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Financials Revisited

Richard Croft
March 6, 2012
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We’ve been a friend to the financial sector since last November when we looked at bullish positions in the Canadian financial services sector. Turns out that was very near the bottom of the market for the iShares S&P/TSX Capped Financial Services Index Fund (TSX: XFN). Since then, XFN has advanced 16%. We also suggested similare strategies on some of the big Canadian banks that had been beaten down, including Royal Bank of Canada (TSX: RY). Royal Bank has advanced 30% since then.

Financials are back in the news again, benefitting from the halo effect of massive bank bailouts in the eurozone. For Canadian banks, the news has been doubly good, as first-quarter profits helped propel bank shares to their highest levels in nine months. Bank of Montreal, for example, reported a 34% increase in first-quarter profit over the same period last year. Even shares of Toronto-Dominion Bank and Royal Bank advanced, despite reporting lower net income than the same period a year ago.

But with the positive news, there are things to consider before making commitments to financial stocks. The first is the level of interest rates. Ultra low interest rates are good for consumers, but those low rates squeeze bank margins. Which partially explains why some Canadian banks reported lower net income despite strong loan demand. You should assume based oin the rhetoric coming from the US Federal Reserve, that interest rates will remain ultra low until well into 2014.

The second consideration is loan demand which hinges on the medium-term economic outlook. If you believe that the economy is bottoming and on the road to recovery – a position taken by more than a few analysts – banks will be front and center. It takes a well capitalized banking system extending credit to get the economy shifted into high gear.

From my perspective, I think we are in the early stages of a banking sector recovery. But with the sector having rallied over the past three months, I would normally suggest playing further advances with a more conservative bent. Specifically focusing on strategies like covered call writing.

However, options on Canadian banks are cheap. In terms of implied volatility, Canadian bank options are in the lowest quartile of all Canadian options. As an example, the Bank of Montreal (TSX: BMO, Friday’s Close $57.90) slightly out of the money July 60 calls are trading at 90 cents (implied volatility 14%). A 10% rally in BMO over the next five months would result in a triple for the July 60 calls. Similar leverage is available with the other bank stocks. And that leverage with limited risk seems to be the better strategy at this stage.

As such, assuming you are bullish about financials, consider buying slightly out-of-the-money calls on your favorite bank.

Richard Croft
Richard Croft http://www.croftgroup.com/

President, CIO & Portfolio Manager

Croft Financial Group

Richard Croft has been in the securities business since 1975. Since February 1993, Mr. Croft has been licensed as an investment counselor/portfolio manager, operating under the corporate name R. N. Croft Financial Group Inc. Richard has written extensively on utilizing individual stocks, mutual funds and exchangetraded funds within a portfolio model. His work includes nine books and thousands of articles and commentaries for Canada’s largest media channels. In 1998, Richard co‐developed three FPX Indexes geared to average Canadian investors for the National Post. In 2004, he extended that concept to include three RealWorld portfolio indexes, which demonstrate the performance of the FPX portfolio indexes adjusted for real-world costs. He also developed two option writing indexes for the Montreal Exchange, and developed the FundLine methodology, which is a graphic interpretation of portfolio diversification. Richard has also developed a Manager Value Added Index for rating the performance of fund managers on a risk adjusted basis relative to a benchmark. And In 1999, he co-developed a portfolio management system for Charles Schwab Canada. As global portfolio manager who focuses on risk-adjusted performance. Richard believes that performance is not just about return, it is about how that return was achieved.

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