The low multiples we’re seeing in Canada relative to U.S. stocks suggest there are some bargains to be had on the TSX right now.
With a trailing price-to-earnings ratio (P/E) of 17.7x, the S&P/TSX is currently trading 15.8 per cent below its two-year average, and 18.1 per cent below the S&P 500, its cousin to the south.
That would be a steal, all things being equal — but, of course, all things in the world of equities are never equal.
So how does your average value investor take advantage of the Canada discount?
Index funds may be one way, for passive investors, but senior portfolio managers rely on more sophisticated strategies. Here are a handful of their best tips for finding deep value in the unloved north.
Compare apples to apples
While it can be tempting to look for sectors that are undervalued when compared to their U.S. counterparts, the problem, according to Barry Schwartz, vice president and chief investment officer at Baskin Wealth Management, is that the indices that measure such sectors are not always comparable.
Health care and information technology, for instance, are woefully underrepresented in Canada, so the few big names that do exist north of the border can throw averages out of whack.
Even sectors that are more broadly comparable will include the occasional outlier. On both sides of the border, consumer discretionary stocks include retailers with similar business models (The Gap vs. Canada Goose; Lowe’s vs. Canadian Tire) but the U.S. sector also includes the likes Amazon and Netflix — behemoths that have no peers in Canada.
“I would be more of a fan of picking out a sample set of individual companies and comparing them that way, instead of looking at an overall index, where they may have names that are completely irrelevant,” said Schwartz.
Keep an eye on movement
Beyond doing a static comparison of multiples based on current prices, Schwartz recommends keeping an eye on how the multiples have been moving. If a sector’s P/E has risen in the U.S. but not in Canada, that may say more about value than the spread.
“What’s important, in terms of the P/E ratios, is what they look like today versus a year ago, versus two years ago, and whether one’s gone up versus one’s gone down,” said Schwartz.
The U.S. financial services sector, for example, has been trading at a consistent multiple for the past two years: it’s at 16.3x today with a two-year trailing average of 16.1x.
By comparison, multiples for the Canadian financials index have fallen dramatically, from 13.6x to 12.3x, as negative sentiment keeps bank stocks down. Schwartz says this type of unusual movement, based on questionable market sentiment, could signal an opportunity.
Exploit Canada’s obscurity
Stephen Takacsy, CIO at Lester Asset Management, says the really deep discounts in Canada have little to do with industrial sectors and more to do with the size categories.
“No question, in Canada small- and mid-cap are trading at a huge discount, and that’s where you’ll see the differences — by market cap and also by liquidity. That’s where we get big discounts,” he said.
As an increasing number of investors opt for passive, index-based strategies, Takacsy says that small-cap stocks — and particularly those in Canada — are being ignored.
“They’re less liquid, so the big institutions can’t buy them and the ETFs don’t own them,” he said. “They’re not part of any basket. That’s where you find the bargains.”
Takacsy points, for instance, to one of his proudest investments: winemaker Andrew Peller Ltd. Five years ago, the stock was trading at multiples around 4x. Since then, it has jumped over 300 per cent.
Be wary of the herd
We tend to think of modern markets as being ultra-efficient, led by supercomputer algorithms that can spot valuation gaps and exploit them instantly — but that’s far from the truth.
Even obvious discounts are often ignored for months or years, because the market tends to move like a herd, says Takacsy, with capital flowing in and out of regions as macroeconomic conditions change.
“Foreign investors get hot and cold on Canada,” he said. “If it’s not doing well, they pull their money out in a panic. And then when it is doing well, the plow back in.”
What that means for a bottom-up value investor is that cheap stocks can stay cheap for a long time, but eventually some major event turns the tide.
Tax cuts and deregulation in the U.S. have ignited markets to the south in the past year. Investors in Canada should be on the lookout for similar indicators — like rising commodity prices, surprise rate hikes or favourable trade deals — that will attract investment to discounted equities.
Use multiple multiples
Though price-to-earnings is still the most commonly used valuation metric, it’s not the only one, and in many cases it’s not even the most relevant one.
For income distribution plays in utilities or real estate, the key metric is funds from operations (tied to cash flow). In financial services, it’s price-to-book (market cap over book value).
Natural resource companies, meanwhile, are highly leveraged and tied to the underlying commodity price. When prices are low, they earn little and produce outrageous P/E multiples, often in the hundreds. And then, almost on a dime, commodity prices will break a threshold and higher earnings will bring those multiples back down to earth.
When it comes to valuation metrics, Schwarz says P/E is just one tool in the box: “You want to buy quality companies when their valuations are low, but there’s also momentum and earnings growth and changes in sentiment — sometimes there’s a very good reason why a company has a low P/E ratio.”