Survival of the Fittest

02/23/2010 12:01 am EST

Focus: GLOBAL

Gavin Graham

Chief Strategy Officer, INTEGRIS Pension Management Ltd

Two Canadian life insurers look very attractive after weathering the downturn, writes Gavin Graham in The Income Investor.

The financial sector has recovered sharply from the lows seen in the first quarter of last year, with Bank of Nova Scotia (Toronto, NYSE: BNS) (aka Scotiabank) up 59%, Sun Life (Toronto, NYSE: SLF) up 36%, and Power Financial (Toronto: PWF, OTC: POFNF) up 32% from a year ago. However, the three stocks are still down from their prices three years ago, despite having weathered the worst financial crisis since the Second World War. 

Part of the reason is their exposure to the asset management business. The severe bear market reduced the fee-earning assets that drive the growth from this part of their business. As well, the market fall led to substantial switching of assets from higher fee-earning equity products into [less profitable] bond and cash products. 

Sun Life reported a third-quarter loss of C$140 million, although this was lower than the $396 million loss in the same quarter of 2008. The life insurer forecast that its operating earnings for 2010 would be in the range of $1.4 [billion] to $1.7 billion, compared with an average of $2.1 billion from 2005-07. 

Similarly, the purchase of Putnam Investments in 2007 by Power Financial's Great-West Life subsidiary led to a $983-million write-off. However, Great-West's third-quarter net earnings were actually up from $436 million to $445 million, although earnings per share were down from 48.7cents to 47.1 cents due to an equity issue. IGM (Investors Group), which is also owned by Power Financial, saw lower earnings of $167 million (63 cents a share), down from $199 million (75 cents a share) last year. 

Scotiabank's 2008-09 net profit was up from C$3.14 billion to $3.55 billion, showing the worst of the crisis had passed. But that was still below the $4 billion earned in 2006-07. Earnings per share at $3.32 is off almost 18% over the two years. 

However, as Kevin Choquette, the leading financials analyst at Scotia, has pointed out, if the worst that happens to a Canadian bank is that its return on equity falls from over 20% to 15% at the bottom of the credit cycle (as happened with Scotiabank), that is not a bad position to be in. 

The bad news is that it seems likely that the capital requirements under the new Basel II accord will mean Canadian banks will not be able to increase their dividends before the middle of 2011, so the temporary underperformance that we have seen from the bank sector after its strong rally from the lows in March last year may continue for a while.

Action now: Sun Life and Power Financial are Buys. Scotiabank is a Hold. 

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