History holds lessons for investors in Canadian equities

Conditions are bleak, but far from catastrophic.

Michael Leonard 6 January, 2016 | 6:00PM
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As an investor in Canadian equities, are you feeling pessimistic these days? If so, try these market statistics on for size:

Return on equity (ROE) net of the risk-free (T-bill) rate for the median Canadian stock of -4.75% (begging the question as to why anyone would own stocks at all);

Year-over-year earnings growth for the median Canadian stock of -10%, with 34% of companies experiencing earnings contracting at a 50% clip or worse;

Fewer than 30% of Canadian companies reporting a positive quarterly earnings surprise;

On average, analysts' earnings expectations cut by 16.4% -- that's just for one quarterly period;

The above conditions resulted in the median stock in Canada trading at 1.13 times book value.

Combined, these metrics paint a bleak picture for the Canadian market. But take note: The data cited above is from Dec. 31, 1990.

Back then, Canada and much of the world suffered through a painful, prolonged recession. Negative net returns on equity, declining earnings, negative earnings surprises and reductions in earnings estimates persisted in Canada for the next 18 to 24 months. Even so, the S&P/TSX Composite Index would never again trade lower than it did in October 1990.

Fast forward to today, where we find that market conditions on the whole are nowhere near as poor as they were 25 years ago. In fact, only one of the five metrics cited above -- median price-to-book-value -- is as weak today, or even close, as it was in December 1990. At Dec. 31, the median P/B of Canadian stocks was 1.13 times, the same as it was in the midst of the 1990-92 recession.

Currently, the median Canadian ROE net of T-bills is 2.6%. This is not particularly strong relative to the past 30 years of observations, but it's a far cry from the aforementioned -4.75% seen in 1990.

Furthermore, if all analysts' estimates for 2016 come true, net ROE is projected to be 4%. Based on history, we know that these estimates are virtually certain to be too optimistic. Still, barring multiple unforeseen increases in short-term interest rates in 2016, we're likely to see net ROE in the 3% to 3.5% range by the end of 2016. There's no indication from Canadian equity analysts that the fortunes of corporate Canada are in any danger of a repeat of the early 1990s.

For the third successive quarter this year, median year-over-year earnings growth has straddled zero, while the projected value for early 2016 stands at 1% if analysts' estimates for the current quarter are realized. Whether the median earnings growth value is slightly positive or slightly negative is immaterial. The real issue, as with expectations for net ROE, is that there are no suggestions from the analyst community that earnings are plunging or are about to plunge.

Another point on earnings growth: it has now been more than a year since the price of oil began its nosedive. Consequently, year-over-year earnings comparisons for this sector should become much less of a drag on overall Canadian earnings growth than has been the case throughout 2015 (unless the price of oil is heading to the US$20 range per barrel!)

The Canadian equity market is not without meaningful problems. While not as dreadful as those seen in 1990, current 90-day earnings-estimate revisions continue to suffer, receding at a 13% pace this quarter.

That theoretical dollar of earnings that analysts, at the start of the year, expected Canadian corporations to earn in 2015? You will end up seeing only about 58 cents of it when all is said and done. This largely reflects the degree to which the estimates for oil-related companies have been slashed through the year. (In a "normal" year, investors in Canadian stocks realize 75 cents to 80 cents of that promised dollar.)

So, while the Canadian equity landscape has a few issues yet to work out, there is no justification for this market's valuations to be plumbing the depths of those seen in 1990. Valuations are so low that we are now within 15% of the very nadir of the 2008-09 financial crisis.

Canadian equities seem to be suffering from very negative sentiment due to some combination of declining prices for resources, a weakening dollar and weak operating performance for some of our other prominent sectors, such as the banks. Certainly, we are told that these factors are keeping international investors away.

At some juncture over the next one to three years, investors in Canadian stocks are going to make a lot of money as valuations return to normal. In the meantime, since it's unlikely that valuations can sink much more, disciplined investors in Canadian equities should have no trouble stock-picking among the half of Canadian equities whose earnings are rising and whose shares, in many cases, are trading at bargain-basement valuations.

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Michael Leonard

Michael Leonard  Michael Leonard, CFA, is chief equity strategist at Morningstar Canada.

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