BMO’s run in 2018 marks another win for our winning bank picking strategy

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Analysts at RBC Dominion Securities have upgraded their recommendation on Bank of Montreal to “outperform” from “sector perform,” and investors who follow our strategy of buying laggard bank stocks will no doubt applaud the move.

Our strategy at the start of this year identified BMO as the best Canadian bank stock for 2018. And look at BMO now: Midway through the year, the stock has emerged as the sector’s top performer, edging past Toronto-Dominion Bank.

BMO’s share price is up 3.3 per cent (not including dividends) as of Wednesday’s close. That tops the 3.2-per-cent gain for TD and an average decline of 1.2 per cent for the biggest five banks.

If you’re unfamiliar with our stock-picking strategy, it is remarkably simple: Rank the Big Five banks (we exclude National Bank of Canada) based on their one-year returns and buy the year’s worst-performing stock. Hold the stock for a year, then repeat the strategy next year.

You’re always buying the previous year’s lagging bank stock and holding it – the idea being that Canada’s biggest banks are very good at closing the performance gap with their peers.

The track record is persuasive. According to data going back to 2000, buying laggards has produced an average annual return (excluding dividends) of 17 per cent. That beats the 11-per-cent annual return for the S&P/TSX Commercial Banks Index and wallops the 5-per-cent return for the S&P/TSX Composite Index.

The strategy has beaten the banks index 72 per cent of the time (or 13 out of 18 years). The previous year’s laggard has become the current year’s top-performing bank stock about 39 per cent of the time.

How does it compare with a buy-and-hold strategy? If you held, say, TD for those 18 years, you would have an 8.2-per-cent average annual gain before dividends. In the case of Royal Bank of Canada, you would have scored an 11.3-per-cent average annual gain.

In others, staying loyal to one bank stock is good – but not nearly as good as playing the field.

The laggard strategy’s recent performance is also compelling. In 2017, Canadian Imperial Bank of Commerce beat its peers (although Royal Bank of Canada was the year’s top performer). And in 2016, Bank of Nova Scotia, a laggard for two years in a row, surged above its peers and was the year’s best bank stock.

If BMO’s current success continues through the end of this year, it will mark three consecutive successes for the laggard strategy, which isn’t bad at all.

Full disclosure: I own an exchange-traded fund that gives me exposure to all of Canada’s big banks, though I feel like I’m missing out on a good opportunity here.

RBC Dominion Securities’ upgrade on Wednesday only adds to the allure this year because it suggests that the strategy for picking BMO is now underpinned by improving fundamentals.

In a note, analyst Darko Mihelic said BMO’s earnings on a per-share basis should increase 8.2 per cent in fiscal 2019 and 5.1 per cent in 2020.

According to Mr. Mihelic, that’s the best profit growth among the large Canadian banks he covers. BMO’s expected 2019 growth, in particular, is double the peer average.

“Our forecast reflects good revenue growth and cost control (including the benefits of restructuring charges that were taken in the second quarter of 2018), partly offset by higher provisions for credit losses (PCLs),” he said in his note.

He added that those higher PCLs (money set aside to cover bad loans) should be muted because BMO’s exposure to Canadian personal and commercial banking − which could struggle amid slower economic growth − is small relative to that of its peers.

There is even a valuation argument in favour of BMO: Although the shares trade at a slight premium to the peer average, based on consensus profit expectations, the premium has been higher in recent years. This suggests that there is room for the price-to-earnings ratio to rise from the current 11.4.

Meanwhile, keep an eye on Scotiabank: It’s back to being a laggard, which bodes well for its future.