What’s behind the ‘Canada discount’ in equity markets?

Experts weigh in on how investors can leverage the huge valuation gap with U.S.

For investors keeping score over the past 12 months, the difference in performance for equity markets north and south of the border has been hard to ignore.

During that time, S&P 500 has rocketed 12.4 per cent while the S&P/TSX Composite indexes has returned a measly 3.8 per cent, leading to the opening of a fairly significant valuation gap, overall, between the two.

A deeper dive into just which sectors are responsible for that outperformance yields some interesting results, but whether that information is enough to bring value hunting investors back to certain Canadian sectors is not so clear.

Barry Schwartz, chief investment officer at Baskin Wealth Management, says he isn’t a fan of comparing U.S. and Canadian indexes in order to find bargains, because the business environments tend to be so different, and because individual companies can skew the averages.

Still, Schwartz acknowledges that a basic “reversion to mean” principle suggests that the Canadian index, with a 12-month trailing P/E of 17.6, could outperform relative to its U.S. peer, with a comparable P/E of 20.8 in the years to come, although when that reversion happens is anyone’s guess.

“If you’re looking for history to be your guide in terms of performance of P/E ratios, it might not be very helpful,” said Schwartz. “On the other hand, the underperformance of the TSX of the past 10 years has been dreadful, so the TSX could be a meaningful performer assuming commodity prices stabilize at these levels.”

The Canadian discount, it’s worth noting, is a recent phenomenon. Both the Canadian and American indexes averaged trailing P/E ratios of about 21 over the past two years. This year, however, the bottom seems to have fallen out in Canada.

So what’s going on? Schwartz blames the TSX’s low P/E on the underperforming financial services sector in Canada (12.3 P/E in Canada vs. 16.1 in the U.S.), which has suffered from fears that interest rate hikes could provoke a real estate crash.

Despite phenomenal returns over the past couple of quarters, shares at the Big Six banks have barely moved, resulting in lower multiples for the sector, which makes up about 35 per cent of the composite index.

Schwartz says the threat of a housing correction is overblown, and that the Canadian banking industry isn’t as sensitive to the mortgage market as investors may fear.

“Many people have gotten killed trying to bet against the Canadian housing market. The banks seem to prove time and time again that they have many other levers and drivers to their businesses,” he said. “Even a meaningful decline in housing prices wouldn’t have much of an impact.”

Stephen Takacsy, CIO at Lester Asset Management, has a slightly different take on the financial services sector in Canada.

Though bank multiples have dipped recently, Takacsy notes that they’ve been lower in Canada for a long time now (two-year average of 13.6 in Canada vs. 16.1 in the U.S.), and this is a function of structural difference south of the border.

“In Canada there are six big guys that control pretty much everything,” he said, “whereas in the ‘States there are regional banks, there are the investment banks — you know it’s very, very different.”

The Canadian financial services sector may seem cheap right now relative to the American financials, but Takacsy suggests investors take a look at historical price-tobook ratios. Using that metric, the big banks are actually expensive.

Both portfolio managers agree that some sectors are more comparable than others. Resource sectors like energy (28.2 Canada; 31.3 U.S.) and materials (21.3 Canada; 20.5 U.S.) may appear comparable but are exceedingly tricky to benchmark.

Other non-comparable sectors include health care, IT and real estate (which are too small in Canada) and utilities (where P/E metrics are irrelevant).

Industrials (22.4 Canada; 19.9 U.S.) may be somewhat more comparable, as well as the consumer staples sector (20.1 Canada; 18.9 U.S.) and the consumer discretionary sector, where Canadian retailers have been trading at low multiples relative to their American peers (17 Canada; 24 U.S.)

Telecommunication services companies, meanwhile, suffer from the opposite problem of the big banks in Canada: they trade at a premium (16.7 Canada; 12.6 U.S.) because they can command higher margins in Canada’s lesscompetitive environment.

The U.S. telecom industry is still fragmented and highly competitive, says Schwartz. Efforts to consolidate cablecos and telcos and media companies have roiled the market and upended balance sheets.

By comparison, the cozier market in Canada is dominated by three integrated players that are focused on the far more predictable business of growing their wireless businesses.

“The valuations on some of the U.S. telcos seem to be depressed but that’s because they seem to be blowing up their balance sheets to make these massive media acquisitions, whereas the Canadian telcos have been much more stable and predictable,” he said.

Even a meaningful decline in housing prices wouldn’t have much of an impact.