Monday, March 31, 2008

Financials Rated 'Underweight' at RBC CM

RBC Capital Markets, 31 March 2008

Our strategist Myles Zyblock wrote a piece entitled Swimming Upstream in the River of Opinion on March 26. In it Myles argues that investors should start thinking about adding to equity holdings and that economic risk should decline in H2/08.

We are still not ready to sound the "all clear" signal on Canadian financials, nor is Myles who carries an Underweight rating on financials in Canada. There are names we cover, however, that could benefit from a rally in equity markets, but also have defensive characteristics that could keep downside risk reasonable if a market rally did not occur. These names are not necessarily the ones we believe could have the most upside in an equity market rally.

We believe that the following stocks in our universe could allow investors to play Myles' theme, without deviating from our cautious outlook:

• Manulife's insurance and wealth businesses have strong sales momentum, the company is well capitalized and well positioned to make an acquisition, and an equity markets rally could be positive for its segregated fund/variable annuity businesses.

• Industrial Alliance is well positioned from a credit risk and currency exposure standpoint, while margin improvements and sales growth are helping individual insurance value of new business. Stronger equity markets could help retail wealth management (approximately 30% of income).

• ING Canada is also well positioned from a credit risk and currency exposure standpoint, is cheap in our view given the quality of the company, and could potentially be a takeover target. Its investment portfolio is more exposed to equities than peers.

• IGM Financial's AUM is overwhelmingly comprised of equities, like its peers, and we are relatively positive on future sales given growth in the consultant channel. IGM does not have as much upside from a rally market as its peers, in our view, but is the safest name to own if markets are flat to down.

• Royal Bank's stock should benefit from solid domestic retail results, a diversified capital markets business and a strong capital position. Stronger equity markets could help the bank's industry leading asset management and retail brokerage businesses.

• We like TD Bank given its retail strength, expected earnings accretion from the Commerce acquisition and relatively lower exposure to wholesale businesses. Stronger equity markets/lower US economic concerns could be positive for US businesses.
Financial Post, 28 March 2008

As we head into first quarter reporting season for U.S banks, Merill Lynch analyst Sumit Malhotra has an interesting take on the relative value of Canadian bank stocks versus shares in their U.S. counterparts.

“On a market-cap weighted basis the Canadian banks now trade at 9.6 times [analysts’ earnings estimates for 2009,] a modest 4% premium to the 9.3 times multiple accorded to the large-cap U.S. Banks,” Mr. Malhotra notes.

“This differential is well-below the one-year (15%) and three-year (14%) averages, suggesting to us that the possibility of mean reversion exists as U.S. bank estimates continue to be revised downwards.”

U.S. banks are facing margin compression, slow balance sheet growth, weakening credit quality and liquidity concerns. Canada’s big banks, with their strong domestic retail franchises, also face margin pressure but are less concerned by the other factors likely to hit U.S. bank results this quarter.

The Merrill Lynch analyst says he is “not bullish” on Canadian banks in the near term. But with limited opportunities for profitable long trades in the banking sector, “a relative value trade” of Canadian banks over big U.S. banks “makes sense,” he says.
The Globe and Mail, Fabrice Taylor, 28 March 2008

Here's two cents worth of asset-backed advice for Canaccord's beleaguered ABCP investors: Don't fall for the Montreal gang's bluff. You'll get your money if you don't panic and keep agitating.

This is such an embarrassment of bungling and typical big bank behaviour that the odds are the big boys will dig deep and make this go away.

Canaccord's motto is "independent thinking." In a word, "huh?" The firm has 1,400 unhappy clients who bought non-bank asset-backed commercial paper on its advice. Some are suing. Rather than making its clients whole, Canaccord is digging in its heels, insisting it can't afford to and blaming Scotia Capital. Scotia sold Canaccord the paper that ended up with Canaccord retail clients.

But Canaccord's Dept. of Thought isn't looking terribly independent. In its court filing, it basically says Scotia should have warned it that this paper was risky, or getting risky, because Scotia knew. That is quite possible. But Canaccord could have known too.

The main point of contention is an e-mail sent last July by Coventree, which sponsored the ABCP trusts in question. The e-mail was sent to Coventree's sales agents, including Scotia, and revealed that there were subprime assets in the trusts, although the percentages ranged.

A couple of weeks later, Scotia sold Canaccord another pile of paper from its inventory, most of which the brokerage placed with clients. Within days, that paper seized up and some clients face losing their homes.

Canaccord contends that Scotia had material information about the trusts and that had it shared this information, it would never have bought and placed the paper. Scotia says the information in the e-mail was incomplete and therefore not material.

Really? It was important enough that Royal Bank stopped selling Coventree paper, and CIBC stopped trading it. Point Canaccord.

That said, Canaccord had access to the list of assets the trusts held. Furthermore, Standard & Poor's published a research report in 2002 called "A leap of faith," which described the huge risks of owning non-bank ABCP. Canaccord tells me it wasn't aware of the report until after the market seized up last summer. Point Scotia.

I also asked Canaccord why, with a 5-per-cent share of the retail brokerage market, it has an 80-per-cent share of retail clients stuck with ABCP. The firm argues that this is only because other dealers have made their investors whole, buying the paper back. Other than National Bank, no big bank has acknowledged this (or denied it).

But to look at Bank of Nova Scotia's balance sheet, it doesn't seem to have had to buy back much paper from its clients. Scotia had $144-million of non-bank ABCP on its books, after having taken writedowns of about a little over $100-million. Some of that paper may have been bought back from clients directly, but there's also the possibility that some was bought from money market funds and yet more was inventory the bank couldn't move once the credit crunch hit. If Scotia did buy paper back from clients, it would probably be less than these figures suggest. Maybe a lot less.

And maybe it didn't have to buy back any because it didn't sell its clients any. Scotia was not only an official seller of Coventree paper, it also made money selling assets into the trusts. It was certainly familiar with some of the stuff backing the notes.

While the bank claims there's a Chinese wall separating the bank, which would have sold assets to Coventree, and the brokerage, which would have sold Coventree paper, the fact is that the institution's chief risk officer is responsible for the entire organization, brokerage and bank. So much for that Chinese wall.So while Canaccord's total exposure is disproportionately huge at about $300-million, it's hard to argue Scotia can't take any credit for that, having smartly moved a lot of its own inventory into the Canaccord selling chain.

As for why Canaccord was so eager to sell this paper, it's hard to know. It wasn't money. The firm insists it made no money selling the paper to its clients, that it was a service. What's obvious is that, whether hoodwinked by a self-interested bank or not, it should have known.

As for Scotia? It's role in this will come out in time.

But investors shouldn't have to wait. Purdy Crawford says retail investors are now his priority. And while he makes noises about how they should take a deal that involves getting paid back, hopefully, over a few years, I say don't.

First, you're not likely to get full recovery on your money. Second, why should you wait? To make retail investors whole will cost the Montreal Accord players nothing. Canaccord is willing to pay a big chunk of the penalty. The rest is chump change to the players. The only question is optics.

So keep embarrassing and threatening. They'll do the right thing soon enough.