The Globe and Mail, Report on Business
Published April 5, 2008

A couple of times in recent months I've used the banks as a framework for talking about investing and the buy side of the street. I'm back at it.

We have just finished quarter-end reviews with our fund managers and as you would expect, the banks were discussed extensively. The two managers that invest in large-capitalization stocks have been taking different approaches - one is holding back on further commitments to the financial sector and the other has started to nibble on banks that have been badly beaten up.

Cranston Gaskin O'Reilly & Vernon Investment Counsel manages our Equity Fund (we picked them despite having the most awkward name in the industry). The fund holds two banks - Toronto-Dominion Bank and HSBC - in addition to Manulife and Home Capital in the financial sector. For a Canadian-focused fund, this is a unique lineup. Most funds of this ilk own four or even five of the Canadian banks. In contrast, CGOV's approach is to make large commitments to the stocks they like the most and run a concentrated portfolio (maximum 25 stocks). Thus two banks.

Like everyone else, Gord O'Reilly, who manages the fund, is watching the goings-on in the sector and trying to figure out what will happen next. His assessment is that there are more skeletons in the closet, but there isn't enough transparency to know how many there are, or how big they'll be. Gord wants to see more bad news come out before he goes value-hunting in a big way.

Having said that, CGOV recently added to TD when it was under $60.

This trade may seem a tad inconsistent given their industry view, but it's really not. There are no guarantees obviously, but TD is not involved in most of the banking industry's war zones. It has its problem areas for sure - some analysts are concerned about the Commerce Bancorp acquisition in the U.S. and/or its commitment to help fund Ontario Teachers purchase of BCE - but compared with CIBC, BMO and many of the global banks, it's very clean.

For CGOV, the TD purchase was not an industry call, but simply an addition to a long-term holding that had gotten too cheap. They know that TD isn't the stock that will benefit the most from an industry turnaround - it hasn't had enough problems - but as Gord's partner Roy Hewson said in our meeting: "We're buying it for the next six years, not the next six months."

Edinburgh Partners, who manage our Global Equity Fund, also runs concentrated portfolios and has a similar take on the industry. They expect further bad news and have factored it into their estimates. On stocks like Bank of America, Citigroup and Royal Bank of Scotland, they are assuming substantial writedowns are still to come. With some of the banks, they are also allowing for further dilution from equity issues at discounted prices.

Christine Montgomery, who pulls the trigger on trading decisions for the fund, said to me this week that "our numbers show that even with further writeoffs and dilution/capital-raising, many bank shares offer a reasonable risk-reward tradeoff."

In her typical understated way, Christine is saying that the odds are stacked in her favour. Despite the unknowns, there is limited downside risk remaining in some of the stocks, and huge upside when the recovery comes. In their view, when it does, the stocks will move fast.

In this column I often talk about taking risk. Risk is the fuel that drives an investment portfolio. The key to being a successful investor, is making sure you are being compensated for the risks you take. At this stage in the cycle, CGOV is not there yet - they're holding the highest quality banks while they watch and wait. They like the exposure they have and are happy to use their risk budget in other areas of the market where there is more transparency.

Despite a similar macro view, Edinburgh Partners has started to take new positions (including Citigroup) and add to existing holdings. In their view, the bank stocks have just gotten too cheap. They have diversified across a number of banks in different countries, but given increased uncertainty surrounding the ones they're interested in, their strategy is a few notches higher on the risk/reward meter.

Two managers. Same objective - to generate attractive risk-adjusted returns. Similar view of the world. Very different strategies. That's what makes the buy side so interesting.