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Why Canadian Equities Are Poised for a Rebound

February 26, 2024 8 min 23 sec
Craig Jerusalim
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. 

Craig Jerusalim, senior portfolio manager, Canadian Equities, CIBC Asset Management. 

Canadian Equities have gotten off to a rather mediocre start for the year, especially in relation to the impressive outperformance of the Magnificent Seven S&P 500. What’s interesting is that this underperformance by Canadian Equities is not due to lacklustre earnings growth. In fact, through early reporting, the TSX has been delivering at least as strong performance growth relative to the U.S. benchmark. And then putting these two pieces together, price underperformance and superior earnings growth, we find the TSX is now trading at the widest discount to the S&P 500 on a forward price-to-earnings basis than we’ve seen in the past few decades. 

The more cyclical composition of the TSX has been what’s been holding the TSX back. And now, with green shoots starting to emerge for global growth, it sets out the potential for a very sharp rebound for sectors, such as energy and materials, that can go a long way to closing the relevant valuation gap of the S&P 500. 

Artificial intelligence hype is another reason for the relevant gains U.S. equities over Canadian equities. There are lots of reasons to continue to want exposure to the artificial intelligence theme and all the productivity enhancements that come with this explosive technology. 

If I use the much-overused baseball analogy to communicate where I think we are in this theme, I’d go as far as saying we’re still in batter’s box, we haven’t even started the game, the umpires aren’t even on the field yet. We have never seen this speed of adoption of a technology happen quite as fast as it did for AI, nor the potential productivity enhancements still to come. And for these reasons, investors would be foolish to assume that the share price gains we’ve seen to date would be fleeting. 

Now, if you want the purest, most direct exposure the AI trend, you have to go to the U.S. And Robertson Velez combined with Michal Marszal are co-managers of the Science and Technology Fund have amongst the strongest track record on the category over almost every validated time period. That being said, there are still a handful of Canadian leaders who are much further ahead of the curve than their peers, and will likely be beneficiaries of those strategic moves for years to come. 

So I thought I’d point out some of the Canadian companies that we have exposure to in our Canadian equity growth funds. The three categories of exposure we’ve identified are those with direct exposure, the second are companies that enable or facilitate AI gains, sometimes referred to as the picks and shovels of the industry, and the third group constitute the infrastructure that either enables or benefits from AI growth. 

So the company with the most obvious direct exposure in Canada is Shopify. Ignoring comments on valuation, the crown jewel of their toolset is what they call Shopify Magic, an assistant that auto generates product descriptions, removing yet another barrier to e-commerce growth. Additionally, Shopify offers a retailing assistant called Sidekick. Sidekick knows all of Shopify’s capabilities and all of the data from commerce in general, and is able to assess the merchant’s content, and thus help improve quality, increase productivity, and accelerate overall merchant sales. 

Another large-cap company that mentioned AI no less than 50 times in a recent conference call was Thomson Reuters, as they continue to build out capabilities incorporating their plethora of data from their proprietary databases and charge their customers accordingly. This added functionality has added it to their already impressive grown in their three main large segments. 

On the small cap side, Docebo, Dye & Durham, Kinaxis all benefit from both revenue growth, as well as the cost reduction as a result of AI. Specifically, Docebo uses large language models to build out corporate learning tools, spanning content creation, learner behaviour and engagement for both training and, importantly, for sales enablement, and they use highly customizable architecture. This aims to significantly reduce the development time and resources, as well as increasing sales productivity. We are particularly excited about the company’s upcoming release later to include a new chat bot interface with the product. With AI content generation supported by a diverse selected of backend LLMs, large language models, including proprietary LLM technology developed by Docebo specifically for learning use cases. 

We also see companies well positioned themself to benefit from reduce costs from AI, like OpenText and CGI. But CGI specifically is expected to be an early beneficiary of the demand generated by their institutional clients wanting to show progress in artificial intelligence themselves, and CGI has the skillset and relationships to be able to assist their clients in that AI progress. 

And then finally on the infrastructure side, we have Brookfield group of companies who’ve always managed to position themselves for major transformational themes. They’ve recognized quite early that we’re in a once-in-a-generation investment cycle for data and digitization that comes with AI computing. They estimate that there will be the need for over $1 trillion of investments over the next 10 years to deploy data centres to ensure there’s sufficient infrastructure for the growth in data consumption. Additionally, and strategically, Brookfield is uniquely positioned to bring to the table the large pools of capital, the operating expertise, the massive real estate footprints needed, and the power solutions required that most competitors just can’t offer. 

So, while NVIDIA is larger than the entire TSX technology sector, and Microsoft has a larger market cap than the entire S&P/TSX, there are still lots of ways for Canadians to benefit from innovation and artificial intelligence growth in the Canadian markets. In terms of that valuation gap of Canada versus the U.S., on a consensus basis, the S&P/TSX is trading at about 16 times forward earnings, and that’s relative to its 20-year average of about 17 times. The S&P 500 on the other hand, because of the Magnificent Seven and because of some of the explosive growth that it’s had is now trading at 24 times forward earnings. And that also compares to about 17 times for their 20-year average. 

So, we really think that with the global growth improving and the opportunities in some of the cyclical sectors, and maybe some of the Magnificent Seven stocks coming back down to earth, you could see a reversion back to the mean for each one of those indices in the medium term. And that suggests further relative outperformance for the TSX and for the S&P 500. 

The biggest risk we see for some of these companies is just the valuation and the hype and excitement pushes up multiples that just become too large to justify the potential future earnings, and we all know that what happened with the technology bubble in the late 1990s and the 2000s and how long it took for those companies to recover from that collapse. So that’s something we are definitely keeping an eye on. 

Now, I will say that even if we are entering the bubble, we are likely in the early stages of the bubble, which means that there is still the potential for explosive growth in these companies that we don’t want to be missing out on. 

So keeping an eye on valuation and we’re keeping an eye on the hype but we’re still really excited about the earnings and the growth and the potential of these companies still to come.