Although there is agreement generally that the economy will be weaker this year, as well as a palpable concern about how and when the Big Six banks will be able to work through the credit crunch, Canadian financial services firms remain solid investments.

“Over the long term, you’re pretty much safe when you’re playing Canadian financial services,” says Shane Jones, managing director of Canadian equities and senior portfolio manager at Toronto-based Scotia Cassels Investment Counsel Ltd. “We expect the banks and insurance companies to grow earnings in 2008, but at a slower pace than what they have done over the past few years.”

That doesn’t mean this is the time to add to financial services holdings, however. The banks are still sorting through the Canadian asset-backed commercial paper crisis that hit the financial services sector in August 2007; the global credit crunch remains a cloud over the whole industry. And Canadian financial services companies will continue to experience turbulence, especially in the first several months of 2008. It would be wise to wait until the industry weathers these headwinds before buying these stocks.

“Until all the financial institutions really are upfront about their exposure,” says Richard Nield, portfolio manager with AIM Management Group Inc. in Austin, Tex., “and have taken the appropriate writedowns, the negative sentiment should continue.” Nield is co-manager of AIM Canadian Premier and AIM Canadian Balanced funds.

Money managers are hopeful that the sector will have cleared the worst of the ABCP problems by February or March. As well, most money managers and economists agree that a slowdown — if not necessarily a recession — in the U.S. economy is inevitable. That will probably have a negative effect on the Canadian economy, although most money managers think growth will be slightly stronger in Canada than in the U.S.

“But the important point to make,” says Dale Harrison, head of Canadian equity research at Vancouver-based Phillips Hager & North Investment Management Ltd., “is that you can’t wait until the absolute bottom, when things start to improve, before moving back in. Throughout history, with regard to banks and other financial institutions, the stocks start to anticipate recovery even though conditions continue to deteriorate.”

For now, money managers are neutral on the banks, neutral to overweighted in life insurers, and underweighted in property and casualty insurers, mutual fund and investment management firms, and distributors and suppliers.

> Banks. Despite the ABCP problems that many of the banks faced in the second half of 2007 and the hit their share prices took, earnings from traditional business segments remain strong.

“The banks are facing serious issues,” says Dom Grestoni, head of North American equities at I.G. Investment Management Inc. in Winnipeg. “But these issues are being dealt with, and have been dealt with in a serious way already. The banks are still reporting fairly strong earnings from their diversified operations, All the banks have reaffirmed that they’re looking for earnings growth in the 8%-10% range — some even beyond that. They’re all continuing to benefit from expanding retail operations and wealth-management operations. So, it’s looking pretty good.”

Falling stock prices for some of the banks — particularly Toronto-based CIBC and Montreal-based National Bank of Canada, which both hold large amounts of ABCP — are causing their valuations to look more attractive and the dividend yields are enticing for investors willing to stomach the short-term volatility. The fly in the ointment is getting an accurate reading of how deep the ABCP problem runs and when it will be sorted out.

“Some of the banks have not done a good job, in my opinion, of disclosing exactly what they have and what they’re doing with it,” Grestoni says. “They’ve taken on horrendous exposures in an environment that is supposed to be very well controlled internally. I’m not sure investors have been given very good explanations.”

A key offender is CIBC, which in late 2007 regularly released fresh — and increasingly discouraging — news about expected writedowns.

“What happened with CIBC caught a lot of people offside,” says Nield, who is bearish on CIBC’s prospects, even setting aside its ABCP problems. “It has been a cost-cutting effort over the past two years that has driven CIBC’s growth. So, the underlying profit-growth potential is not as strong at CIBC as it is at the other Canadian banks.”

@page_break@Toronto-based Bank of Montreal also had a bumpy 2007, experiencing both commodity-related trading losses and problems regarding structured investment vehicles, which were affected by the global credit crunch.

Toronto-based Royal Bank of Canada has been less affected, as it held a relatively modest amount of the questionable ABCP instruments. Money managers believe that the strength of its underlying operations will allow RBC to overcome any current issues. Says Jones: “It dominates the landscape in most banking products in Canada.”

Bank of Nova Scotia, also based in Toronto, likewise appears healthy. Money managers especially like the bank’s strength in developing countries. “Frankly, right now [those are] stronger markets than the U.S.,” Nield says. “Scotiabank benefits from that.”

Toronto-based TD Bank Financial Group has been one of the sector’s strongest players for several years now. It stands out as the only one of the Big Six not holding any ABCP. “A tremendous, powerful franchise,” Jones says.

Among the regional players, money managers like Edmonton-based Canadian Western Bank, which has benefited from the strength of the Albertan economy. But managers consider the stock very expensive. They also like Montreal-based Laurentian Bank of Canada. “New management at Laurentian has done a very good of job tackling the cost structure and introducing new growth products,” says Nield, whose funds hold neither CWB nor Laurentian.

