Squeezing Speculators On Canadian Banks

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Includes: BAC, BMO, CM, RY, TD
by: Dr. Jacques Saint-Pierre

Summary

Canadian banks are value creators.

Canadian banks have increasing positive performance spreads.

Buyers of Canadian banks stocks get the growth options for nothing.

Canadian banks are under valued.

This article is about four Canadian banks: Toronto-Dominion Bank (NYSE:TD), Bank of Montreal (NYSE:BMO), Canadian Imperial Bank of Commerce (NYSE:CM), and Royal Bank of Canada (NYSE:RY).

In the following analysis, we will show why short sellers in these value creators Canadian banks will be squeezed using our proprietary data and our own valuation methodology based on the integration of the economics of strategy and the principles of modern corporate finance.

We recall that a short squeeze is a situation in which a stock's price increase causes a rush of buying activity among short sellers. Short sellers must buy stock to close out their short positions and cut their losses, which results in a further increase in stock prices, which compel still more short sellers to cover their positions.

Actually, the "Days to Cover" are, for these four banks, TD, BMO, CM and RY of 3, 14, 50 and 16 days respectively.

"Days to Cover" is calculated as the aggregate short interest for the month divided by the average daily share volume traded for the period between short interest settlement dates. "Days to cover" is also referred to as 'Short-Interest Ratio'. The term "days to cover" indicate how many days it will take short sellers to cover their positions if the price of a stock rises. And, we expect, for the reason developed below, that the price of these Canadian banks will rise and the short sellers will be squeezed.

Let us recall, a "short squeeze" is a situation in which a heavily shorted stock moves sharply higher, forcing more short sellers to close out their short positions and adding to the upward pressure on the stock. A short squeeze implies that short sellers are being squeezed out of their short positions, usually at a loss. A short squeeze is generally triggered by a positive development that suggests the stock may be embarking on a turnaround. Although the turnaround in the stock's fortunes may only prove to be temporary, few short sellers can afford to risk runaway losses on their short positions and may prefer to close them out even if it means taking a substantial loss.

Why the short sellers will be squeezed.

  1. Actually, all these four banks have a positive performance spread, as we will see below, respectively, of 6.8%, 5.2%, 8.6% and 9.5% (percentage points).By comparison, Bank of America (NYSE:BAC), a fair valued bank, has a spread of around -9%.
  2. All the performance spreads, for the four banks, during the last five years, have been on a stable or increasing positive trajectory as shown in the table below. By comparison Bank of America has had a negative spread for the last five years.

Performance Spreads (Trailing 12 months)

2011

2012

2013

2014

2015

Toronto Dominion Bank

3.6%

3.8%

2.7%

6.2%

6.8%

Bank of Montreal

6.3%

7.2%

4.2%

4.9%

5.2%

Canadian Imperial Bank of Commerce

9.3%

8.9%

8.2%

6.9%

8.6%

Royal Bank of Canada

8.0%

8.6%

8.1%

8.5%

9.5%

Click to enlarge

Companies that have generated returns on their capital higher than their cost of capital (positive performance spread) for many years of operation usually have a competitive advantage; especially if their returns on capital have increased over time as it is the case for these Canadian banks.

This line of reasoning is fundamental. Again, we say that a business has a competitive advantage when the difference (the performance spread) between the return on capital and the cost of capital is positive (a difference correctly measured, that is obtained after transforming GAAP numbers into a rigorous computation of economic profit, after deducting the full cost of capital, and eliminating the accounting distortions). The more positive the performance gap, the greater the competitive advantage and the higher the expectations about an increase in the share price.

  1. Actually, all these four banks are grossly undervalued by a margin between 20%-40% as revealed by the results of our conservative simulation presented below.

Intrinsic Value, Value of Assets in Place,

Value of Growth Opportunities

(Trailing 12 months)

In CDN dollars

Intrinsic Value

Recent Price

Total [VT]

Va

Vg

Toronto Dominion Bank

$67.39

$51.51

100%

110.2%

-10.2%

Bank of Montreal

$107.19

$73.53

100%

115.7%

-15.7%

Canadian Imperial Bank of Commerce

$125.81

$88.42

100%

121.9%

-21.9%

Royal Bank of Canada

$101.08

$69.29

100%

115.6%

-15.6%

Click to enlarge

All these three major and fundamental groups of data, presented so far, lead to believe in an upward correction in the share prices of the four Canadian banks in our analysis. Following is another reason in support of our thesis that we should expect an upward correction in the price of our four Canadian banks; correction that will be amplified by the "short squeeze."

Getting the Growth Options for Nothing

In support of our overall analysis, we now show, that actually, you get the Canadian banks growth options for nothing. What do we mean by this and what confidence do we have in our estimations presented so far?

To answer these questions we need to recall that the value of any company (i.e., the market value of total capital) is composed of two parts: the value of assets in place, [Va] or, the value of the current operations (i.e. the discounted value of the current net operating profits), plus the value of the future growth opportunities [Vg]. In the simplify approach that we use here, this second part is just the result of subtracting the first part, (i.e. the value of assets in place) from the market value of total capital [VT].

As you can see in the table above, [Va] plus [Vg] is equal to [VT] or 100%. The greater the market value of the total capital of the corporation is composed of the value of the current operations [Va], the less significant is the value of the most uncertain part of the total value, i.e. the future growth opportunities [Vg]. For our four Canadian banks, the market value of their total capital is lower that the value coming from the current operations, the most confident part of their value. It means that the investor who buys the banks get the value of the assets in place (i.e. the value of current operations) at bargain price and get the value of future growth opportunities for nothing.

Value Creators

It is no surprise, based on the performance spreads presented in the first table, that all the four Canadian banks are value creators: Market value added (MVA) is positive at around 30%.

The creation or destruction of value is measured by calculating the market value added (MVA). Market value added will increase if value expands by more than the amount of capital committed to the business, and vice versa. Mathematically, market value added is the market's assessment of the net present value of all investments the banks have made, those already in place plus those expected to materialize in the future. It shows how successful management had been at allocating, managing, and redeploying scarce resources of all kinds. This is another strong argument in favor of an increase in the market price of our four banks that will squeeze the shorter-sellers of the Canadian banks. Squeezing that will amplified the market price correction.

Actionable advice:

All the Canadian banks analyzed here have a great future and it seems that the short sellers will be squeezed because they forgot to base their short selling decisions on a careful analysis based on the integration of the economics of strategy and the principles of modern corporate finance.

It is the time to put Canadian banks in your diversified portfolio before (1) the upward correction in their market value and (2) the amplified positive impact, on the price of the stocks, by the short sellers being squeezed out of their short positions.

Disclosure: I am/we are long TD, CM, RY.

I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.