MNLCF - Manulife: The Perpetual Preferreds Are Now Getting Attractive

2023-10-05 14:47:41 ET

Summary

• Manulife Financial Corporation's Q2-2023 results showed strong core earnings, with earnings per share up 9% YoY.
• The company's valuation is considered undervalued, trading at 7.3X earnings and 1.1X book value.
• We examine our last preferred share idea and give you a new one.

Note: All amounts discussed are in Canadian Dollars.

Manulife Financial Corporation ( MFC ) ( MFC:CA ) is a stock we have owned in the past. Generally we have had a modestly optimistic outlook on this one and changed our tune primarily on macro setups as well as the relative valuation. In our recent work, we gave it a buy rating in May 2022 and then were fortunate to switch to neutral just as the stock was about to top.

In our last article, we looked at the resetting preferred shares as a way of getting quality yields with less risk. We review and update our primary recommendation and turn our focus now on the perpetual preferred shares, which have been flirting with our buy point.

Company Fundamentals

Q2-2023 results showed very strong core earnings, with earnings per share at $0.83. This was up 9% year over year and hit the magical 15% return on equity mark. The negative there was the massive $612 million charge on ALDA (alternative long duration assets). The $612 million can be called massive as it is about 40% of the core earnings for the quarter. But it is tiny in relation to the total asset base that MFC holds and invests.

This has been our key theme for being a little less than raving-mad bullish on the stock as its fate is amplified by changes in that massive asset base. If we expect (and we do) the standard 60:40 portfolio to perform poorly, then you can bet that MFC will struggle to deliver big returns, despite being "cheap". Getting back to ALDA, we expect some more significant hits as bank lending tightens, but it will be buffered by the low loan to value ratios. The fixed income side will also benefit significantly as older bonds that were purchased yielding next to nothing, mature and roll into very high relative yields. About $200 billion of the portfolio is made up of investment grade bonds, and those rolls are going to have MFC officers laughing all the way to the bank.

Some additional commentary from Q2-2023 is also worth presenting here.

Meny Grauman, Scotiabank

First question, I wanted to ask about expected investment earnings. We're seeing a big improvement sequentially and then very, very strong growth year-over-year. Just trying to understand the sustainability and the potential variability in that number going forward. I guess the first question is what we're seeing from a year-over-year basis, really just a function of the higher rate environment? Or is there some other key factors that we should keep in mind? And as we look forward, if we assume that the rate environment maybe has peaked to some extent, what does that mean about the trajectory of this line item going forward?

Colin Simpson, CFO Manulife

Meny, it's Colin here. I'll kick off and others can join in. I mean what you're seeing is, absolutely as you intimated, high yields. We're looking at and through core earnings, to the extent that yields stay where they are, we would expect this to persist. So absolutely sustainable, if yields go up even further than we would expect to earn more through that line item.

Scott Hartz, CIO Manulife

Sorry, it's Scott, to add a bit to that. What's driving it is the higher rate environment. And as Colin said, if rates stay where they are, we would expect it to be sustainable and, in fact, even grow a bit. As the portfolio turns over, we will be turning it over at higher yields.

Meny Grauman

And how does the inversion of the yield curve, is that playing a factor here in terms of how this line item behaves? And so how should we think about sort of the shape of the yield curve in terms of what the impact is on this line item?

Scott Hartz

I think while the yield curve is inverted, all yields are higher that exist on the current portfolio, so that's all positive.

Source: MFC Q2-2023 Earnings Call Transcript

Valuation

MFC trades at about 7.3X earnings and at about 1.1X book value. The LICAT ratio at 137% is solid. It is hard to argue that these are not undervalued levels. The risk comes from a protracted bear market in capital markets, but even that appears to be well discounted here. If you are looking out 10 years from here, this will be a level from where the probabilities of 8-10% total return are quite high. You have the dividend yield itself, which is at 5.8% currently and, assuming even modest growth, should average about 6% over the next decade on this price. If you assume zero growth in earnings run-rate, then you will still have $18 a share of excess earnings, over and above the dividends accumulated over the next decade. So for MFC to not deliver those additional 2% to 4% returns over the dividend would require some major breakage in the model.

Preferred Shares

We had suggested the ( MFC.PR.K:CA ) as our choice in the MFC preferred suite. Those have done quite well, even with the generalized bloodbath in fixed income land.

This happened as they were the least sensitive to higher bond yields, as they would incorporate that immediately into the upcoming reset. They also handily outperformed the common shares since that article.

These preferred shares have been reset to 6.35% on par.

The dividend rate for the five-year period commencing on September 20, 2023, and ending on September 19, 2028, will be 6.35000% per annum or $0.396875 per share per quarter, being equal to the sum of the five-year Government of Canada bond yield as at August 21, 2023, plus 2.22%, as determined in accordance with the terms of the Series 13 Preferred Shares.

Source: MFC

That means they are now going to yield 8.09% for the next five years on the current price. This is competitive yield from MFC for its credit ratings.

So if you want to hit the snooze, that is fine, and the current spread of the dividend is attractive relative to Government of Canada 5-year bonds (GOC-5). These will reset in five years at GOC-5 plus 2.22% though, so keep that in mind.

Perpetual Preferreds

We have been biased on the higher for longer strategy and favored resetting preferred shares. Recently, we have started slowly adding duration sensitive securities as we feel they now offer a relatively attractive risk-reward. You can see the setup with ( MFC.PR.B:CA ) which is a fixed rate security (4.65% on par) versus MFC.PR.K:CA. The former has underperformed the latter by 20% in the last six months.

The current yield on MFC.PR.B is now 6.85% and something we consider attractive to lock-in. Could it go lower (yield higher)? Of course, it can. You can avoid 90% of the drawdown from the peak yield chasing madness in 2021 and still get blamed for entering too soon. MFC.PR.B had a peak closing price of $25.59 in 2021. The price is down 7.5 years worth of dividends since then, and yes it could go lower in a full scale meltdown. But we like it, and we bought some. This may not be a popular opinion in today's bond markets, but neither was telling you that bonds were weapons of mass destruction in 2021 , and we did that as well.

Please note that this is not financial advice. It may seem like it, sound like it, but surprisingly, it is not. Investors are expected to do their own due diligence and consult with a professional who knows their objectives and constraints.

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