> Life Insurers. The big life insurers appear to be better positioned than the banks. They have little to no exposure to credit problems and are well managed, well capitalized and well diversified companies with significant U.S. and international business segments.

“There’s no question that the insurance market is more attractive right now than banking,” Nield says. “In an economy in which you’re still getting positive but not rapid growth, insurance companies are largely defensive compared with the banks.”

However, insurers are at risk of being hurt if interest rates continue to drift downward, say money managers. They are also concerned about the possible effects of a slowing of the U.S. and domestic economies on the insurers. “You really need a decent economy and a normal yield curve,” say Jones, “in order to sell your products and make your products profitable.”

As well, valuations are not low, Harrison adds: “Insurance companies are a great place to hide, but they’re not cheap.”

Most money managers wouldn’t be surprised if one or more of the big insurers pulls the trigger on an acquisition in the U.S. in 2008. “Some of the possible target U.S. insurance companies are a bit too pricey right now,” says Jones. “But the strength of the Canadian dollar really helps Canadian insurers. They are extremely strong institutions. So, we could see the possibility of one or two large acquisitions.”

Money managers praise Toronto-based Manulife Financial Corp. for its strong leadership and diversification, both geographically and in terms of business lines. “It’s close to being bank-like,” Grestoni says, “without the investment banking and brokerage part of it.”

Sun Life Financial Inc. of Toronto has struggled in recent years, but many money managers believe it to be a value play. “It’s always been, in my mind, an undervalued insurance company on a continuous basis,” Grestoni says. “It’s been steadily working on improving operations; the worst is behind it, in terms of U.S. operations.”

Winnipeg-based Great-West Lifeco Inc. has been the most consistent performer, in terms of return on equity, Grestoni says. He praises GWL for its dividend yield of 3.5%, which is higher than that of either Manulife or Sun Life, which both have yields of less than 3%.

Although Industrial Alliance Insurance & Financial Services Inc. of Quebec City is saddled with more than $100 million in ABCP holdings, on which it has so far taken a modest charge, it is nevertheless considered a well-managed firm. “It is a good company,” says Nield.

> Property & Casualty Insurers. This segment enjoyed a great run earlier this decade, but the business cycle is now working against P&C insurers. “It’s definitely a tougher operating environment for these folks,” says Harrison.

Jones agrees: “It’s not the right time in the cycle, but some of the companies do look fairly cheap on a valuation basis. They could come a little cheaper.”

Harrison’s PH&N Dividend Income Fund does not hold Toronto-based Fairfax Financial Holdings Ltd. “Fairfax managed to sort out a lot of its holding-company problems and some of the specific underwriting issues and reserve issues with some of its subsidiaries,” Harrison says. The company is also one of the few firms to benefit from the ABCP crisis, as it took an increased investment position in credit-default swaps before the crisis hit. “That has gotten some attention,” he adds, “and helped the stock as well.”

> Mutual Fund And Investment Managers. Money managers are generally shying away from firms in this segment because valuations are thought to be too high. A long bull market has helped these firms, but if equity markets were to turn downward, they would be hurt.

“They’re great businesses. And at the right valuations, we’d be interested,” Harrison says. “Given the current market environment, the valuations appear to be a little high. But we’re watching closely.”

Money managers prize Winnipeg-based IGM Financial Inc. for subsidiary Investors Group Ltd.’s captive sales force. “It keeps redemptions at a much lower level than some of the other companies with different sales channels,” says Nield. “We view it as a pretty safe, defensive mutual fund company.” His funds have long-standing positions in IGM.

Although money managers generally admire Toronto-based CI Financial Income Fund, they are staying away from it because of its high valuation. “It’s one of the more expensive ones in the segment,” Grestoni says. He thinks the distribution relationship CI has with Sun Life, which owns 37% of CI, has gone well. “There’s a lot more potential to align more closely,” he adds.

Toronto-based AGF Management Ltd. has done a great job of turning around but is now overvalued, Jones says: “AGF has just gotten a little bit ahead of itself. We will take a look at it again in the near future.”

Most money managers are staying away from Toronto-based DundeeWealth Inc. as suitors woo the firm.

> Distributors And Suppliers. Money managers are being cautious about taking positions in any firm in this segment. “They are certainly very profitable businesses. But, again, because they are cyclical, we feel we need to be pretty disciplined,” Harrison says. “We keep a close eye on them, but we’re not there yet.”

> Stock Exchanges. Money managers laud the long sought-after tie between TSX Group Inc. and Montreal Exchange Inc. , saying that significant cost savings undoubtedly can be wrung out of the two businesses.

However, money managers remain concerned about the competition TMX Group Inc., as the combined entity will be named, will face from both domestic alternative trading systems and the global exchange environment.

> Holding Companies. Many money managers own Montreal-based Power Financial Corp. as a way to get exposure to IGM and GWL. Although the parent company is notoriously reticent, money managers nonetheless admire its performance and its handling of acquisitions. IE