Wednesday, February 08, 2006

4 Cs: Cdn Banks or Insurers?

The Globe and Mail, Sinclair Stewart, 8 February 2006

Remember last year? Remember how the banks issued meagre profit forecasts, and how their investors suddenly got nervous, fearful that the benign credit cycle was about to turn on the industry with a vengeance? If you do, you're either a) kicking yourself for betting against the Big Six, or b) tallying your gains with a grin of self-satisfaction.

On average, the group has posted a total return of more than 27 per cent over the past 12 months, a combination of stock price appreciation and dividend payouts. Compare that to the healthy 17 per cent recorded by the country's life insurers, who begin reporting their year-end financial results tomorrow, and you get a sense of just how well the banks performed.

The question confronting investors now, particularly those who want to keep a foot in the financial services sector, is whether the banks can keep it up. There are several factors anyone should consider when trying to make a choice between banks and insurers, but the primary ones for 2006 can be boiled down to a handful we'll call the "Four Cs": credit, currency, capital and consolidation.

Credit: Easily the defining issue in financial services today. Banks have fattened their bottom lines on the credit cycle gravy train over the past couple of years, taking advantage of the unusually sunny lending environment to slash provisions for soured loans and even claw back some of this money through reversals. It is one of the major reasons the banks did so well in 2005, but there were signs toward the end of the year that the credit luck is running out. That should be good news for insurers, relatively speaking, who continue to add to reserves during bright spots in the credit cycle. The result? Banks will have to raise their provisions when things go bad, while insurers won't -- at least, not to the same extent.

"At the beginning of a rough patch, insurers outperform banks in a material way," explained Mario Mendonca, an analyst at Genuity Capital Markets. "If you can pick that quarter, somewhere in 2006 or even 2007, where investors become convinced that credit has started to deteriorate, that's the time to pick the insurers." Mind you, there could be arguments for jumping on board earlier. Advantage: Insurers.

Currency: The strong Canadian dollar may be nice for exporters, but it's plain lousy for insurers. Manulife Financial Corp. and Sun Life Financial Inc., both of which have substantial U.S. operations, have been hurt by the loonie's continued rise over the past two years, but some, like National Bank Financial Inc.'s Robert Wessel, predict that the currency issues are largely behind the sector. If you're bearish on the prospects of a significantly higher Canadian dollar, then it's one more reason to like the insurance sector. Advantage: Insurers.

Capital: Insurers would appear to have many more options for spending their cash on expansion or acquisitions because of their international platforms. The banks, however, have notably higher dividend payout ratios, and there is a chance -- even if considered slim by many -- that they could meaningfully increase their dividends in light of Ottawa's recent shift in tax policy. Advantage: Toss-up.

Consolidation: The big question mark. A Conservative majority would have given bank shares a nice nudge, especially perennial takeover targets Bank of Montreal and Canadian Imperial Bank of Commerce. But any potential advantage has evaporated with the Tory minority. Advantage: Toss-up.

Bottom Line: On fundamentals, insurers look to have the momentum. Their share profit growth in 2006 and 2007 is expected to be in the low double-digits, a few percentage points higher than the banks, where profit is vulnerable to a deterioration in the credit climate. Banks are also flirting with record high valuations.

The real trick, though, is assessing the macro factors: Picking a winner between banks and insurers will boil down to forecasting currency moves, and predicting when the kindly credit cycle finally shows its teeth.