It may be time to edge away from banks, mutual fund companies and investment dealers and become overweighted in the often overlooked large life insurers. They may offer more potential for returns in the year ahead.

Apart from a few bumps in the road — massive Enron Corp.-related litigation settlements and the federal government’s on-again, off-again bank mergers game — last year was undeniably a good one for most Canadian banks. Continuing low interest rates, strong credit quality and booming domestic investment markets drove some very robust results.

Likewise, fund companies enjoyed their strongest net sales in years, a few merger-and-acquisition skirmishes livened up their stocks and they flirted with the idea of income trust conversion.

Strong capital markets and the prospect of trust conversion also boosted the brokerages and TSX Group Inc.

These trends were good for life insurers, too, but they seldom found themselves at the centre of the action in 2005. They may be the ones on which to focus in the year ahead, however, as other parts of the financial services industry grapple with expected challenges.

As always in the financial services sector, the interest rate environment is a key macro variable heading into 2006. Rising U.S. and Canadian rates, a trend that has been in play for the past 18 months, could hamper economic growth and cool corporate earnings. Higher rates could also crimp valuations for blue-chip stocks, such as banks, by raising the relative appeal of fixed-income investments.

While the interest rate situation is obviously a critical factor for banks’ earnings growth, other elements of the macro environment could also affect their prospects. At the top of that list is credit quality, which, of course, is tied to interest rates. This past year presented something of a peak in credit quality. As that quality degrades in 2006, banks may find themselves boosting loan-loss provisions and their earnings taking some heat. Canadian banks are particularly exposed to the risk of weaker credit quality in the personal and small-business lending areas.

The question of bank mergers could remain unanswered for some time, given the current political climate. The Jan. 23 election makes the identity and composition of the next government unknown, and even when past governments have pledged to address this issue, they have ultimately failed to do so. Given that uncertainty, it is impossible to factor the notion of mergers into an investment decision with any degree of confidence.

More likely, the Canadian banks will have to continue finding their growth by expanding their foreign operations through acquisition. On that count, the leading performers are Bank of Nova Scotia and TD Bank Financial Group, which have had the greatest success with international growth.

Scotiabank has indicated it would like to do some domestic deals, particularly in its wealth-management business, but there are relatively few viable, attractive targets. Assuming full-scale domestic mergers do not stand a chance in the coming year, Scotiabank will probably continue to concentrate its expansion plans on underdeveloped banking markets in Latin America and the Caribbean. This strategy has proven successful for the bank over the past couple of years.

At TD, the approach is much different. It has continued building its foreign presence through TD Waterhouse, its leading discount brokerage franchise in the U.S., and it has begun a focused U.S. expansion in the New England area through its stake in what has become TD Banknorth. Both of these prongs give TD a leg up on its competitors in tackling the U.S. market. But execution remains a key challenge, as these are very competitive markets. TD’s track record has been good so far, but it remains to be seen whether Banknorth can continue to grow through acquisitions. And although the added scale of the combination with Ameritrade helps Waterhouse, this also remains a competitive, market-driven business.

You need only to look at Royal Bank of Canada to see how an apparent winning strategy in the U.S. can go wobbly. Royal Bank has put a lot of its U.S. troubles behind it, but it is too early for investors to declare definitively that its U.S operations are no longer an issue. Just how the bank will grow that part of its business is still to be determined.

Getting growth out of a strong U.S. anchor has long proven tough for Bank of Montreal. Its move into the discount brokerage side of the business was recently abandoned with the sale of Harrisdirect, and it has yet to capitalize fully on the Chicago-based Harris franchise. Nonetheless, BMO had very good earnings in its most recent quarter, although analysts attribute part of that to stellar trading results that may not be sustainable. Longer term, BMO remains an acquisition target — should we ever get a Canadian federal government prepared to allow domestic mergers.

@page_break@CIBC is a potential turnaround story. Its new management embarked on an aggressive cost-cutting strategy last year. Given the early results, it is probable that the bank will meet or beat its expense-reduction targets. However, it remains to be seen whether it can carry out all these cuts and absorb the accompanying changes to its business without hurting its ability to compete in the cutthroat Canadian banking business.

One of the advantages that the more beaten-up banks, such as CIBC and BMO, have over their higher-flying rivals is valuations. In general, the Canadian banks are trading at somewhat higher multiples than their U.S. counterparts. In 2005, the Big Five were trading at about 14 times earnings, vs around 12 times for major U.S. banks. While the Canadian market and economy were certainly hotter than those of the U.S. over the past year, it is hard to believe a valuation premium is sustainable in the long run. Thus, the Canadian banks with the better strategies and higher valuations may have farther to fall when valuations converge.

