Opportunity fades in financials rally

One of the largest and most vigourous rallies in equities — financial services stocks — appears to have largely run its course.

Financial services was the hardest hit sector of the downturn; in a number of cases, investor sentiment seemingly left the sector for dead. As economic prospects and earnings expectations have bounced back slightly, valuations of the stocks have skyrocketed almost across the board.

Last month, the Morningstar Financial Services Equity Fund Index posted a 9.8% gain during the month of July alone, indicating clients may be feeling confident about the sector again. The problem is, with the exception of asset management companies, there is a growing consensus that the bulk of the money to be made from financial services recovery has been made.

The banks

The most widely held financial stocks, large Canadian banks, are essentially viewed as being fairly valued by analysts and fund managers.

“With an economy that looks as if it might be on the recovery, we actually view the banks being fairly valued, if not a little overvalued. This is largely because on a forward price-to-earnings (P/E) ratio, the banks are getting close to cyclical highs in an environment where earnings are still under pressure and really quite volatile,” says John Aiken, vice-president and senior analyst of financial services for Dundee Capital Markets. “Looking out at 2010 or 2011, I think it’s irresponsible to begin to forecast very strong growth, given the fact that we still don’t know what the impact of rising unemployment is going to have on long-term income growth.”

According to Aiken, the banks just don’t have the capacity to earn revenues that would outpace their current P/E ratios, thus making them an attractive bargain.

“First off, profitability of the banks is going to come under pressure largely based on the fact that the capital raises hit the bottom line, either in the form of preferred share dividends or the dilution of return of equity (ROE) or earnings per share on common equity,” he says.

Stricter regulation is going to make it more difficult for the large banks to orient their business models to rapidly changing business conditions on their high-margin equity-trading businesses.

“The banks are not going to be nearly as agile as they have been in the past. All of this leads us to believe that ROE for the banks is going to be lower than it has been in the past years. A 20% ROE is going to be very hard to achieve over the next few years,” he says.

Aiken does see reduced funding costs for the wealth management division of the banks as it derives a larger share of its earnings from lower-cost deposit products such as GICs and renewed interest in mutual funds. These products don’t bring in the same margins as the equity side of that business.

“In trying to maintain their capital ratios, the banks are reducing risk; one of the easiest ways to do that is to lower lending levels. We question in the near term — over the next 12 months — whether we’re going to see pressure on net interest income,” he says. “Even though funding costs are lower, you’re also not getting interest income coming in to the same degree.”

Dividend stock specialist Juliette John, a senior vice-president and portfolio manager with Bissett Investment Management, says she also sees the banks as fairly valued.

“Some of the banks have been really successful in terms of their trading revenues, and that has supported a lot of their earnings,” she says. “As we look forward, a lot of the movement in the share prices really takes that into account. We have seen the share prices move quite significantly, and perhaps they are fully valued based on our expectation that we’re unlikely to see further material improvement in trading revenues. We still see a lot of headwinds from a credit perspective going into the second half of 2009.”

Bank stocks do, however, still offer relatively stable and historically high dividend yields, which she doesn’t see being cut.

“We tend to see the banks as more of a mature business that has a steady earnings stream that can be relied upon. We do think that dividends will continue to be an important part of how banks reward shareholders. We’re not likely to see a lot of dividend growth in the near term,” she says. “The dividend yield for the banks is around 4.25% over the entire bank group, and that compares to the index, which is 3.1% or so. So there is still a good cushion of yield support for these securities relative to the index. That will continue to play a role in why people hold them.”

Insurers

The large Canadian insurers have seen a similar run-up to the banks, although the security of their dividends has been called into question after Manulife slashed its dividend in half.

Again, the asset class is viewed as being essentially fairly valued, according to John. Insurer valuations are closely tied to equity markets right now. The companies have had to set aside large swaths of capital to cover off guarantees on their wealth products. As equity markets rise, there will be less pressure on their capital reserves.

John points out that these are not “repeatable” earnings. The rest of the earnings expectations for insurers are viewed to be stable but relatively conservative.

“We’ve seen Sun Life and Manulife report their earnings. On a core earnings basis, I think the numbers were a little bit disappointing. With the huge recovery in earnings and equity market values that we’ve seen, there are a lot of areas where they are able to boost the reported earnings, but it’s not core repeatable numbers,” she says. “They continue to grow in insurance as well as international business. I think there will still be growth in wealth products going forward, but the growth is going to be lower.”

Read: As insurers report profits, Manulife cuts dividend

Asset managers

Asset management companies may offer a little bit more upside opportunity in valuations.

Robert Almeida, senior vice-president and portfolio manager on the AIC Advantage Fund, has seen stellar returns in the financial services rally of the last quarter, with the fund up more than 31% in the last quarter. He’s bullish on asset managers, which, he says, have leveraged earnings potential directly correlated to the returns of the markets.

“Asset manager revenues are a percentage of assets under management, so for every 10% of that market decline, their revenues dropped 10% — and that just eats into profitability. In order to survive, asset managers cut a lot of cost.”

Almeida says the ability to grow assets at a lower cost base means the margins on profits could actually be higher for each proportional increase in assets they see.

“If assets go up, costs don’t go up at the same rate. Asset growth and revenues do go in lockstep. Profitability goes at a multiple of that. There is a very significant operating leverage that kicks in on the asset manager side during a recovering market,” he says. “The best example I can give you is that most recently, Invesco, which owns Invesco Trimark, reported that its assets under management grew 12%. Its operating income grew more than 70%, so it was able to deliver a six-times leverage factor on the last quarter. Markets still have room to continue to move up a lot. The leverage in front of asset managers means there is still significant upside in the asset management segment.”

Aiken is not so sure whether there’s a lot more room to grow in the earnings over the near term.

“On a relative basis, their valuations have actually been hit more negatively than the banks have, so they have rebounded a lot stronger. The same argument holds for the asset managers,” he says. “Their valuations are at a point in which, even though we like them better than the banks, they are probably approaching a fair value level.”

(08/06/09)