Reprinted courtesy of the National Post
by Tom Bradley

I have a friend who hails from Ireland. Years ago, she told me a story I’ll never forget. It was about her parents, who still live in the homeland. Her father did the investing for the family and he loved the Irish bank and insurance stocks. That’s all he held in their portfolio. This worked well until the 2008 crisis when their nest egg was wiped out.

Like my friend’s father, Canadian investors love their banks. It’s no wonder. The stocks have done well. They pay healthy dividends. And the Big Five appear to be impregnable. They operate as an oligopoly (noun — a state of limited competition), dominate all the businesses they’re in and seem to have a Teflon coating. The Canadian banks are also insanely profitable (over $1,000 of profit per citizen).

Indeed, their power was never more evident than this year when they aggressively raised their banking fees at a time when the state of debt-burdened Canadians so worried the Bank of Canada that it couldn’t bring itself to raise the bank rate even ¼ per cent.

Are we falling into the same trap that my Irish friends did? If a third or half of your portfolio is invested in bank bonds, preferred shares and common stock, are you too heavily exposed to a single industry that’s dependent on a single economy — Canada? At the risk of being barraged by hate mail from bank lovers, I believe the answer is yes.

Our banks are powerhouses to be sure, but they’re also highly geared (as are all banks). They trade at low price-to-earnings multiples (10-12 times) because a small increase in loan and mortgage defaults can significantly impact profits, as we found out in the 1980s (oil and LDC loan defaults) and again in 2008. While they operate a variety of businesses, their profits primarily come out of the pockets of individual Canadians and their real estate.

It is hard to see the Canadian banks faltering, but their fat margins are starting to attract technology disruptors and increased scrutiny. Last year, CBC called out the sales practices of TD Bank (and eventually the other banks) while the securities regulators have fined their wealth management divisions for unfair business practices.

If a third or half of your portfolio in bank securities is too high, what is the right percentage? There isn’t a number carved in stone, but over 20 per cent of your total financial assets should get your attention.

Moving beyond the banks, what about your Canadian holdings overall? Even though the Canadian market accounts for only 3 per cent of the value of the MSCI World Index, Canadians hold a high portion of their financial assets in domestic securities. To an extent, this makes sense. We know Canadian companies better and feel we have an edge over other investors. Many Canadian companies are global in nature. They’re priced in Canadian dollars. And we may have a stake in their success, either as an employee or customer.

But going all-Canada doesn’t make sense either. Our market is not well diversified. It’s heavily exposed to financial services, energy and resources, and seriously lacking in big parts of the economy like technology, healthcare and consumer-related businesses. Meanwhile, the other 97 per cent of the world has plenty of great companies to invest in.

As for your ratio of Canadian to foreign holdings, there’s no hard and fast rule here either. Every situation is different. Income oriented investors may own more Canadian stocks to take advantage of the dividend tax credit. Younger, growth-oriented investors may hold very little in Canada.

At our firm, the starting point is 50 per cent Canadian and 50 per cent foreign stocks. Despite the Canadian market’s small size and lack of diversification, we can find a few core growth companies, a good variety of income stocks and enough small-cap stocks to provide some juice for our portfolios. But as I noted above, that leaves some holes.

We actively debate what the right number is. Some wealth managers are at 20 per cent Canada and 80 per cent foreign, and all of Canada’s large pension plans and foundations are heavily tilted to foreign stocks.

There are arguments for 50/50, 20/80 and everywhere in between. One thing is for sure, it’s not 80 per cent Canada and 20 per cent foreign. And it’s not all banks.