Generals are taught to avoid fighting a war on two fronts. It’s a lesson that’s lost on CEOs of Canadian financial-services companies. Heading into 2007, success in banking, insurance and money management means both securing the home front and successfully winning new ground in the United States and foreign markets. Investors embrace companies that get it right, while no mercy is
wasted on those who fail.

In a sector that’s growing at a single-digit pace, companies such as Royal Bank of Canada and Manulife Financial Corp. win premium valuations because they are expanding both domestically and in their U.S. operations at
double-digit clips.

At the other end of the spectrum, Bank of Montreal’s stock is sagging after its branch network bled clients to rivals. Bank of Nova Scotia faces some of the same domestic retail problems.

Outside Canada, Toronto-Dominion Bank shed some of its sheen on news that its U.S. branch network, TD Banknorth, will remain a burden on profit growth, with a return on equity far below that of its parent. On the other hand, Scotiabank is shooting the lights out in South America and the Caribbean.

Among the insurers, Manulife wins kudos for its U.S. expansion, where its John Hancock division recorded 32-per-cent profit growth in the most recent quarter. Sun Life Assurance Co. of Canada, on the other hand, has to show that it can turn around U.S. mutual-fund arm MFS Investment Management, which it considered selling before pulling it off the market this year.

“We see sustainable difference emerging in retail performance, which in our view should drive valuation premiums for Royal Bank and TD,” said analyst James Keating at RBC Dominion Securities. “We also believe that Bank of Montreal and CIBC should trade at relative discounts until they demonstrate some market share staying power.”

And which insurers hold the most promise? Manulife seems like the consensus pick. Merrill Lynch analyst André-Philippe Hardy concludes: “We believe that Manulife’s high relative valuation is justified given the company’s sales growth, excess capital holdings, and lower credit-risk profile.”

One of the major stories of the past 12 months was trust conversion at two strong domestic financial players, money manager CI Financial Income Fund and brokerage house GMP Capital Trust. The question now is how these trust CEOs will navigate out of the storm created when Ottawa decided to shut down the sector by taxing trust distributions.

Cash is an unlikely source of tension heading into the new year, because every major bank and insurer has too much of it. The six big banks churned out a record $19-billion in profit in 2006, so the debate within oak-panelled boardrooms is whether to hand this money back to shareholders (via dividends and share buybacks) or plow it into the franchise by making acquisitions.

Most financial players choose a balanced approach when it comes to return capital. Dividends are expected to rise, but takeovers worth anything up to $1-billion are also expected to be routine.

Scotiabank’s $5-billion in excess capital and massive foreign network make it the bank most likely to do a major acquisition, Merrill Lynch’s Mr. Hardy said. “Scotiabank holds the most excess capital of the Canadian group and has, in our mind, superior medium-.and long-term growth prospects than its peers, due to its presence in Latin America and the Caribbean.”

Any forecast isn’t just about what the banks are doing right. It’s what they aren’t doing wrong. Right now, the bankers aren’t making bad loans. Losing money on credit expended to Third World nations, dot.com companies, real-estate plays and a long list of corporate deadbeats has blown holes in bank balance sheets at some point in every business cycle.

In the past few years, a strong economy has kept provisions for credit losses at all-time lows. But good times must eventually come to end, and National Bank Financial analyst Robert Wessel said in recent report: “To the questions of ‘when’ and ‘how fast’ provision will rise, we forecast ‘first quarter of 2007’ and ‘very gradually’ as the respective answers.”