Strategy of buying last year’s bank laggard holds up with Scotiabank

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When Bank of Nova Scotia reported strong quarterly results on Tuesday, it gave a big boost of credibility to a stock-picking strategy that works wonders with Canada's biggest lenders: Buy last year's laggard. Scotiabank's stock has been the best performer among the big banks this year and the gains seemed justified by a fourth-quarter profit of more than $2-billion.

That's up 8 per cent from last year, on a per-share basis, which was well above analysts' expectations for profit growth of just 4 per cent.

But what's particularly noteworthy here is that Scotiabank was a dog last year. The share price slumped 15 per cent in 2015 and trailed Toronto-Dominion Bank – the best-performing bank stock – by 13 percentage points.

There were some fundamental reasons for Scotiabank's laggard status in 2015. Mostly, investors were worried about its international operations, which were focused on developing economies in Latin America at a time when this region was struggling with low commodity prices and shifting U.S. monetary policy.

But fundamentals only seem to get in the way of picking a good Canadian bank stock.

The better approach is simply to look at the annual share-price performance of the five biggest banks, buy the worst stock and hold it for a year.

There is a 40-per-cent chance that the laggard you buy will blossom into this year's top performer. And there is a very good chance that you'll outperform the S&P/TSX composite index.

Indeed, this strategy – which echoes the Dogs of the Dow – has delivered an average annual gain of more than 16 per cent, using numbers going back to 1999, versus 10 per cent for the index. These numbers do not include dividends.

Importantly, the strategy also delivered better returns than buying and holding a single bank stock, such as TD or Royal Bank of Canada, over the same period of time.

These results are based on calendar years. But given that the Big Banks have begun to roll out their year-end results this week, we figured that now was as good a time as any to examine how the strategy has been holding up in 2016.

From the looks of it, it has been doing very well. Since the start of 2016, Scotiabank shares have risen 32.6 per cent, versus a gain of 15.3 per cent for the S&P/TSX composite index.

However, it is not enough to do well. Ideally, last year's laggard must also outperform its peers – and Scotiabank has done just that from the start of the year through Nov. 28. It beat RBC by 11.2 percentage points, TD by 14.6 points, Canadian Imperial Bank of Commerce by 16.5 points and Bank of Montreal by 18.4 points.

Scotiabank also beat National Bank of Canada – the smallest of the Big Six – by 8.2 percentage points, although we didn't incorporate the smaller bank into the original strategy because it is more regional (maybe next year).

Of course, any strategy that rewards laziness deserves some skepticism. Intrigued investors should rightly question the underlying theory here.

Our answer: Canada's biggest banks are remarkably large, diverse and competitive, offering similar rates and services in the same domestic economic environment.

Unless management makes a real blunder that can't be corrected, or pounces upon an opportunity that can't be replicated by rivals, the stocks should drift along in a fairly tight range. When they don't, opportunity knocks – for now, at least.

Canadian banks have been pegging more of their growth on international expansion: RBC and CIBC recently made big bets on U.S. private and commercial banking, while TD and BMO are focused on U.S. retail banking and Scotiabank has doubled down on the Pacific Alliance countries of Peru, Colombia, Chile and Mexico.

This suggests that their share prices could start to diverge more meaningfully as these farflung operations grow more substantial, offering a potential challenge to this stock-picking strategy.

That seems years away, though. For now, bad is good and good is bad – which sets up Bank of Montreal nicely for 2017 and puts Scotiabank back in the doghouse.