The market has been a roller coaster ride for weeks, and some say things might get worse before they get better. Last week, the Morningstar Canada Index and the S&P TSX Composite index closed the week down 4% - less than the S&P 500, which was down 5% for the week.
This latest downturn is driven by rising interest rates, and inflation running rampant. The U.S. Federal Reserve last week raised the federal funds rate by 0.75% for an unprecedented third-straight meeting, taking the funds target range to between 3.0% and 3.25%. At the same time, Fed officials indicated they expect continued rate increases that could take this key short-term rate to 4.6% next year.
“We have got to get inflation behind us. I wish there were a painless way to do that, there isn't,” Fed Chairman Jerome Powell said. That pain, he said, includes higher rates, slower growth, and a weaker jobs market.
And while Powell didn’t say it directly, my colleague Tom Lauricella writes, it is increasingly expected to include a recession, not just a so-called soft-landing where the economy cools off but doesn’t shrink. He outlines six takeaways for investors:
- Rates Will Keep Rising
- A Recession Is Looking More Likely
- Investors Must Keep an Eye on the Earnings Outlook
- Uncertainty Will Mean Volatility
- Forget About a `V-Shaped' Bounce
- It Will Pay to Stay Defensive
Watch Out for Volatility, Not Risk
The doomsday scenario for many is stagflation, a period of high inflation and slow growth not seen since the 1970s. In that environment, it is useful to remember that risk, not volatility, is the real enemy.
As Morningstar’s director of personal finance Christine Benz points out, as investors, it's helpful to create a mental distinction between volatility and risk. Volatility encompasses changes in the price of a security, a portfolio, or a market segment both on the upside (see 2019) and for the downside (see 2008). So, it's possible to have an investment with a lot of volatility that so far has only gone one way: up.
The most intuitive definition of risk, by contrast, is the chance that you won't be able to meet your financial goals and obligations, or that you'll have to recalibrate your goals because your investment piggy comes up short. “Through that lens, risk should be the real worry for investors; volatility, not so much,” Benz explains.
What’s Going on with Canadian Stocks?
After last week’s correction, there are even more opportunities for investors. Of the 66 Canadian stocks in our coverage universe, 47 are currently trading below our fair value estimates (FVEs). As has been the case for over a year now, the cheapest of these are in cannabis, and none has an “economic moat”.
The Morningstar Economic Moat Rating represents a company's sustainable competitive advantage. A company whose competitive advantages we expect to last more than 20 years has a wide moat; one that can fend off its rivals for 10 years has a narrow moat, while a firm with either no advantage or one that we think will quickly dissipate has no moat.
Today, we look at the 10 cheapest Canadian stocks, all of which are trading 35% below our fair value estimates or more. Of these, six are in cannabis, and the rest are spread across sectors. One has a “narrow” economic moat. Here’s the list:
For details on the Cannabis companies, check out our article on the best cannabis stocks. Here’s a look at the other stocks on that list.
Lithium Americas Stock
Lithium Americas aims to become a low-cost pure-play lithium producer. The company has no current lithium sales volumes but is developing three resources that should eventually enter production, with the first project to enter production by the end of 2022. Cauchari-Olaroz and Pastos Grandes are brine resources located in northwestern Argentina. Thacker Pass is the company’s clay resource in the U.S. state of Nevada. As electric vehicle adoption increases, we expect maintained double-digit annual growth for lithium demand. Lithium Americas should benefit as there should be more than enough demand for the company’s three resources to enter production and expand capacity over time. LAC is considering separating the company into two businesses, based on geography. The Argentina business would contain Cauchari-Olaroz and Pastos Grandes, while the U.S. business would contain Thacker Pass.
-Morningstar Analyst Seth Goldstein
Newcrest Mining Stock
After reviewing our production and cost assumptions, we retain our fair value estimate of AUD 31 per share for no-moat Newcrest Mining and it remains one of our Best Ideas. Newcrest shares trade at around half of our fair value estimate. We think this is due to concerns over a stronger U.S. dollar and rising interest rates, which are potentially negative for gold prices. Physical gold doesn’t provide any cash flow for its owners and rising yields make bonds relatively more attractive. However, we see rising rates as temporary and see the gold price as being relatively well supported by the cost curve. We are also more confident of a recovery at Cadia and Lihir, and think the substantial development pipeline including Havieron, Red Chris, and Wafi-Golpu in Papua New Guinea is likely underappreciated. In our view, Newcrest’s main attraction is its low-cost, long-life Lihir and Cadia mines in Papua New Guinea and New South Wales, respectively. Both mines are likely to produce for decades as resources are converted to reserves. We also think production will recover at Lihir and along with the acquisition of Brucejack and likely development of Havieron, we forecast average annual gold production of about 2.4 million ounces to fiscal 2027.
-Morningstar Analyst Jon Mills
Canfor Stock
We are initiating coverage on Canfor Corporation with a fair value estimate of $37 per share and a no-moat rating. While the firm’s commodity businesses, lumber and pulp, can be immensely profitable when demand is strong, margins crumble during times of weak demand as Canfor’s operations possess no structural competitive advantages. Fundamentally, lumber is a commodity. Building a moat in a commodity business typically necessitates a low-cost production position or a transportation cost advantage—something Canfor, along with its North American peers, fundamentally lacks. We assign Canfor Corporation a stable moat trend rating because we do not expect the firm's competitive advantages to materially strengthen or weaken over the next five years. We expect the competitive dynamics of lumber to remain unchanged, as producers are price-takers and do not possess material competitive advantages. While the importance of lumber in homebuilding and other construction projects is unlikely to change, producers do not possess pricing power and their profitability is tied to lumber prices.
-Morningstar analyst Spencer Lieberman
Shopify Stock
Shopify strives to be a one-stop shop for small retail businesses, especially those that are e-commerce primarily, only, or first. The company offers a simple but robust e-commerce platform with a variety of related add-on functionalities, including the Shopify Fulfillment Network, or SFN, that ultimately converge into a turnkey solution for small and midsize businesses, or SMBs. Shopify’s rapid rise since its 2015 initial public offering underscores a nascent software niche that is rapidly growing and demonstrates a winning solution. We believe the company has established a narrow moat, as switching critical e-commerce platforms has financial and operational costs for an already resource-constrained SMB. We forecast robust top-line growth benefiting from e-commerce trends over the next several years.
-Morningstar analyst Dan Romanoff
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