18 March 2009

Dundee Capital: Long Insurance Cos & Short Banks

Financial Post, Jonathan Ratner, 18 March 2009

Go long on Canadian insurance companies and short on banks. That’s the advice from Dundee Capital Markets stragetist Martin Roberge, who says this recommendation is mostly a valuation call.

“With Canadian banks facing a technical roadblock, and lifecos deeply oversold and undervalued relative to banks, we believe the time has come to initiate a pair trade between the two groups,” he told clients.

Lifecos have deeply underperformed banks over the past six months as concerns about their hedging strategies on segregated funds and guaranteed notes weighed on market sentiment. The group has rebounded more than banks since the March 6 low, but at this stage in the stock market rally, Mr. Roberge believes that lifecos offer more upside potential – or lower downside risk.

If we are in fact past the worst point in the financial crisis, the strategist insists lifecos are too cheap relative to banks. He points out that lifecos trade at a 30% discount to banks on a price-to-book value basis. The lifeco group also has a higher dividend yield than banks for the first time in history.

“The last time that such depressed valuation metrics were seen was prior to the 2001 recession when investors became concerned about the economy,” Mr. Roberge said.

From a technical perspective, he noted that the Canadian bank index has ralled back to its 100-day moving average, which acted as an important roadblock in this bear market.
Financial Post, Levi Folk, 16 March 2009

The last bastion of safety for bank dividends has to be with Canadian banks. The economic recession is laying siege to their gates, but so far dividends are intact and will remain that way according to a recent report by Canaccord Adams – assuming the “poor earnings” scenario does not last into 2011.

The US$1.1-billion payout to Bank of Montreal by the U.S. government in the wake of the AIG bailout is evidence that BMO took in at least one Trojan horse when it bought credit default swaps from the insurer. If it wasn’t for the U.S. government, those dividends indeed may have been cut.

The Canaccord report relays conversations with the CFOs of the five banks (CIBC to come) with focus on banks’ capital. The conclusion is that dividends and banks’ capital ratios hold up well under stress testing – a major earnings recession in 2009, for example.

In the case of RBC, Tier 1 capital would apparently fall from 10.6% to 9.7% were earnings to evaporate as happened in the early 90s recession. This is the end of the story for report authors Nick Majendie and Melanie Jenkins given the regulatory requirement for banks to maintain Tier 1 capital of 7%. That factor and added capital raisings from DRIP programs means dividends should are intact assuming the recession ends this year.

Tell that to investors in Citigroup who have completely lost faith in U.S. banks. Citigroup cut its dividend to a penny on acceptance of government money in January despite a Tier 1 capital ratio in near 12%.

There is also the burning question of the duration the current recession. Bank of Canada governor Mark Carney sees a big snap back to growth in 2010. His U.S. counterpart, Ben Bernanke has warned the recession could last into 2010. For Canadian bank dividends, the outcome is highly optimistic, but the jury is still out.