Portfolio managers are eyeing Canadian financial services companies. Some managers are loading up now on what they believe to be favourably priced stocks with tremendous upside potential. Others are keeping their powder dry and hope to buy into this sector later in 2009, when the stocks will be better positioned for a turnaround.

“As a general rule, financials lead the market down into a bear market, and financials lead the market back up,” says Dale Harrison, head of Canadian equity research with Vancouver-based Phillips Hager & North Investment Management Ltd. “These are extremely high-quality companies that are cheap, and they rank among the most desirable stocks one can own.”

Harrison manages PH&N Dividend Income Fund, which is overweighted in Canadian financial services, particularly banks.

Most money managers agree, however, that the financial services sector’s rocky period will stretch well into 2009. It’s almost certain, for example, that the country’s big banks will book higher loan losses this year, as they contend with a contracting domestic economy. This is just one factor that has led some money managers to give financial services companies a wide berth — at least, for the time being.

And there is very likely a lot more pain to come this year. “The Canadian banks haven’t really felt the pain that their global peers have,” says Richard Nield, a portfolio manager with Invesco AIM in Austin, Tex. “So, I wouldn’t be surprised if there’s still a huge drop in Canada. When you combine that with the fact that Canada is a late-cycle economy, which only in the past three months has felt the effects of the global credit crisis, we think that bodes negatively for Canadian banks.”

Contrary to the view held by many money managers, Nield believes Canadian banks stocks are still too expensive. While many global banks are trading well below price/book value, he says, the Canadian banks as a group are trading at 1.4 times book.

Nield believes that once Canadian banks begin to take higher loan-loss provisions, are done with raising capital and have seen their valuations compress closer to price/book, a lot of the downside risk will have been mitigated. “I feel that at some point in the second half of 2009, some of the bank stocks will start looking interesting again,” he says. Some of the Invesco Trimark Ltd. funds Nield manages are underweighted in financial services, particularly banks.

There’s no question that shares in financial services companies took a beating in 2008, with the share values of a few firms cut in half year-over-year. Banks and insurers were forced to go to the market to raise capital, thus diluting shareholder value. And, in the second half of the year, they began to take larger provisions against loan losses, putting downward pressure on earnings.

On the other hand, Canadian banks and other financial services firms have so far been able to maintain their dividends, which the banks have indicated they will not cut although they are not increasing them. Those dividends, many money managers say, represent remarkable value relative to the battered stock prices,

“If you don’t think the world is going to end, you’ve been given the opportunity of a lifetime to lock in yields of 7%, 8%, 9%,” says Dom Grestoni, senior vice president and portfolio manager at I.G. Investment Management Ltd. in Winnipeg. “And you’re going to get some tax efficiency out of those yields.”

Canadian banks and other financial services companies are stronger than their global peers, in terms of capital ratios, diversification, risk management and regulatory oversight, among other measures, Grestoni says. And the Canadian economy, while being buffeted by the global slowdown, is still better positioned to weather a downturn than the economies of many other countries. This should shield Canadian financial services firms somewhat from the battering being taken by their global peers. “We’re the envy of the world,” Grestoni says, “in terms of embedded potential.”

An important point when looking at bank financial statements is that mark-to-market accounting, introduced barely a year ago, came at the worst time. Some money managers say this accounting method has unnecessarily exaggerated losses on asset holdings, forcing banks to raise capital to meet regulatory requirements, which has diluted shareholders’ equity. “There’s probably a lot of room to recover those paper losses,” says Robin Cornwall, president of Toronto-based Catalyst Equity Research Inc. “Banks and insurers can be long-term holders of things.”

@page_break@Many money managers feel that the big risk for investors at the moment is missing the upturn in financial services, which they believe will probably be sudden and steep. “When the move back into financial services comes, it will make your head spin,” Harrison says. “We could see a 40%-50% rise in stock price in a two-week period.”

Harrison forecasts that credit spreads will peak roughly mid-way through 2009, which could signal the start of a rally in financial services. Until then, he’s happy to own the stocks through the rough patches. “We don’t know when it’s going to happen,” he says. “So, we don’t want to be cute, in terms of waiting to step in. One day, we’ll wake up and the rally will have started.”

