Diversify With These Two Leaders

Many Canadians tend to stick with the five big banks when it comes to the Finance segment of their portfolios. While we do recommend that most investors hold two or more bank stocks, you should also diversify your holdings with high-quality non-bank stocks such as Great-West Lifeco or IGM Financial.

Both companies are leaders in their fields (insurance and mutual funds), are cheap in relation to earnings and have long histories of rising dividends. Their conservative investing styles have also helped shield them from big writedowns of securities backed by subprime mortgages and other risky assets.

GREAT-WEST LIFECO INC. $32 (Toronto symbol GWO; Conservative Growth Portfolio, Finance sector; Shares outstanding: 892.5 million; Market cap: $28.6 billion; SI Rating: Above average) is Canada’s largest insurance company, with over $400 billion in assets under administration. Power Corp. controls 70% of Great-West’s shares.

Great-West sells life insurance and health insurance, directly and through brokers, to groups and individuals under the Great-West, London Life and Canada Life banners. Other services include retirement planning and wealth management. It also provides administrative services to pension fund managers.

Great-West’s revenues rose from $16.7 billion in 2002 to $27.3 billion in 2006, mainly due to its 2003 purchase of rival Canada Life. Earnings grew from $1.27 a share (total $931 million) in 2002 to $2.10 a share ($1.9 billion) in 2006. Great-West likely earned $2.45 a share in 2007.

The company continues to expand outside of Canada, which accounts for 50% of its earnings. The United States and Europe each supply 25% of Great-West’s remaining earnings.

In August 2007, Great-West acquired U.S.-based mutual fund manager Putnam Investments Trust. The purchase included Putnam’s 25% interest in T.H. Lee Partners, a private equity firm that serves high net worth investors.

Putnam ran into trouble over a mutual fund trading scandal a few years ago, which hurt its reputation. That explains why Great-West got it a bargain price of $4.2 billion, even though it had assets under management of $190 billion U.S. Fund redemptions at Putnam still exceed sales, but the rate is declining.

Putnam’s clientele a hidden asset

Owning a mutual fund company increases Great- West’s exposure to sometimes volatile stock markets. However, the takeover gives Great-West an opportunity to market insurance and other financial services to Putnam’s large individual and institutional client base. The Putnam acquisition also expanded Great-West’s operations in Europe, and gave it its first business in Japan.

To help pay for Putnam, Great-West has agreed to sell its U.S. health care business for $1.6 billion U.S. This division provides medical, dental, vision, life and disability coverage to 5,200 groups and 2.2 million individuals.

Larger insurers tend to dominate the U.S. health care industry. That’s because their size lets them negotiate better deals with medical service suppliers. Given these challenges, selling this operation makes sense for Great-West.

Great-West had to borrow the cash it needed to fund the balance of the Putnam acquisition. However, its long-term debt of $5.3 billion is still a reasonable 1.6 times its annual cash flow.

The stock trades at 11.6 times its likely 2008 earnings of $2.75 a share. Great-West’s current dividend of $1.10 a share yields 3.4%.

Great-West Lifeco is a buy.

IGM FINANCIAL INC. $42 (Toronto symbol IGM; Conservative Growth Portfolio; Finance sector; Shares outstanding: 264.4 million; Market cap: $11.1 billion; SI Rating: Above average) is Canada’s largest mutual fund company, with $117.6 billion in assets under management. Power Corp. controls 56% of IGM.

The company has three main divisions. Investors Group sells funds through its own network of over 4,000 financial advisors. Mackenzie Financial sells its funds through independent brokers. IGM also owns 74.5% of IPC Financial, whose 540 advisors provide wealth management services. Unlike Great- West, IGM has few operations outside of Canada.

IGM’s revenue rose from $1.9 billion in 2002 to $2.6 billion in 2006. Revenue probably reached $2.9 billion in 2007. Earnings before unusual items grew from $1.85 a share (total $491.1 million) in 2002 to $2.85 a share ($763.0 million) in 2006. Earnings in 2007 likely grew to $3.17 a share.

The recent turmoil in stock markets has spurred fund redemptions, particularly at Mackenzie. Redemptions hurt IGM’s earnings, since its fees rise and fall with the value of the securities in its funds.

Expansion pays off

However, sales at the Investors Group division continue to rise, mainly due to a 27% jump in the number of advisors in the past four years. Productivity is also improving as these new employees gain more experience.

The rising Canadian dollar has also hurt the value of IGM’s U.S. and international funds. But higher sales of foreign funds have helped offset this.

IGM is steadily expanding its institutional wealth management business, which cuts its reliance on sales to individuals. Institutions and high net worth investors currently account for about 13% of IGM’s assets under management.

The stock has moved down with the overall market in the past three months. IGM now trades at 12.7 times the $3.30 a share it will probably earn in 2008. The $1.84 dividend yields 4.4%.

IGM Financial is a buy.