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.
\u201cAs a general rule, financials lead the market down into a bear market, and financials lead the market back up,\u201d says Dale Harrison, head of Canadian equity research with Vancouver-based Phillips Hager & North Investment Management Ltd. <\/b> \u201cThese are extremely high-quality companies that are cheap, and they rank among the most desirable stocks one can own.\u201d
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\u2019s rocky period will stretch well into 2009. It\u2019s almost certain, for example, that the country\u2019s 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 \u2014 at least, for the time being.
And there is very likely a lot more pain to come this year. \u201cThe Canadian banks haven\u2019t really felt the pain that their global peers have,\u201d says Richard Nield, a portfolio manager with Invesco AIM<\/b> in Austin, Tex. \u201cSo, I wouldn\u2019t be surprised if there\u2019s 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.\u201d
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. \u201cI feel that at some point in the second half of 2009, some of the bank stocks will start looking interesting again,\u201d he says. Some of the Invesco Trimark Ltd. <\/b>funds Nield manages are underweighted in financial services, particularly banks.
There\u2019s 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,
\u201cIf you don\u2019t think the world is going to end, you\u2019ve been given the opportunity of a lifetime to lock in yields of 7%, 8%, 9%,\u201d says Dom Grestoni, senior vice president and portfolio manager at I.G. Investment Management Ltd. <\/b>in Winnipeg. \u201cAnd you\u2019re going to get some tax efficiency out of those yields.\u201d
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. \u201cWe\u2019re the envy of the world,\u201d Grestoni says, \u201cin terms of embedded potential.\u201d
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\u2019 equity. \u201cThere\u2019s probably a lot of room to recover those paper losses,\u201d says Robin Cornwall, president of Toronto-based Catalyst Equity Research Inc. <\/b> \u201cBanks and insurers can be long-term holders of things.\u201d
@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. \u201cWhen the move back into financial services comes, it will make your head spin,\u201d Harrison says. \u201cWe could see a 40%-50% rise in stock price in a two-week period.\u201d
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\u2019s happy to own the stocks through the rough patches. \u201cWe don\u2019t know when it\u2019s going to happen,\u201d he says. \u201cSo, we don\u2019t want to be cute, in terms of waiting to step in. One day, we\u2019ll wake up and the rally will have started.\u201d
Money managers caution that there\u2019s also some risk that the recession, both globally and in Canada, will be more severe than expected. \u201cIf we see the global economy continue to decline at such a rapid pace, then, in reality, nothing is safe,\u201d says Shane Jones, managing director of Canadian equities and senior portfolio manager with Toronto-based Scotia Cassels Investment Counsel Ltd. <\/b> \u201cThat could drag Canadian banks down further.\u201d
Much rests on whether the efforts over the past year by governments worldwide to get capital moving again are successful. \u201cIf they do start to work, we\u2019ll be in better shape,\u201d 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\u2019 corporate bonds, which are offering attractive yields. (See page B18.)
Those clients who don\u2019t 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\u2019s 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. <\/b>Money managers agree that 2009 will be difficult for the banks but not disastrous. \u201cWe think it will be an ugly-looking credit cycle,\u201d Harrison says. \u201cBut loan losses are a lagging indicator, and that\u2019s 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.\u201d
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<\/b> and Bank of Nova Scotia<\/b>. \u201cThey\u2019re definitely \u2018buys\u2019 right now,\u201d says Cornwall, \u201cand [were] all along, in fact.\u201d
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<\/b> and National Bank of Canada. <\/b> \u201cThe right playbook for this point in the cycle is to buy cheap,\u201d says Harrison, who also has positions in the stronger banks. \u201cValuation matters a lot.\u201d
The contrarian view is that Canadian banks still haven\u2019t faced the worst of the credit crisis and the downturn, and that clients would do well to sit on the sidelines. \u201cWith 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,\u201d Nield says. \u201cSo far, they\u2019ve taken writedowns, but against what their global peers have done, I think they\u2019ve been a bit slow.\u201d
> Insurers. <\/b>Canada\u2019s major insurers haven\u2019t suffered the same degree of credit-related issues as the banks, but they\u2019ve 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.
\u201cSeveral of the larger holdings are very equity-sensitive,\u201d Jones says, \u201cand, therefore, we are cautious on the subsector until we get a firmer idea that the market is going to rally.\u201d
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. <\/b>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. \u201cThe time to buy asset managers is when the level of redemptions starts to flatten out or slightly improve,\u201d Nield says, \u201cbecause that tells you that the asset bleeding has stopped. They could turn around in 2009; they tend to be early market movers.\u201d
Adds Grestoni: \u201cIn a recovering market, the asset managers will outperform.\u201d
> Distributors. <\/b>Money managers are steering clear of distributors, for much the same reasons as for asset-management firms. \u201cWhen markets are in decline, nobody wants to own these guys,\u201d Jones says. \u201cTherefore, we have avoided the sector.\u201d
> Stock Exchange. <\/b>As a group, most portfolio managers divested themselves of their positions in the TMX Group Inc. <\/b>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. \u201cIn retrospect,\u201d Nield says, \u201cit overpaid for the Montreal Exchange.\u201d
> Holding Companies. <\/b>Money managers are generally bullish on Montreal-based Power Financial Corp., <\/b>which owns IGM Financial Inc. and Great-West Lifeco Inc. \u201cUnfortunately, [Power] has just been caught up in the downturn,\u201d says Nield, who admires the firm\u2019s track record, diversification and quality of management. \tIE<\/b>
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