As a follow up to my article Canadian Banks: Is Now The Time To Get Out While You Still Can?, this article will carry forward and build a solution to some of the comments that were put forward by some SA readers. One of the questions put forward by a reader was, "If you're advocating getting out of CDN banks, where do you recommend the CDN investor place his money"?
I am a big fan of offering suggestions to problems, and offering a deeper exploration of my opinion and thought process. What I will try to avoid, is saying short this, but then offer no long position alternative if one exists. After all a pair trade is not such as bad strategy to deploy as part of an overall investment toolbox. My reply in the previous article was that I find that the big Canadian insurers are a better play than the big five Canadian banks, and this article will articulate that argument.
The Canadian Insurers that will be analyzed herein are Sun Life Financial, Inc. (SLF), and Manulife Financial Corporation (MFC). I will not be analyzing industry peers Great West Lifeco In (GWLIF.PK), Power Financial Group (POFNF.PK), and Industrial All & Ins (IDLLF.PK).
Many Investors in the "Big 5" Canadian Banks—Royal Bank of Canada (RY), The Bank of Nova Scotia (BNS), BMO Financial Group (BMO), Toronto-Dominion Bank (TD), and Canadian Imperial Bank of Commerce (CM)—consider a long position a good investment, based on the criteria of dividend yield, the perceived stability, oligopoly (the moat), and the age of these banking businesses. The preceding criteria generally holds true, and are good criteria nonetheless, but that doesn't mean that there might not be a better choice. For example, the following dividend yields for the group are: Royal bank of Canada, 4.45%; Toronto-Dominion Bank, 3.67%; The Bank of Niva Scotia, 4.20%; Canadian Imperial Bank of Commerce, 5.08%; versus Sun Life Financial, 6.5% and Manulife Financial Corporation, 4.87%.
Right off the bat, the reader will note that Sun Life Financial has the highest dividend yield, and that Manulife Financial, even after cutting its dividend by 50% over 09-10 period, still remains on par with the group. Yes, a high yield can mean potential distress, and yes dividend cuts are not good. However, with that said, the insurers have had a history of consistently raising dividends just like the banks, and Sun Life Financial has not had to cut its dividend thus far. I cannot think of a more difficult time for insurers to go through than now, so Sun Life Financial not having to cut its dividend shows strength. Because of the temporary distress, there should lie the potential opportunity.
Consider that a low interest rate environment is one of the worst case scenarios for insurers, and for pre-contracted insurance annuities. Sun Life Financial has already adapted by getting out of this part of the business in the US. Moreover, there are other parts of the insurance business that present a good business model. Consider the fact that most benefits plans run positive metrics for the insurers; if not, they simply raise your premiums until it works for them! Furthermore, consider that people are living longer, and the second largest growth in an age cohort is over 100. This translates to less payouts, in policies that are not whole life products, such as term life insurance. There is also the segregated products, that are separate from regular investment funds, and offer advantages over traditional products but charge higher MERs. One such advantage is that segregated funds are an insurance product not a regular mutual fund, and they can be used to by-pass probate in Canada as an example.
I personally like that insurance is a simple business to understand, and has a steady residual stream of premiums. In my opinion, I feel that it is easier to offer insurance, or to joint venture in the emerging markets, then it is to setup banking business (sans The Bank of Nova Scotia). This comment is supported by this recent article about SLF teaming up for operations in Vietnam. With the rising incomes, and the emergence of the middle class in these markets, it should translate to growth for insurers like Sun Life Financial.
As for regulation and oligopoly, the argument and the support exist in which the Canadian insurers have just as much, or more regulation as the Big 5 have. In fact, Canadian insurers are only allowed to invest in the higher quality investment grade securities. This is good, when you see that the insurers are trading at/or below book value, as there is some comfort knowing that the below book value holdings are of high quality. On the subject of book value, compare that Sun Life Financial is at a P/B of 1.0 against Manulife Financial at 0.8, versus a P/B of Royal bank of Canada, 2.0; Toronto-Dominion Bank, 1.7; BMO Financial, 1.4; The Bank of Niva Scotia, 2.0; and Canadian Imperial Bank of Commerce, 2.0. One could make the argument that you are over paying for the Big 5 versus the insurers simply based on P/B.
As a long-term income holding, I feel as though the insurers present a good play. Furthermore, I do feel that a larger potential for capital appreciation exists with the insurers, and less downside versus the Big 5 banks. Some of the banks' risks were detailed in the previous article, which I encourage to be read. Most if not all of this group of equities offers some form of DRIP discount as well (at least to Canadians), which is always a nice feature for long-term investors. A good strategy may be to DCA through any continued present volatility, knowing that eventually the status quo of the low rate environment will change.
Disclosure: I am long SLF.