Ruth Saldanha: Banks and financial services are extremely important to Canadian investors. Today, we have Sam Baldwin, Senior Portfolio Manager at Guardian Capital, here to discuss his rather unusual stance on financial services. Though he has 30% of his portfolio in the sector, he doesn't hold any banks.
Sam, thank you so much for joining us here today.
Sam Baldwin: I'm really happy to be here. Thank you.
Saldanha: Why do you not hold any banks in your portfolio right now?
Baldwin: In our process, we regard the banks to be high-quality companies. Where we might have a unique opinion possibly is that we believe in our process that there are risks worth factoring in relating to valuation and cyclical risks. So, specifically, with regard to valuation, the loan losses that have been experienced in the Canadian banking system have been very low for quite some time now. And so, there's continued expectations for that trend to continue. But when you normalize the amount of loan losses to sort of a mid-cycle level, then the banks look a lot less cheap.
So, the second thing we do from a risk perspective is to think about what would it mean for the Canadian banking sector to go through a genuine credit cycle. And this exercise really involves broadly speaking investigating three different fundamental drivers. So, one would be in a genuine credit event you would have higher loan losses. We touched on that. You would probably also have a reaction from the central bank to cut rates to stimulate the economy and lessen the blow from the credit cycle and that would have a possible narrowing effect on the banks' net interest margins which would crimp profitability and capital growth and the like.
And the third thing to think about would be if we are in that sort of environment where loan losses are stacking up, the central bank is aggressively fighting against that by cutting interest rates, you'd probably see markets not performing well. And so, the wealth management businesses, which have been growing over the past decade quite substantially, would have compression in profitability because markets would be at lower levels and they charge a fee on assets. Whereas most stress tests that focus on one of those components make the banks look fine. If you are focusing on stressing those three elements at the same time, then it looks a lot less fine. And so, what we would look to do is invest in banks, and our banks are high-quality banks, at a time when expectations are lower and when the bank valuations are more attractive than they are today.
Saldanha: So, if not banks, where do you see value in financial services right now?
Baldwin: So, we do have a significant weight in financials within the portfolio. The largest chunk is actually in the insurance sector. So, specifically, property and casualty insurers not the life insurance companies. And we quite like the property and casualty insurers that we found in Canada, there's two larger-cap high-quality names, Intact Financial (IFC), and Fairfax Financial (FRFHF). These companies are able to produce defensive growth. They are both properly run, good insurance operations. And also, one of the attributes of the property and casualty industry is that their profitability cycle doesn't march in lockstep with the general economy. So, they provide diversification in terms of their cyclicality being different timing than larger parts of the rest of the portfolio. So, they are high-quality growing companies, but they have also the attribute of marching to a different drumbeat when it comes to cyclicality. So, they are good diversifiers.
Saldanha: Thank you so much for joining us with your perspectives, Sam.
Baldwin: Thank you, Ruth.
Saldanha: For Morningstar, I'm Ruth Saldanha.
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