John Reese is CEO of Validea.com and Validea Capital, and portfolio manager for the National Bank Consensus funds. Globe Investor has a distribution agreement with Validea.ca, a premium Canadian stock screen service. Try it.
Canadian stocks have lagged U.S. equities considerably since the start of the current bull market in March, 2009. However, this year the tide is turning, and if valuations and history are any guide, the superior relative performance out of Canadian stocks could be sustainable.
So far this year, the S&P 500 is up 4.4 per cent while the TSX is up 12.2 per cent, and despite the runup, Canadian stocks are still better bargains than their U.S. counterparts. Using a CAPE (cyclically adjusted valuation price-to-earnings ratio), Canada's market has a ratio of 18.4 versus 24.7 for U.S. blue chips, and a price-to-book value of 1.8 compared to 2.8, according to data analysis by Star Capital. When valuations creep above the long-term average, as is the case with the U.S. index, it indicates potentially lower future returns, while lower valuations offer potentially higher future returns.
To be sure, the Standard & Poor's 500 has hit record after record lately, even with such temporary shocks as Brexit – Britain's vote to exit the European Union back in June.
For Canadian investors wanting to invest in companies at home, meanwhile, it's been a rough go of it. The Canadian market is heavily exposed to the natural resources and energy sectors, and both have been hit hard over the past few years from sluggish global growth, while financials, another major sector in Canada, have suffered under downward pressure on interest rates.
Meanwhile, the U.S. markets have enjoyed a rally after faltering in the decade between the bursting of the dot-com bubble and the mortgage-lending crisis, which happened to be the most recent decade during which the Canadian market outperformed.
It is a pattern that has repeated since the 1970s. Canadian stocks outran the United States in the 1970s and the first decade of the 2000s, both periods of economic pain in the United States, while U.S. blue-chip stocks outperformed Canadian stocks in the 1980s, 1990s and since 2010.
When a market has a positive upward climb for five or more years, valuations can get stretched. That means there are opportunities for patient investors to find bargains elsewhere, and right now the perceived value of Canadian stocks is attractive.
Already, commodity and energy stocks have bounced back from their slump last year. And a new government in Ottawa lends a bit of stability compared to the uncertainty of the upcoming election in the United States, where central bankers are also still rattling markets as they weigh an interest-rate increase.
Often, investors tend to have a home bias in their portfolios. This means they overweight stocks in the country where they live and know best. This bias can sometimes detract from returns, like it has for most Canadians over the past few years. But that home bias for Canadians will mostly likely be a positive contributor to performance for those investors who have remained disciplined.
Translating this into selecting stocks might not seem obvious. One of the interesting observations we are seeing this year in the set of quantitative models we track is that the value-based approaches – based on the investment strategies of Benjamin Graham, Joseph Piotroski and Joel Greenblatt – are among those doing the best. Value strategies tend to perform well during periods of economic growth and during periods when interest rates are rising steadily. The nice performance from value bodes well for the Canadian market as a whole.
The value model that has been the top performer so far this year on Validea Canada is based on the approach outlined in the research study conducted by Mr. Piotroski. In the study, he concluded that it's possible to identify unfairly undervalued stocks from those that are merely distressed by looking at a number of variables, including return on assets, which should be positive. The model tends to select some of the smallest and deepest value names in the market. Below are a handful of stocks that currently score highly based on the model.
- Brookfield Renewable Partners: The renewable-energy company stands to benefit from growth in the sector. Its low price-to-book value of 0.4 also suggests it has room to grow.
- Cogeco Inc.: The Montreal-based media and telecommunications company meets the Piotroski test for a stock that is unfairly undervalued. Cash flow is positive and greater than profit and its return on assets has expanded to 8.36 from 7.38 the prior year, an indication of growth.
- Brookfield Canada Office Properties: The owner of office buildings, including the 1.2-million-square-foot Exchange Tower, which houses the Toronto Stock Exchange, also fills Mr. Piotroski’s criteria. Return on assets in the most recent fiscal year was nearly double the prior year.
- Power Corp. of Canada: A somewhat misleadingly named Toronto holding company made up of a variety of financial services and communications firms. Its modest P/E ratio of 11 and price-to-book value of 0.38 suggest it has some upside potential.