Banks profit from you, you profit from them

Bank bashers can be so ignorant.

All that snivelling about high fees for using bank machines and extortionate credit card interest rates. Open your eyes, people. Yes, the banks can certainly be rapacious, but they're also God's gift to investors. Anyone who isn't helping themselves to their share price gains and dividends is flat out negligent.

In fact, you could make a radical argument that bank shares are all you need as an investor. Let's run with this idea.

Imagine you bought a share of each of the Big Six banks 10 years ago and just held them. Your average annual gain would work out to 12.9 per cent, which far exceeds the 7.6-per-cent gain posted by the S&P/TSX composite index. Throw dividends into the picture and the banks pull ahead even further.

The dividend yield for the S&P/TSX composite has on average been 1.7 per cent over the past 10 years, while bank shares have had an average yield of about 3.1 per cent. Thus the average annual total return -- share price appreciation plus dividends -- for bank stocks was 16 per cent over the past decade while the index made 9.3 per cent.

The banks have made a lot of money for investors in the past decade, but don't get the idea that gains are as hell-or-high-water certain as those fees charged when you use a bank machine outside your own bank's network. Truth is, the past 10 year have included, to quote Charles Dickens, the best of times and the worst of times. The lesson for the small investor: Bank stocks can hurt you, but if you're patient you can do extremely well in the long term.

Investing in bank stocks is the perfect way to soothe the kind of anger over fees that led to the current round of bank bashing. Total fees for using automated teller machines not operated by your own bank can amount to $3 to $4, and there are estimates from the federal NDP that the combined haul amounts to $420-million a year. Think of this money as being part of the fuel that keeps bank stocks motoring along.

Common sense investing dictates that you'd never hold only the banks in your portfolio. Theoretically, the lack of diversification would make you vulnerable if the financial sector were to slump, and rob you of returns when sectors like energy or gold or technology take off.

And yet, bank stocks can be viewed as a proxy for the entire Canadian economy. Retail banking, which is the most important generator of bank revenue, reflects the health of the consumer. Commercial banking reflects the health of the business sector, while wealth management and investment banking reflect the health of the capital markets. By owning bank shares, your investing success goes hand in hand with Canada's economic and financial success.

"Given their breadth, if you look at the banking industry as a whole, I think it's a very good proxy," said Brenda Lum, managing director of Canadian financial institutions at DBRS Ltd.

You'd think that an investment in the diversified S&P/TSX composite index (or a Canadian equity mutual fund) would accomplish the same thing while also cutting risk. We've already seen that bank stocks have performed much better than the index, but they've also offered less risk.

One way to measure this would be to look at mutual funds in the Canadian dividend and equity income category, where financial stocks often dominate. Take the TD Dividend Growth Fund as an example. It has close to 60 per cent of its assets in financials and it has been 68 per cent as volatile as the S&P/TSX composite index in the past three years.

The fund's 15-year compound average annual return beats the S&P/TSX index by a bit, and that's after fees.

Bank stocks have rolled along so well in the past five years that a proviso must be issued: They're no bargain right now. Some are at or above their average price-earnings ratios of the past several years, while dividend yields are right around the average in most cases. A higher-than-average PE and a lower-than-average yield suggest an expensive stock.

If you buy now, you could be in for a flat spell or pullback if the economy were to slow down. Then again, the ever-rising stream of dividends paid by bank stocks will give you at least something to chew on.

Truth is, dividends are the best reason to buy the banks. As an example of why this is so, consider Canada's largest bank, Royal Bank of Canada, which just last week announced a 15-per-cent increase in its quarterly dividend. In March of 1997, you would have paid a split-adjusted $15.15 for an RBC share paying a quarterly dividend of just under 1 cent a share. The dividend is now 46 cents, which means the yield on that original $15.15 share is now 12.1 per cent. That's money you can count on because RBC and the other banks have a sterling record of keeping their dividends flowing without interruption.

In addition to giving you a reliable stream of income, dividends also act as a safety net for a company's share price. If the price of a solid blue chip falls a lot, the yield rises and investors buy. Don't think bank stocks are immune from this kind of shock because they're not.

Bank bashers act as if the banks are robotic profit machines, but there are plenty of examples of the banks running into significant trouble. Back in 1998, for example, the sector endured a very rough year for the financial markets and the disappointment of having the federal government overrule two proposed bank mergers. Shares of Toronto-Dominion Bank, which had planned to merge with Canadian Imperial Bank of Commerce, lost about 48 per cent of their value from peak to valley during the year.

Then, in 2002, the banks were hit again amid concern about loans to the crumbling telecommunications sector. TD's shares fell about 44 per cent at one point that year before rebounding.

Smart investors don't bail out of their bank stocks at this point, they buy more. TD's now the second best-performing Big Six bank over the past three years behind RBC, and it just raised its dividend by 10 per cent. CIBC is the second-worst performer over the past five years; right now, it's the one-year leader.

As well as being the masters of turning your money into their money, the banks are probably the most resilient businesses in the country. Even if you're a bank basher, you really should own their shares.

A Do-It-Yourself Guide

How to buy them: Any investment adviser registered to trade stocks can buy bank shares for you, or you can purchase them on your own and pay much lower commissions using a discount broker. You can buy any number of shares you want - there's no need to buy in round lots of 100.

How to own them: Buy, hold and collect the steadily rising stream of dividends over the years.

Which banks to buy: The major banks all have their ups and downs, which suggests a strategy of buying the weakest-performing name of the moment and waiting for it to rally. You can easily identify the most out-of-favour bank because it will have the highest dividend yield. The hottest bank will have the lowest yield.

In your RRSP, or out?: Bank shares are fine for registered retirement savings plans because they generate such solid total returns. But there's a major benefit to holding them outside an RRSP thanks to the newly enhanced dividend tax credit. The tax rate on dividends today is likely to be much lower than what you'd pay on money withdrawn from an RRSP when you're retired.

DRIPs: All the banks have dividend reinvestment plans, whereby your dividends are reinvested automatically in new shares at no charge. You can set up a DRIP through many full-service and discount brokers, or contact a bank's investor relations department for instructions.

For mutual fund investors: Dividend funds typically have 40 to 60 per cent of their assets invested in financial stocks, including the banks.

For further study: The banks do a good job of making historical share price and dividend information available in the investor relations area of their websites. The "company snapshots" on Globeinvestor.com will help you locate bank websites.

By the numbers

16

The average percentage annual total return - share price appreciation plus dividends - for bank stocks over the past decade.

9.3

The average percentage annual total return for the S&P/TSX composite over the same time period.

Bank stocks: the long view

Here's a look at how shares of the Big Six banks have performed over the past 10 years.

SOURCES: BANK WEBSITES, TSX GROUP, GLOBEINVESTOR.COM