10 million shares were bought back in the six months ended April 30, 2007. Is buying back your own shares necessarily a good investment though when you have a ROE of 23% compared to BMO’s 19%. I would rather a bank make investment in growth rather than buybacks.

RY has a pay out ratio goal of 40% - 50%. Considering it is currently 39%, they absolutely do have more room to raise the dividend more rapidly compared to BMO which is already paying out 55% of earnings. (For example if RY’s earnings were flat they could still raise substantially, whild BMO would possibly have to pause.) Raising dividends rapidly will catch up with you when your earnings are not rising to match, which will result in a high pay out ratio. Personally I want my investments to grow, and my dividends to grow at the same time. High yield without good growth is nothing special. It looks good on paper in the short term, but there is no compounding behind it (ie Rothmans).

Don’t forget, yield is a ratio (Price / Dividend). In BMO’s case the only reason the yield is so high is because they have drastically underperformed while raising the dividend nicely. BMO’s 5 year return is in the 90% range while RY’s is more like 120%. Maybe a more conservative investment currently yes, but does that necessarily mean it will be the higher returning investment…that remains to be seen.

I don’t think either stock is cheap right now, but it’s hard to argue with the fact that RY is the better bank.

Warning: I’m an amateur investor, so don’t invest in BMO based solely on my cursory analysis.

There are two ways to grow dividends: higher cash flow and higher payout ratio. I’m thrilled with cash flow growth, but hiking payout ratio is just a temporary solution. To say RY has better long-term growth potential because of the low payout misses the fact that:

- They can only hike so much before being on par with BMO
- Even when they get there, the yield is still lower than BMO’s.

An advantage with BMO over RY is BMO shareholders can reinvest the disparity in dividend yields back to the stock or any other investments. Sort of like DRIP; more shares means more dividends.

I’m an advocate of share buybacks, because it’s the safest way to grow my investment. Not every dollar can be reinvested to return 23%. A business will always invest in its best idea first, then second, then third, etc… Just because the ROE is 23% doesn’t mean the next dollar invested will return 23%. I’d much rather buy out the existing investors, and keep more of the best ideas to myself.

Is RY a better bank than BMO? I don’t know, but wouldn’t be by much. Both banks have comparable Return on Invested Capital (ROIC) over the recent years. One potential reason why RY has a higher ROE is because of leverage; RY’s Debt-to-Equity ratio is 0.40 while BMO is only 0.29. That may tip the scale with interest rates creeping up.

So essentially you are saying that you like stocks with high pay out ratios? To me a high pay out ratio is a red flag. Not a death sentance, but a reason to be wary about growth prospects.

I never said that I would want RY to hike their payout ratio, on the contrary, I just pointed out that their dividend has much less room to be stalled than BMO’s does. If RY maintains their relatively low pay out ratio I am happy because I know they will continue to raise dividends, therefore if their payout ratio remains low that means their earnings are increasing at a good clip. Look at any stock with a high pay out ratio, their growth projections are anemic (ie ROC, PFE,ED). Put it this way, in my opinion RY is a safer dividend growth stock right now than BMO (if a high dividend growth rate is the endgame).

As I said, what has happened to BMO is that their earnings growth can’t keep up with their dividend growth.

If you say you are happy with increased cash flow then you would have been happy with RY, meanwhile BMO has been performing your ‘temporary solution’ of raising payout ratio.

I’m sure BMO will be fine long term, however personally I like to invest for share price growth as well as dividend growth and their growth prospects trading at a P/E of 13 do not excite me in the least. If BMO dropped down to around $64 or $65, which it probably won’t do because of yield seekers, I would pick it up in a hearbeat. However, I would consider BAC, a safer, better valued bank at current levels.

The financial landmark looked very different 10 years ago, and will look very different 10 years from now, so I’m not going to predict which bank will dominate. In the meantime, BMO’s valuation and yield are more compelling to me, and I can reinvest the higher yield back to the company for more shares to boost dividends. Historically, the lagging banks tend to outperform, and the current laggers are BMO and NA.

I think it’s unfair to compare BMO to ROC which is in a dying business, and BMO still has a much lower payout. I wouldn’t put much emphasis on PFE’s payout ratio seeing that their earnings are very volatile. Don’t know about ED.

This is a becoming a silly debate for me, since I love to own RY as well (in fact, all the banks)… possibly near this level.

I also have plenty of BAC, but their dividends don’t qualify for our tax credits. For that reason, I’m generally more forgiving of Canadian dividend paying stocks in terms of valuation.

I’d say ROC is more in a killing industry then a dying industry ;-).

I own and follow TD and BNS but I’d be a bit careful about using only P/E for the banks which are at or near the peak of the credit cycle. Correct me if I am wrong but P/B is the traditional yard stick for valuing banks and by that measure none of the banks are screaming buys now (though BMO is the cheapest).
Personally, I’d add to my bank holdings when they are 15%-20% cheaper.

Wow, I didn’t intend to start a full out discussion about banks. Just a couple of points:

1. All the big Cdn. banks have done well over the last 10 years so we are really arguing over how many angels fit on a pin’s head.

2. The argument really comes down to whether you are happy with high dividend and high dividend and growth. RY, according to everything I read, seems to be in a better position than any of its peers to have high dividend and growth.

3. RY’s stock split recently- usually a sign from mgt that it is confident of future growth.

4. As mentioned by others, the better bargains now are in US and int’l banks. HSBC is an interesting stock- it seems to be punished unduly for the subprime collapse (even though its exposure was small).

My BMO vs. RY argument is really based on what I wrote on June 4th in my blog; there’s some fundamental business issues in BMO that make it less attractive than RY in my eyes. End of the day, if you can’t decide there’s an ETF that tracks all of them.

[…] Financial Jungle explains why he prefers Bank of Montreal over investing in a 10-year bond. […]

Hello FJ,

After being in the market over 10 years. Just because a stock has a good dividend is not a reason to buy. At $59.15 for BMO and $50.XX for RY the sub prime mess will come up here and bring these stocks probably lower…

Most good fund managers have lots of cash on hand to buy, but my understanding is that their take on the Canadian market is that it is too pricey! Also, most DIYS, do not know how to short stocks missing some great deals!

Reagrds,

Brian

Looking at the history of these banks, investors buying on dips (such as this one) were subsequently rewarded.

The hallmark of successful dividend investing is to buy businesses with strong cash flows and long histories of rising dividends, but buy them when they’re down and out.