Beyond the Big Five, Montreal-based National Bank of Canada has also traded at a discount in recent months. It produced strong earnings in its latest quarter, but much of that performance is linked to credit quality. To the extent that credit quality may deteriorate, it will be challenged to grow earnings.

Weak results have also been an issue at the other Quebec-based player, Laurentian Bank of Canada. It has seen full-year revenue decline for several years in succession. Nor is it a bargain, trading recently at a premium to the rest of the group. (For more on Laurentian, see p. 18.)

The big banks tend to dominate the financial services group, but it may be the large life insurers — particularly Manulife Financial Corp., Sun Life Financial Inc. and Great-West Lifeco Inc. — that have assembled the most impressive businesses. To be sure, they face the same headwinds as the banks, in terms of rate hikes and credit quality. But compared with the banks, their exposure to these risks is lower because they are diversified by product line and by geography.

Manulife has probably done the most impressive job of diversifying and growing its business internationally. Its most recent big step is its acquisition of Boston-based John Hancock Financial Services Inc. According to the latest reports, Manulife’s integration of the John Hancock acquisition is playing out even better than projected. The company’s size in its key markets — Canada, the U.S. and Asia — and its diversification position it as a probable long-term winner at a time when conditions for other big financials are challenging.

It’s a similar story at Sun Life and Great-West, although analysts note their consolidation paths have left them with higher leverage than Manulife. Nevertheless, the three big insurers dominate the Canadian insurance business. And they derive a large portion of their earnings from non-Canadian sources, leaving them reasonably diversified and seemingly well positioned relative to the banks.

The impressive dominance exhibited by these three insurers poses competitive challenges for the rest of the field. With insurance a slow growth area in Canada, rivals must move into other businesses if they hope to ramp up earnings to a meaningful level. Industrial Alliance Insurance and Financial Services Inc. recently served notice of its intention to become more of a force in the wealth-management business by outbidding CI Financial Inc. for asset manager Clarington Corp.

The Clarington acquisition will pump up Industrial Alliance’s presence, but it still faces fundamental challenges in the sector. Mutual fund net sales certainly rebounded strongly in 2005, but these sales were very concentrated by both asset class and fund sponsor. Investors favoured income-focused funds almost exclusively, ignoring higher-margin equity funds; they also bought funds from just a handful of firms, with the bank-owned companies recording particularly strong sales throughout the year.

The banks have become powerful players in the wealth-management business with their strong product lineups in the popular asset categories and their expanding distribution capability. The independents that have struggled for sales hope their businesses will pick up once investor appetites shift, but, given the importance of distribution, this may be a vain hope.

Best positioned are those with distribution, such as CI, IGM Financial Inc. and Dundee Wealth Management Inc. , which all have some strong core products. AGF Fund Management Inc. is another story, given continued net redemptions. It appears to have refocused on its core business but is still waiting for sales to turn around.

Margins could also come under pressure as CI, with its impressive record of controlling costs, leads a charge for lower fees. This will make scale, which both CI and IGM have, very important. But it is still too early to assess definitively the impact of this trend on the competitive landscape.

The wait-and-see approach also appears to recommend itself for the property and casualty insurance sector. Many P&C firms — including Fairfax Financial Holdings Inc. — were walloped by the devastating U.S. hurricane season last year. In the P&C business, a tough claims year is often followed by firmer prices the next year. But, given how battered this business has been in recent years, as well as the political pressure to contain auto insurance rates and the unpredictability of claims, investors must be cautious.

In the meantime, many of these businesses may have to contemplate the wisdom of converting to an income trust. CI has long flirted with the idea; analysts have suggested it makes sense for AGF and, indeed, for most firms that have mature, cash-generating businesses, including TSX Group.

The federal government’s decision to cut the taxation of dividends was designed to make trust conversion a less compelling tax arbitrage play, but it has not entirely eliminated that advantage. As a result, some of these businesses may yet see an advantage in trust conversion and the valuation premium such a move has attracted in the past.

Most firms have been circumspect about the possibility of trust conversion, but with GMP Capital Corp. leading the way, more conversions may come. For investors, this could represent a short-term trading opportunity but should not necessarily be a long-term investment differentiator. IE