LB – Divestor

Laurentian Bank

I’ve been seeing a few “strategic review” press releases lately, this one on July 11 by Laurentian Bank (TSX: LB):

MONTRÉAL , July 11, 2023 /CNW/ – Laurentian Bank (TSX: LB) (the “Bank”), announced today that its Board of Directors and Management Team are conducting a review of strategic options to maximize shareholder and stakeholder value.

The stock rose from $33 and traded as high as $48 in the morning (it opened at $45, spiked to $48 in 2 minutes of trading before crashing to earth again).

One of the difficulties of keeping a wide watchlist of companies that you’ve researched over the past decade, coupled with defensive posturing (i.e. holding cash that is now yielding an extra 25bps from yesterday) is that statistically speaking a couple times a year you get these situations where companies announce something that cause the stock price to really rise. LB got on my radar in early 2021 as a pure value play – it is a mediocre institution, appears to have little in the way of competitive advantage beyond a lengthy existence, and trading at a steep discount to book value. Indeed, if/when they do finally sell out, they will likely get something below book value.

I was eyeballing Laurentian in early 2021 when it was in the lower 30’s (adjusted for dividends this would be the upper 20’s today). Given that the world was still losing their minds over Covid at the time, there were plenty of other opportunities that I engaged in but kept LB on my “boring as bricks and likely low downside” list.

Psychologically, it is difficult to see the product of research work like this when you can instead keep cash balances invested. However, it is akin to looking at the six digits of the latest lottery and thinking to yourself “had I picked 43 instead of 44, I would have won the million dollars”.

Another strategic review situation that I also missed out on was National Western Life (Nasdaq: NWLI) which has chronically appeared as one of the deepest value stocks on a price to book stock screen – the issue being that they had management/owner that was entrenched and was so glacial it made my investment style look like a meth-addled day trader by comparison.

Canadian Bank Stocks

Bank financial institutions usually make money by borrowing short and lending long (i.e. having their cost of capital at the short-term interest rate, while earning money with the long-term interest rate). The flattening yield curve is making it more difficult for financial institutions to capture this spread and this is reflected in what we see in Canadian bank stocks.

Looking at the six majors (TD, BNS, RY, CM, BMO and semi-major NA), they are all down for the year. Looking at the juniors (CWB and LB), they are also down, especially in LB’s case (which has some other business operation issues that I will not get into this post, but suffice to say there is a reason why it is trading at less than 75% of book and a P/E of 8).

There are also other quasi-banks (e.g. EQB, HCG, FN – yes, I know FN is not a bank, etc.) that appear to be doing reasonably well despite their obvious reliance on the stability of the Canadian mortgage market.

Some people are advocating that this is a good time to get into the sector as traditionally most of Canada’s big banks have proven to be stable in history, and the big banks are making record amounts of profits.

Assuming you had to be locked into an investment in these Canadian banks, the proper question to answer is whether these institutions will continue making money at the rate they have been making it historically that justify their valuation. They look cheap from a historical perspective, but just relying on historical analysis is a very dangerous method of investing. There is a lot of competition in the financial sector domain and I am not sure whether forward looking, profitability will be as strong as it has been in the past half decade. The easy money appears to have been made.

In general, I would not be surprised at all to see the major banks tread water price-wise for the next few years or even see investors today take small unrealized capital losses over that time frame while clipping their 4-5% dividend coupons.

Finally, I will clarify this post does not take into context the insurance sector (e.g. MFC, SLF, etc.) which has their own dynamics. I also do not hold anything mentioned in this post, although I have taken a hard look at LB and CWB recently.

Obsession with dividend investing does not prevent capital losses

There are quite a few financial websites out there dedicated towards investing in dividend-bearing securities.

Some give the impression that it is nearly guaranteed to produce returns superior to the overall market.

In addition, a lot of them convey that the production of income through dividends is somehow “safer” than investing in major index ETFs.

In general, I do not have issues with dividend-bearing equities. In a lot of instances companies do not have proper places to re-allocate capital and giving it to shareholders is the right decision – especially if their stock price is high and the cost of their debt is low.

Where I have issues with dividend investing is in companies that have suspicious cash flow profiles or give cause to believe that their earnings profiles are going to be less than what is implied by their market pricing.

I’ll give an explicit example. Cineplex (TSX: CGX) I have written about in the past. Specifically in a May 2014 article (when the stock was trading at around $41), I was puzzled why the stock was doing so well given the “dinosaur” aspect of their business.

A lot of people though will take a look at their current 5.4% dividend yield (currently trading at $32/share) and blindly buy on the basis of that number alone. What will not be asked is whether this can be sustained or whether the business is fundamentally sound to generate sufficient cash flows in the future. Maybe it will, but there is an awful amount of risk for that 5.4%, much more than I could justify for my own (cowardly) risk profile. The 5.4% doesn’t compensate for the risk of future potential losses.

Another example that I have not written about in the past is Laurentian Bank (TSX: LB). This got on my radar back in June when their CMHC securitization issues hit the headlines. After doing some deep-dive research, while I believe the financial institution in general will continue to generate cash, I determined that better prices in the future could probably be had. Their last quarterly report was a prime example of mediocrity that one would expect from a centuries-old financial institution and their stock got hit 5% on the day after the report. Dividend investors were screaming “buy, buy, buy!”, looking at the juicy 6% yield and apparent value (then trading around 17% under book value). How can you lose? Today, it is down another 5% from the day after they reported earnings. It would take a year of dividends and a flat stock price to “catch up” to even.

The real test of the veracity of dividend investors is what happens when the capital value of their investments go south, and I am not talking 5-10% – when they start seeing 20-30% capital losses across their portfolios, will these dividends be nearly as important?

Just note this is not a prediction on the future outcome of CGX or LB or the market in general. It is simply a commentary that dividend investing is not risk-free magic and it requires just as much financial rigour as other types of investing. For common share investments, I’m agnostic towards companies that either give out or do not give out dividends or distributions. It factors little in my investment decision-making. I’m much more concerned about what management does with the capital they have.