After years of snubbing Canadian equities in favour of US stocks, it might be time for investors to consider the possibility of an emerging value opportunity in the Toronto Stock Exchange.
“Although the Canadian market outlook doesn’t engender much excitement at the moment, the multiple compression of the TSX over the past two years reflects very pessimistic expectations,” argued Tim Corney and Joseph Wu of RBC Dominion Securities in a new commentary.
The pair pointed to a 23% decline in the forward price/earnings ratio of the TSX Composite Index from December 30, 2016 to January 4, 2019; in comparison, the S&P 500 sank by only 14% by the same measure. This is despite the fact that the two benchmarks have delivered the same 37% earnings growth during the period.
“Aside from a few countertrend rallies, the TSX has reliably lagged the US market over the last seven years,” they added. The commentary noted three broad concerns, all of which have depressed sentiment toward Canadian equities:
- Eroding relative competitiveness, most notably due to the large cut in US corporate tax rates and an increasingly business-friendly regulatory environment pursued by the Trump administration since 2017;
- Canadian household debt levels that have surged from 130% in 2006 to around 170% of annual income as of Q3 2018. With Canadians taking on larger mortgages and, to a lesser extent, debt-financed consumption, the country’s financial system faces questions about its vulnerability to loan defaults and long-term growth prospects.
- Commodity dependence, as seen in the 30% weighting of natural resource stocks within the TSX. The inadequate pipeline capacity plaguing Canada’s oil industry is unlikely to be resolved soon. Given that, the commentary said, the use of more-expensive rail and truck systems, as well as the heavy discounts relative to the WTI, could persist.
While acknowledging that things could get worse from here, Carney and Wu noted that the TSX trades at roughly 13x forward earnings, an 11% discount relative to its long-term average of 14.6x. And on a forward P/E basis, the TSX currently trades at an “extraordinarily deep” 13% discount compared to the S&P 500. “[T]he Canadian market has rarely been this cheap,” they wrote, with the most recent instance being the early 2000s — when US stocks were still expensive due to lingering after-effects of the dot-com era.
Looking at at 1-, 3-, and 5-year forward return trends for the TSX, they observed that “forward return prospects were, on average, quite a bit more attractive across all time horizons if one had invested in the TSX when its forward P/E was below the historical average.” Similarly, they said, the TSX has tended to outperform the S&P 500 across all three time horizons when trading at discounts of over 10% compared to the US market on a forward P/E basis.
“[W]e contend that the market is fully reflecting investor concerns and discounting very little in the way of potential positive outcomes,” the duo said.
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