Money managers caution that there’s also some risk that the recession, both globally and in Canada, will be more severe than expected. “If we see the global economy continue to decline at such a rapid pace, then, in reality, nothing is safe,” says Shane Jones, managing director of Canadian equities and senior portfolio manager with Toronto-based Scotia Cassels Investment Counsel Ltd. “That could drag Canadian banks down further.”

Much rests on whether the efforts over the past year by governments worldwide to get capital moving again are successful. “If they do start to work, we’ll be in better shape,” says Jones, who is overweighted in financial services, particularly banks.

Money managers acknowledge that one way clients can step back into the financial services sector is through owning those companies’ corporate bonds, which are offering attractive yields. (See page B18.)

Those clients who don’t want any volatility, who are concerned more with income and the stability of income, and who are willing to forgo the potential capital appreciation, suggests Grestoni, might prefer a five- or seven-year bank bond rather than bank stock.

While a client’s asset mix is always contingent on a host of factors, money managers who are bullish on financial services say that clients could do worse than matching the 25%-30% share that the sector holds in the S&P/TSX composite index. In general, money managers are overweighted in banks, neutral in insurers and underweighted in all other categories in financial services.

> Banks. Money managers agree that 2009 will be difficult for the banks but not disastrous. “We think it will be an ugly-looking credit cycle,” Harrison says. “But loan losses are a lagging indicator, and that’s not useful for making money in stocks. Relative to the fundamental outlook on the economy and the quality of the institutions, bank stocks have been punished the worst. So, on a risk-adjusted basis, they offer the most upside.”

Money managers and analysts who are bullish on banks appear to fall into two distinct camps. Some prefer the stocks of those banks that are generally considered the strongest, with the most robust retail franchises: Royal Bank of Canada, Toronto-Dominion Bank and Bank of Nova Scotia. “They’re definitely ‘buys’ right now,” says Cornwall, “and [were] all along, in fact.”

The other camp prefers the growth potential of those companies that have faced more difficulties during the downturn and have taken steeper losses, specifically Bank of Montreal, Canadian Imperial Bank of Commerce and National Bank of Canada. “The right playbook for this point in the cycle is to buy cheap,” says Harrison, who also has positions in the stronger banks. “Valuation matters a lot.”

The contrarian view is that Canadian banks still haven’t faced the worst of the credit crisis and the downturn, and that clients would do well to sit on the sidelines. “With commodity prices collapsing and the housing market coming off quite fast, you have to expect that all the Canadian banks are going to have to raise their loan-loss provisions a fair amount over the next 12 to 18 months,” Nield says. “So far, they’ve taken writedowns, but against what their global peers have done, I think they’ve been a bit slow.”

> Insurers. Canada’s major insurers haven’t suffered the same degree of credit-related issues as the banks, but they’ve taken a substantial hit on their equities portfolios, forcing them as a group to raise capital to cover losses on their segregated funds and variable annuities.

“Several of the larger holdings are very equity-sensitive,” Jones says, “and, therefore, we are cautious on the subsector until we get a firmer idea that the market is going to rally.”

Money managers say the insurers are well managed and positioned to perform better in the future, particularly when the market rebounds. But they are staying on the sidelines for the moment.

> Asset Managers. Money managers have underweighted this category, as all the asset managers are contending with declining asset levels and lower revenue from fees. However, money managers say, asset managers are likely to lead the parade once the market rebounds. “The time to buy asset managers is when the level of redemptions starts to flatten out or slightly improve,” Nield says, “because that tells you that the asset bleeding has stopped. They could turn around in 2009; they tend to be early market movers.”

Adds Grestoni: “In a recovering market, the asset managers will outperform.”

> Distributors. Money managers are steering clear of distributors, for much the same reasons as for asset-management firms. “When markets are in decline, nobody wants to own these guys,” Jones says. “Therefore, we have avoided the sector.”

> Stock Exchange. As a group, most portfolio managers divested themselves of their positions in the TMX Group Inc. in 2008 or earlier. Although they agree that the stock exchange has good long-term prospects, TMX is considered an expensive stock that will underperform in the current downturn. “In retrospect,” Nield says, “it overpaid for the Montreal Exchange.”

> Holding Companies. Money managers are generally bullish on Montreal-based Power Financial Corp., which owns IGM Financial Inc. and Great-West Lifeco Inc. “Unfortunately, [Power] has just been caught up in the downturn,” says Nield, who admires the firm’s track record, diversification and quality of management. IE