Favour Canadian stocks, but don’t fill a sector with a weak player, or one that’s trading at an extreme P/E ratio, when there’s so many alternatives outside our borders, writes Tom Bradley.CHRIS HELGREN/Reuters
A friend was telling me that his adviser is making a big shift out of U.S. stocks and into Canada. He couldn’t articulate the reasoning but knew the S&P/TSX Composite Index was up more than 30 per cent in the last year and was doing far better than the S&P 500, the most popular U.S. equity index.
The conversation lined up with reports I’ve seen recommending that now is the time to invest at home. For sure, Canada should be a part of a well-diversified portfolio, but this “all-in” narrative needs further analysis. Let’s look more closely at the reasons for buying Canadian stocks now.
Past performance
Indeed, the Canadian market has been on fire but as a poster in our office points out: “Last quarter’s performance is a reliable indicator of last quarter’s performance.” Investment products have a warning label on them for a reason – past is not a predictor of future.
For context, the Canadian market still lags the world index over 10 and 20 years (in Canadian dollars to April 30th) by 1 to 2 per cent per year, despite the latest surge.
Exposures
Our stock market is not well diversified. There are plenty of great Canadian companies, but it’s difficult to build a Canada-only portfolio that represents what’s going on in the economy. Rather, the TSX is an odd mix of sector bets, the primary ones being banks, energy and gold, with little exposure to the biggest economic drivers, namely technology, health care and consumer products.
Valuation
The pro-Canada reports usually point out that the TSX is trading at a lower valuation than the S&P 500. This general statement is misleading.
Our market should trade at a lower multiple. Banks make up a quarter of the index and trade at price-to-earnings ratios well below the overall market (as I explained in a recent column).
When resource-related sectors are reporting top-of-the-cycle earnings, their stocks also tend to trade at low P/E ratios because investors don’t expect outsized profits to be sustained.
And part of our market is made up of domestic oligopolies such as groceries and telecommunications, where the companies are highly profitable, but not growing very fast.
The TSX is underexposed to higher priced sectors such as technology. We have a handful of growth stocks in other sectors, which are global leaders in some cases, but they trade at full valuations because of their scarcity value.
Valuation comparisons are a critical part of investment decision-making, but should be done at the company and sector level.
Currency
There could be currency reasons for making the shift. The Canadian dollar has been chronically undervalued relative to its purchasing power, however, predicting major shifts in exchange rates is a low-quality bet. Currencies can remain under or overvalued for decades because of deep-rooted political and economic factors, not the least of which are lower or higher interest rates.
If you want to bet on the loonie, it’s easy to do so using currency-hedged mutual funds and exchange-traded funds.
Canada-centric
By all means, buy Canadian stocks. Now is a better time than ever to support our own, given what’s going on around us. But don’t force it.
You might try what I call a Canada-centric global model. In building a portfolio that’s properly diversified across industries and geographies, start with Canada. Populate it with domestic companies you like, and that stack up well against their peers from around the world. And then, look elsewhere to fill out the sectors that aren’t well represented here.
Favour Canadian stocks, but don’t fill a sector with a weak player, or one that’s trading at an extreme P/E ratio, when there’s so many alternatives outside our borders.
And certainly, don’t buy an index ETF because you’ve heard it’s time to buy Canada, or you want to chase last year’s returns. The TSX may continue to do well for a while longer, depending on what gold and oil do, but short-term market calls don’t align with your portfolio’s goals and time frame.
Tom Bradley is a portfolio manager with Purpose Investments, co-founder of Steadyhand Investment Management, a member of the Investment Industry Hall of Fame and a champion of timeless investment principles.