When you buy shares of a stock, you’re buying a piece of a business. So, you’d better be buying shares of a company that you’re comfortable being a part owner of.
So, how do you decide if a stock is for you? Ask yourself this: “Do the shares become more attractive the lower they go?”
I know it may be difficult to answer the question at first. However, going through the exercise will help you decide if it’s a stock for you. That’s because market crashes occur occasionally.
Learning from history
In 2008 and 2009, the financial crisis triggered a recession. For new stock investors then, the downturn came fast and furious.
Even the top Canadian banks, the most profitable group of companies in Canada, such as Royal Bank of Canada (TSX:RY)(NYSE:RY) and Bank of Nova Scotia (TSX:BNS)(NYSE:BNS), fell as much as 50%.
However, in retrospect, the downturn was actually an opportunity. Investors could have picked up shares of the top Canadian banks for up to 40-50% of the original cost.
Royal Bank fell 40% from about $50 to roughly $30, and Bank of Nova Scotia fell 50% from about $50 to roughly $25.
Now, almost eight years later from the bottom, Royal Bank and Bank of Nova Scotia have more than tripled to over $90 and $76, respectively.
Simultaneously, their dividend hikes have allowed their yields on cost to be 11% and 11.8%, respectively.
What’s today’s situation?
On a per-share basis, the banks are the most profitable they have ever been. For fiscal 2016, Royal Bank generated earnings per share (EPS) of $6.96 and paid out less than 47% of its earnings as dividends.
Similarly, Bank of Nova Scotia generated EPS of $6.05 and paid out less than 48% as dividends. Their payout ratios of roughly 50% align with the industry’s ratios.
Shareholders of the banks have enjoyed an outstanding run as multiple expansions occurred. Royal Bank and Bank of Nova Scotia have appreciated 21% and 31%, respectively, in the past 12 months.
Unfortunately, for interested buyers, the banks are no longer trading at discounts. In fact, the banks are fully valued from their long-term normal multiples.
The takeaway
Stocks are inherently volatile. Even the best companies have volatile shares. For example, the top Canadian banks fell 40-50% in the last recession about eight years ago.
A stock that’s right for you is a business that you’re willing to buy more shares of when its shares fall lower. The lower they go, the more comfortable you should feel, because you’ll think they are a bargain.
