Canadian equities roundtable: Part 2

How the insurance giants measure up

Sonita Horvitch 20 April, 2011 | 6:00PM
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In today's second instalment of this week's Canadian equities roundtable, which focuses on the non-resources sectors, three value managers continue their discussion of financial-services stocks before turning to telecommunications.

The participants: Kim Shannon, president and CEO of Toronto-based Sionna Investment Managers Inc.; Mark Thomson, managing director and head of research at Beutel Goodman & Co. Ltd.; and Ian Hardacre, vice-president and head of Canadian equities at Invesco Trimark Ltd.

They spoke with Morningstar columnist Sonita Horvitch, whose three-part series began on Monday and concludes on Thursday.

Q: Let's talk about other players in the Canadian financial-services sector.

Shannon: On a relative basis the insurers are cheaper than the banks, and we tend to have more exposure there. We have Intact Financial Corp. IFC. We have been taking profits on it. We have also been taking profits in TMX Group Inc. TMX.

Thomson: Our insurance holdings include Manulife Financial Corp. MFC and Sun Life Financial Inc. SLF.

Hardacre: Brookfield Asset Management Inc. BAM.A was our largest financial-services stock until the middle of 2010. It is no longer so. It got closer to our price target and there were better opportunities elsewhere. It is still in the portfolio, but no longer in our top 10.

Kim Shannon

Q: Time to talk more about Manulife, which is under a cloud.

Hardacre: It is an intriguing stock. Investors are skeptical. They are focusing on the company's exposure to markets, equities and interest rates. We like Manulife's underlying businesses, particularly its operation in Asia. Over time, there will be more focus on Manulife's earnings power, which is higher than the Street is giving it credit for. Manulife can earn $2 or $2.50 per share in a few years. The estimate for 2011 is $1.70 per share. These estimates move around. Manulife is our core insurance holding. Its return on equity is not going to be what it was. Those were different times.

Shannon: We did not own the stock until Manulife cut its dividend and the stock got pretty cheap. It showed up really well in our models. The company is reducing its risks. We like the current management. The reason why we did not own it previously is because it was aggressively managed. Now we know the negative outcome of that. For a long time, I avoided Manulife because it was so aggressively managed, to my detriment. It appeared that the previous management was good at managing risk, until it was not. The new management team and the board are unlikely to permit the company to be exposed to those kinds of risks again. This has an appeal to investors like us.

Mark Thomson

Thomson: We are overweight financial services and more overweight insurers than we are the banks. A big weighting in the Canadian equity portfolio is Great-West Lifeco Inc. GWO. We own about 10 million shares. We are the largest investor in this company, outside of the Power Group, of which it is part. Great-West is a great business, great management. It has been hit seriously short-term by the impact of the strong Canadian currency on its large foreign operations, a currency-translation problem. Its business is growing. It is a conservative manager of its cash. It has a high dividend-payout ratio, which also establishes discipline. It is almost 4% of our portfolio. It is under-followed.

Shannon: I also own it. Depending on the fund, we own Great-West Lifeco, IGM Financial Inc. IGM, Power Corp of Canada POW and Power Financial Corp. PWF. It is a good-quality management team, which is a good capital allocator. Great-West Life is the gold standard. During the financial crisis, it produced reasonably steady and stable results.

Thomson: Why do I like Manulife? Almost one third of its business is in Asia, which has been growing at 10% per annum over the last decade or so. Japan is going to slow down. It has a decent business in Canada. Its big problem is its U.S. business. This has a wealth-management component, which has held its own and continues to do well. Then there is its variable-annuity business, which was the problem. It is well positioned in its U.S. insurance business. It will grow its U.S. wealth management and insurance business to compensate for the capital it tied up in the variable annuity business. The earnings-per-share estimates for Manulife are too low. It also has excess capital of about $5 per share. The question is: How is that going to be reinvested?

Shannon: Manulife was the only player that was not hedging its variable-annuity exposure.

Thomson: Yes.

Hardacre: Clearly it worked, until it did not.

Q: Moving on to the telecommunications sector, which is a modest 4% of the composite.

Thomson: We have a big overweight in this sector.

Ian Hardacre

Shannon: I have Telus Inc. T, BCE Inc. BCE and no Rogers Communications Inc. RCI.B. We were zero-weight the telecom sector for most of the past decade, in the aftermath of the technology mania. We sold BCE at $45 a share, the stock was overpriced and was so until about two and a half years ago. With the CRTC allowing new entrants, the sector got cheap and we started entering it. Now we are overweight telecom. It is a nice defensive play to have in a volatile, risky market. A stock like BCE has a pretty decent expected return and it has a 5.6% dividend yield, which we feel is sustainable. Its land-line business is in decline. The market has priced that in now. Wireless has been offsetting this, but it is competitive and less profitable. Telus is probably a better-quality company than BCE. But we have more of a tilt toward BCE, which has the cost-cutting capability.

Hardacre: We do not own any telecom stocks. We had a big position in Telus last year and it hit our sell price. It was one of our largest holdings. Telus, BCE, Rogers and Shaw Communications Inc. SJR.B are all well managed. It is a question of the valuation on these stocks, for us. Even though these stocks have good dividend yields, I do not see much upside in them, relative to what else we can own.

Thomson: We really like the telecoms. They offer similar total returns over a three-year time horizon as the banks. I will include Quebecor Inc. QBR.B, which is technically not in the telecom group, but which we consolidate with the group. It is probably the best-run cable company in North America. It trades at a ratio of enterprise value to EBITDA, (earnings before interest, taxes, depreciation and amortization) of five times. It is probably worth double that. We have a big weighting in Quebecor at 3.5%; we own more than 10% of the company. It is well positioned in Quebec on the wireless side.

We also have a big weighting in Telus at 5.5%. It trades around 5.5 times EBITDA. It is probably worth around seven times. It has good free cash flow now. Historically, its expenditures have been high. It now has religion as far as cash flow is concerned. The third holding is Rogers, which has a cheap valuation. There are some costs to be taken out. The market is ignoring this stock, which has done nothing for the last two years. It has great dividends. We do not own BCE.

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Sonita Horvitch

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