Earnings growth in Canada is at a crossroads

After two quarters of near-zero growth, are markets ready for a turnaround?

Michael Leonard 29 June, 2015 | 5:00PM
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As we approach the midway point in the calendar for 2015, we find that North American equity markets are trundling along, with a return not much ahead of zero for the year. However, the symptoms of this uninspiring performance on both sides of the border are markedly different. While U.S. markets walk a fully valued fine line (analysis to be posted here in coming days), the Canadian market is plodding its way through working out its issues.

These issues centre mainly on the precipitous decline in the price of oil in the latter half of 2014. The downhill slide resulted in a snowballing of the percentage cuts to analysts' fiscal earnings estimates over three months. These estimate cuts reached an average of -11% at year-end (where -3% to -5% is normal) before nose-diving to -22% at the end of March. Oil companies accounted for roughly three-quarters of the latest cuts. To put these cuts in perspective, they're among the deepest in the past 30 years, exceeded only by those recorded during the 2008-09 financial crisis and the 1991 recession.

Now that the dramatically lower price of oil is fully reflected in the reporting of first-quarter earnings, we can measure the overall damage done to the bottom line. Quarterly earnings growth for Canadian equities now stands at 1.1% lower than a year earlier. More than half of the 723 companies in the Morningstar CPMS Canadian stock universe saw their reported operating earnings per share in the first quarter come in below their Q1 2014 results.

While this is not a good thing, there are a couple of caveats. First, unlike our neighbours to the south, we are quite accustomed to earnings reversals, due to the cyclical nature of many Canadian companies. For instance, median earnings growth in Canada dipped below zero for a few months in late 2012, without catastrophic effect on the broad market.

Second, when we recalculate the median earnings growth in Canada without including oil stocks, we get a perfectly decent median value of 4.6% for all other companies. In fact, only 29 of the 153 oil stocks in the CPMS Canadian universe had positive earnings growth in Q1. So, most of the rest of corporate Canada is doing alright, if not brilliantly.

A look ahead at projections for the second quarter indicates that if all analyst consensus earnings estimates for the quarter come true, median earnings growth will be zero. Given that earnings surprises for the market as a whole tend to be close to zero, it is likely that this growth will come in close to zero, if not exactly flat.

Therefore, corporate Canada is nearing a crossroads. After two quarters of near-zero growth, do we rebound and head back into positive territory? Or does this environment of declining earnings momentum carry on well into negative figures? Healthy earnings growth is important because it fuels return on equity (ROE). If companies are not generating healthy returns for their shareholders, investors will look elsewhere.

While it is too soon to tell -- investors need to monitor trends in earnings growth -- there is at least one good sign to report. In the current three-month period after the posting of that -22% estimate revision, this value has rebounded significantly to "only" -6.3%. It seems that for the time being, much of the cutting of earnings estimates in the Canadian oil patch has subsided.

Let's not forget either that the Canadian equity market is trading at an unusually low price-to-book (P/B) multiple. The current median of 1.37 times is below its normal range of 1.45 to two times for much of the past 30 years.

If (and it's a significant "if") the resulting earnings growth does not dip much below zero in coming quarters and indeed sees positive growth recurring, we may just be rewarded. A turnaround in earnings would be likely to lead to significant across-the-board gains in equity prices as P/B multiples returned to their normal range.

If instead, earnings growth trickles into negative territory for any length of time, Canadian equities are likely to continue to languish. On the brighter side, only a catastrophic, unforeseen series of events could cause Canadian equites to fall significantly from their already inexpensive multiples.

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Michael Leonard

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