Why Regular Portfolios Don't Contain Canadian Stocks - Part 2: Valuation

Last update on Sept. 1, 2014.

In the last article published exclusively for our members, I explained the various risks associated with Canadian stocks to partly explain why regular portfolios don't hold Canadian stocks today. However, even risky stocks can deserve our money if the prices are cheap enough.
 
In this article, I'll explain the valuation level of Canadian stocks.
 
 

What CAPE Tells Us About U.S. And Canadian Stocks 

There are several ways that we can measure the valuation level of the stock market overall. As I've explained in the past, one good way is to use the Cyclically Adjusted Price to Earnings Ratio (CAPE). As you can see in the linked article, there is a direct logical link between long term stock returns and price to earnings ratios, assuming that the future looks somewhat like the past.
 
Currently, the U.S. stock market has a CAPE of roughly 26, which is high by historical standards. In the meanwhile, the Canadian market had a CAPE of roughly 20 in March of this year. Since Canadian stocks went up by roughly 10%, we can deduce that Canadian CAPE is roughly 22 right now.
 
At first glance, Canadian stocks look cheaper than US stocks right now. Therefore, CAPE measures imply that if the average companies of both respective countries earn roughly the same as it did for the past 10 years, Canadian stocks will outperform U.S. stocks.
 
However, that's IF the future looks like the past. The truth is, there are compelling reasons to think that U.S. companies' earnings will probably outpace that of Canadian companies.
 
 

Taking Growth Into Account

I explained in the past that I'm a fan of Return on Equity (ROE) as a gauge of a company's quality, but there's another reason why I like ROE. That's because ROE also indicates the earnings growth per share.
 
For every $1 of earnings that a company retains (i.e. doesn't pay out in dividends, share buybacks, etc), a company will grow its earnings at the rate of ROE. So if ROE is 10%, the company will increase a $1 of each retained earnings to $1.10 next year, and $1.21 by the year after, etc.
 
The average company in the S&P 500 has historically generated an ROE of roughly 15%. By contrast, the ROE of the average company in the TSX is 11%. In other words, the average American company has been able to grow its profits faster for its shareholders than Canadian companies.
 
If future ROE looks like the past ROE for both countries, and if we assume the same dividend payout in the future, then we can expect the average U.S. company profits to grow by around 7%/year, while we can expect the average Canadian company profits to grow by around 5.5%/year.
 
Remember, CAPE is just the ratio of price to historical earnings. This means that in 10 years time, even if both the S&P 500 and the TSX go up by the same percentage, the CAPE of both indices will become the same because S&P 500 earnings will grow faster than TSX earnings. In 20 years time, the CAPE of S&P 500 will be lower than that of the TSX.
 
If we believe the CAPE of both markets will be roughly equal in 10 years time, then we should expect both U.S. and Canadian stocks to go up at a similar rate for the next 10 years. In other words, if we invest in both a broad market Canadian stocks ETF like XIC.TO and also in a broad market U.S. stocks ETF like IVV, we should expect a similar rate of return on both. However, we should expect higher risks for Canadian stocks as I mentioned last month.
 
If Canadian stocks' riskiness was the only issue, then Canadian stocks would still have made it into MoneyGeek's portfolios since I expect them to generate similar returns to U.S. stocks. However, we also have to take the availability of ETFs into account.
 
 

Availability Of ETFs

Currently, MoneyGeek's U.S. stocks component consist of BRK-B and CAPE (the ETF, not the valuation metric). I chose them because both have a history of outperforming the overall U.S. market by at least 2%/year, and I believe they will continue to do so in the future (no guarantees though, of course). I'll write about why I believe this in later articles.
 
For Canadian stocks though, I sadly can't find an ETF that I feel such confidence about. Sure, there are Canadian ETFs that try to pick undervalued stocks. However, I personally have a hard time trusting that the methodologies they employ will continue to pick out undervalued stocks.
 
Since ETFs lack a salaried manager, they have to rely on mechanical rules to determine whether a stock is undervalued. Using such rules is like trying to filter houses with superficial metrics like square footage and age of the building to find undervalued houses. Unfortunately, such methodologies are prone to error.
 
Still, I think some methodology will yield good results, and that's why I've chosen CAPE (the ETF) for the regular portfolios. I just haven't found a Canadian ETF that I have similar level of confidence in.
 

Summary

In summary, Canadian stock ETFs have the following 3 disadvantages:
 
  1. They are more risky compared to U.S. ETFs
  2. They will likely generate return lower returns than U.S. ETFs in the very long run
  3. Owning both U.S. and Canadian stock ETFs won't offer much diversification since they have moved in tandem historically

Because of these reasons combined, I have decided not to include Canadian ETFs in MoneyGeek's regular portfolios.

Now, don't get me wrong - as a Canadian, I feel optimistic about the long term future of this country. I believe that it has a good economic system and is full of intelligent people.
 
However, Canadian stocks don't really represent the Canadian economy, nor its people. Canadian stocks represent the business realities of just a small subset of companies in Canada that are publicly traded.
 
It's entirely possible that Canadian stock do well beyond my own expectations. But I personally believe that the odds are against that. Time will tell if I'm right. In the next month, I'll write about why I chose CAPE to go into regular portfolios.

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