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Canadian Equities Set For Growth Despite Recent Underperformance

September 11, 2023 8 min 30 sec
Colum McKinley
CIBC Asset Management
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Welcome to Advisor ToGo, brought to you by CIBC Asset Management, a podcast bringing advisors the latest financial insights and developments from our subject matter experts themselves.

Colum McKinley, senior portfolio manager, CIBC Asset Management.

We have seen a period of time here where Canadian equities have underperformed their U.S. peers, but we think there continues to be reasons to be quite positive about the longer term outlook for Canadian equities.

And if you first look at the performance that we’ve seen over the last year to the end of August 31st, 2023 in U.S. equities, it really has been performance-driven by a really narrow market. And there’s been a lack of breadth. And technology stocks or a handful of technology stocks have really driven that performance. If you look at the performance of Nvidia, Tesla, Microsoft, Apple, Google, Amazon, all fabulous companies, all great businesses that are doing quite well in delivering for shareholders, but they have disproportionately driven the performance of the U.S. market. And absent the returns you’ve had here, it’s a very different market when you think about how the U.S. has returned. Yet that performance is embedded in the overall return of the index.

If we look at the outcomes of this at the end of August, the valuation of U.S. stocks is much higher than Canadian stocks. U.S. stocks are trading above their long-term averages while Canadian stocks are trading at a discount to their long-term averages. So the S&P 500 at the end of August is trading at a price to earnings ratio of about 19 times. That’s long-term average over the last 10 years, has traded around 18 times. So it’s trading at a premium to where it historically trades.

And in contrast, the S&P/TSX composite at the end of August is trading at a price earnings ratio of approximately 13 times, and its 10-year average is closer to 15 times. And so we can see the Canadian market trading again at a discount to its historical average, and a meaningful discount to where U.S. stocks are trading today. We think that ultimately gets recognized by the market.

I think the second thing that is noticeable, especially in this low interest rate environment and an environment where investors continue to look for attractive dividend yield, the dividend yield in the Canadian market is basically twice that of the U.S. market. So the S&P/TSX has a dividend yield of 3.3% at the end of August, while the S&P 500 has a dividend yield of 1.5%.

And we know that dividend income is incredibly important to investors over the long term. We think about that as the bird in hand for equity investors. So we like to expose your portfolios to high quality dividend paying stocks that have sustainable dividends and that can grow those over time. And we think investors have been rewarded.

So over time, we expect the valuation differences between the Canadian market and the U.S. market, that those will eventually revert to their long-term averages. And as a value investor, I think that’s one of the key ingredients to thinking about how the U.S. market and the Canadian market will perform over the coming years.

For this to work, for Canadian markets to regain some of this performance, we really need some key sectors, such as the energy sector and the financial sectors, to be a key driver. And we think both those sectors are trading at really low and attractive valuations today. They offer attractive dividends. And we think that ultimately those components will be recognized by the market and drive performance.

So what sectors still provide opportunities in the marketplace today? I think the energy market continues to remain quite attractive for investors. These stocks are trading at below historical valuations. So we think they are continued to be mis-priced assets. They’re generating very strong cash flows. And very strong cash flows generated with today’s current commodity prices. And we also have a constructive view on commodity prices going forward given the supply and demand dynamics around the world.

And third, the management teams in this sector continue to remain very focused on capital discipline. So they’re generating strong cash flows, they’re using that to pay down debt, and the returning excess cash to shareholders. And so we think that this sector broadly remains quite attractive, and one we want to be exposed to for all of our clients.

One of the specific stocks that we hold across most of our portfolios is CNQ. This is a company with great assets, has a very strong management team. They’re generating substantial excess free cashflow and returning that to shareholders. So in the last quarter, CNQ returned $1.5 billion to shareholders, so a billion dollars in dividends and $500 million in share buybacks. And these amounts will go up. The company has committed to using a hundred percent of their free cashflow, returning a hundred percent of their free cashflow to shareholders when they hit a $10 billion debt level. And they’re at about $12 billion today in debt. And so over the coming year, we are going to see more and more of that cashflow being returned to shareholders via higher dividends and more share buybacks.

The other area within the energy space that we think is quite attractive is the midstream and pipeline companies. And these are businesses that have contracted revenues, contracted relationships with the E&P companies, so with strong companies today. And we think that a basket of energy and pipeline companies is going to do quite well for shareholders. And so we like Enbridge, Gibson Energy, TC Energy. All of these stocks very well positioned. They have very highly predictable dividend streams, and current yields in the high single digits.

And so again, in an environment where people are looking for consistent stable dividend income, we think that a basket of midstream and pipeline companies is able to provide that and have certainty in the cash flows and those dividends over the long term.

One of the risks we are watching and monitoring in the marketplace is what I would describe as a broad risk related to the effect of interest rate increases that we’ve seen over the last period of time. And we know that consumers drive a big part of the overall economy, and we have just gone through the fastest interest rate tightening cycle that we’ve ever seen.

Now, generally, when interest rates go up, it has a lagged effect before it begins to negatively impact consumers. But we know that the cost of mortgages, the cost of car loans, cost of consumer loans, they have all risen quite substantially. And we know this is happening in an environment that is already challenging for consumers because of the broad inflation that has been taking place.

Now, there are some signs that inflationary environment is coming under control. But we are monitoring and watching very closely the effect that the rise in interest rates could have on consumer consumption. And again, this could have an impact on a large number of sectors given the overall contribution of consumers to the broader economy.

Now, the key offset to this in today’s environment is the labour environment. So as long as labour markets remain tight, it will help consumers navigate some of the rate challenges.

But I think this interest rate environment and the changes that we’ve seen so very quickly is something that we should be thinking about across all of our portfolios and across all sectors.