Bottom fishing-3: Canada

In line with the famous adage, we left the last part of our "Bottom Fishing" trilogy for the best. So far this year, the S&P/TSX has lost just about 9.5% (before dividends), on track to wrap up a truly bad year, pending a last moment Santa Claus rally. In contrast, the S&P 500 has so far lost some 4%, not to mention the currency benefit for unhedged Canadian investors.

From a valuation perspective, a number of listed Canadian companies have now become plain attractive. Bank earnings have grown some 8% in the past year, and the price-to-earnings (P/E) ratios for banks range between 10 and 12 times (on trailing basis) while dividend yields are in the 3.5%-4.5% range. That compares very favourably with the valuation of US banks and other sectors.

The other major component of Canadian equities is the energy sector. There, not only Canadian companies are suffering from higher production costs, versus US shale, but also from major logistics problems. Pipelines and rail cars are working at full capacity, and export channels, some of which are still under development, are not sufficient to ship susplus capacity. As a result, Canadian oil is selling at a severe discount versus US oil. Accordingly Canadian energy companies are now trading at a justified, albeit unsustainable, discount versus US peers, and that is also reflecting on pipline companies.

This circles back to Canadian banks valuation, given market concerns about the quality of their loans to the energy sector. But there are other factors hurting banks share prices, such as late cycle concerns and the quality their mortgage book. Even though there are no signs of an impending recesssion, at least not yet, this economic cycle has run for such long period that economists now fear its end is coming soon. As for the quality of the mortgage book, much has been said about the Canadian housing bubble. A combination of slower economic growth and higher interest rates could inflict further damage to housing prices and, to the quality of housing mortgages.

All things considered, we are convinced that much of the bad news has been already reflected in equity prices, and that Canadian equity valuations are now attrractive in general, simply because the battered financial/energy sectors, which together account for half of the Canadian equity index, are both under-valued in relative terms. We say that for five reasons:

First, we do not have any major concerns with respect to the quality of Canadian banks loans. They have all reaffirmed that they are adequately provided, but we are not simply taking them on their word. We know that, when it comes to provisioning, large Canadian banks are conservative, and we believe that, in most likelihhod, they have taken advantage of their growing earnings to beef up provisions in preparation for worse times. In fact, the banks are comfortably meeting or beating earnings expectations, and hence are not pressured to under-provision. Moreover, the housing bubble seems to be cooling off and Canadian mortgages are more soundly regulated versus US mortgages and are generally well covered in terms of CMHC insurance and loan-to-value ratios. Therefore a sub-prime like crisis is highly unlikely here.

Second, Canadian banks' operations are not domestically confined. Each one of the large banks has its own successful business franchise(s) outside Canada. In other words, you are diversifying your portfolio by indirectly assuming foreign exposure via Canadian banks.

Third, Canadian banks' earnings momentum remains intact. Even though such momentum may slowdown with an eventually slower economic cycle, much of that has been already discounted by equity prices, as evidenced by the relatively low P/E ratios.

Fourth, dividends are both attractive and fairly safe.

Fifth, the energy sector is always cyclical and therefore a turnaround is bound to happen some time down the road. Waiting for the good news before you invest will not help because you would likely miss a good chunk of the recovery.

Still, if you are concerned that the energy sector is still too risky and that some sectors of the Canadian market are not as attractive as financial stocks, for example, you may want to confine your choices to one or more of the following alternatives:

-A low cost financial services or dividends exchange traded fund, which would pay a dividend of 5% or so, and/or

-A more diversified, actively managed financial services fund such as Dynamic Financial Services Fund (a FundScope Choice fund) which invests in a combination of Canadian and US banks.

There are also several other fine choices that you can uncover by searching our FundScope Choice selection under the Dividend and Equity Income and Canadian equity categories.

December 10, 2018

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