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When is a blue-chip stock at a bargain price not a bargain?

Daily Buy-Sell Adviser
0 Comments|September 12, 2008

It’s not always as simple as “buy low, sell high” in cases such as this.

Be very careful which blue-chip stocks you buy at low prices in a bear market, says this analyst, who uses the big banks to make his point.

Get ‘em while they’re cheap. Step right up and buy those good stocks while the market is down.

You’ve heard that one more than a few times of late. And why not? What could be wrong with buying a blue-chip stock at a bargain price and watching it ride back up as the market recovers?

Well, maybe it’s not quite as blue-chip as it ought to be. Perhaps it actually deserves some of the bad fortune that has come its way. Maybe some of its peers are better buys at the price.

Take Canada’s big banks. That’s what Mr. John Sartz did in the latest issue of Investor’s Digest of Canada. He kicks the tires of one bank that may look like a good buy, but has some trouble under the hood.

Along the way, he warns against leaning too heavily on one piece of data—no matter how impressive it may be—to make investment decisions.

A little knowledge

The lower-priced bank in question is CIBC (TSX: T.CM, Stock Forum), the Canadian chartered bank that has taken the most flack during the financial crisis. Here’s how Mr. Sartz states his case.

“A little knowledge, they say, can be a dangerous thing. I was reminded of this recently when I read an article wherein a journalist wrote about return on equity as a tool and based on this concluded that CIBC was a good buy.”

This is not entirely a wrong-headed idea, the analyst admits. On many occasions he has praised companies with high return on equity, or ROE.

“If you own a company which can consistently achieve a 20% ROE, and it reinvests 75% of its savings back in the business every year, then it can attain sustainable growth of 15%,” he says. “Purchasing such an earnings stream at a reasonable price will provide superior returns.”

But there’s a catch. The company has to be able to keep it up.

A poor candidate

If a company keeps investing retained earnings, the game changes. Future growth is no longer determined by average ROE, but by marginal ROE, or how much you might make above the average rate of return.

But if the average ROE is going down, the marginal ROE will be shrinking too. It may even fall into the red.

In short, average ROE is a good measuring stick of a company’s worth “only if opportunities exist to reinvest earnings so as to retain the current level of return on equity,” says Mr. Sartz.

Take all this into account, he adds, and CIBC is a poor candidate for investment. 

First, he says, remember how ROE is calculated. It is earnings as a percentage of shareholders’ equity. When you get to the case of CIBC, the calculations aren’t all that straightforward.

The bad stuff

At CIBC, the top number, or the numerator in the equation—net earnings—was based on an estimate that eliminated unusual items. Mr. Sartz calls it “earnings before bad stuff.”

But the denominator—shareholders’ equity—is even more interesting. “Remember that the lower shareholders’ equity, or book value, the higher the ROE,” the analyst explains.

So if the bank can shave certain items off the book value, the better the return looks. And look what got shaved.

First, there was Enron. CIBC had its fingers deep in that pie. The settlement of the mess took a couple of billions off book value. Then there were the investments in sub-prime mortgages—a couple of more billion.

In addition to these money losers, the board of directors decided to create shareholder value by trading stock. “Regrettably, when a bank repurchases its own shares in [the] $80s and $90s and then does an equity issue in the mid-$60s,” comments the analyst, “it has exactly the same result as anyone else who buys high and sells low: it reduces net worth.”

Mr. Sartz here inserts a comment that implies that a firing squad might be too good for such a board, although he also assures us he does not really wish to be taken seriously, simply to make his point.

And the point is clear. 

Only one bank stock

This bank has achieved a higher return on equity by reducing that equity through a series of rash and unsuccessful moves.

“The bank’s current high ROE therefore cannot be considered a good predictor of future earnings growth,” is Mr. Sartz’s almost understated conclusion.

It seems odd that in a banking industry basking in privileges such underachievement could be possible, he adds as an aside.

“Having said all that, shares of CIBC do look cheap at these levels,” he concedes. “As such, I can certainly support a buy decision. However, if I were looking to own only one bank stock, this assuredly would not be it, given its spotty long-term record.”

Select one of the “class acts” in banking, Mr. Sartz tells his readers in Investor’s Digest of Canada. In his book, they are TD Bank (TSX: T.TD, Stock Forum), Royal Bank of Canada (TSX: T.RY, Stock Forum), and Scotiabank (TSX: T.BNS, Stock Forum). If you wish to own CIBC, do so in conjunction with one of these higher-quality banks, he concludes.

Because sometimes when you look twice, a cheap stock may not be such a bargain after all.    

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