3 best financial stocks to buy

Toronto-based Desjardins Capital Markets analysts Doug Young and Gary Ho name their ‘top picks’ from the Canadian financial sector for 2019—an insurance company, a bank and an alternative credit services provider.

Desjardins Capital Markets’ analysts pick their three favourite financial stocks for 2019.

Looking back on the Canadian financial sector in 2018, the life insurance companies lagged the bank stocks, contrary to our call, while the asset managers underperformed both. Desjardins Capital Markets’ financial sector ‘top picks’ this year are Sun Life Financial Inc. (TSX—SLF; NYSE—SLF) (life insurers, or lifecos), Toronto-Dominion Bank (TSX—TD; NYSE—TD) (banks) and Alaris Royalty Corp. (TSX—AD) (alternative lenders and credit services).

For Canadian bank stocks, the focus in fiscal 2019 will be acutely on credit and whether we finally see credit trends start to turn, given we are arguably in the late stages of the credit cycle and household debt levels are elevated.

Otherwise, net interest margin (NIM) expansion should continue (partially offset by deposit betas and increased competition in the commercial segment), and we believe the banks will further reduce expense ratios in order to offset slowing loan growth.

For the insurance companies, a sustained increase in 10- and 30-year bond yields would be favourable, and we see a few catalysts that should drive core earnings per share (EPS) growth; however, sentiment could be negatively impacted if equity market volatility remains elevated.

For the credit services and asset managers, we expect industry net flows to be flat-to-slightly higher than in 2018, ETFs to continue their momentum, and investors to pay greater attention to both alternative assets and expense management.

Sun Life top insurance, wealth management stock

There are four drivers behind our positive views on Toronto-headquartered insurance and wealth management company Sun Life Financial.

First, we anticipate core EPS growth of nine per cent in 2019 (in line with management’s medium-term EPS growth target of eight per cent to 10 per cent), driven by US group insurance, Canadian operations (including expense actions), getting to scale in more Asian markets, and capital deployment.

Second, the company has about $4.1 billion in excess capital and debt capacity, by our math. This includes $2.2 billion of excess holding company cash, $900 million of excess operating company capital assuming a 125 per cent LICAT (Life Insurance Capital Adequacy Test, a measure used by financial regulators) ratio and roughly $1 billion in debt capacity, assuming a 25 per cent debt-to-capital ratio.

It also generates about $800 million of excess capital a year net of dividends and funding organic growth. If this is put to work, core EPS growth could surpass our forecast. And we believe SLF could buy back about $800 million of stock in 2019, which at the current stock price equates to roughly three per cent EPS accretion.

Third, we acknowledge subsidiary MFS (formerly Massachusetts Financial Services) net flows have been hurt by certain popular funds being capped, along with a shift to passive (versus active) strategies as well as a shift to fixed income (from equity) mandates.

To cut to the chase, MFS remits between $400 million and $500 million of cash to SLF annually, and even if earnings flat-line, management believes the eight per cent to 10 per cent medium-term EPS growth target is achievable.

Fourth, we believe SLF has the most attractive Canadian insurance franchise of the group.

We set a target share price of $58 for Sun Life.

TD has room to grow and acquire

There are five drivers behind our positive view on TD. First, we like its scale in Canadian personal and commercial banking, with the opportunity to build market share in certain areas such as commercial lending (currently No. 3) and mortgages (currently No. 2). Of note, TD has about 22 per cent of all demand and notice deposits in Canada, a strong tie to consumers.

Second, in our view, Toronto-headquartered TD has high-quality franchises in Canada and the US (both in terms of personal and commercial banking as well as wealth management).

Third, it offers higher relative exposure to US markets compared to its Canadian peers.

Fourth, it has lower exposure to capital markets versus peers, a business we believe should command a lower valuation multiple.

Fifth, it has the highest CET1 ratio of the group, which positions it well from a defensive perspective, but also offensively if acquisition opportunities arise (for example, in the US).

TD gets an $82-per-share target price.

Alaris will benefit from rising interest rates

Calgary-headquartered financial and credit services provider Alaris Royalty has a diverse portfolio, solid track record of dividend growth, and deployed capital strongly in 2018 (which we expect to continue into 2019). In addition, within our coverage, Alaris stands out as a name that benefits from a rising interest rate environment (reduces competition for deals by private equity firms and mezzanine-debt alternatives).

Our bullish thesis is predicated on several factors: noise related to its underperforming files is largely behind it; our belief that the environment is changing in Alaris’ favour, with interest rate hikes increasing the appeal of its royalty structure; net capital deployment could pick up, reducing the payout ratio to 80 per cent by year-end; and its valuation is attractive, trading at 1.1 times price-to-book value (compared to a historical average of 1.6 times), with a compelling 9.1 per cent dividend yield.

We assign a price target of $21.50 per share for Alaris.

Doug Young and Gary Ho are financial analysts at Desjardins Capital Markets in Toronto.

This is an edited version of an article that was originally published for subscribers in the February 8, 2019, issue of Investor’s Digest of Canada. You can profit from the award-winning advice subscribers receive regularly in Investor’s Digest of Canada.

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