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The Canadian stock market has been a no-go zone for investors for a while now.
The resources-rich equity market has suffered as commodities have tumbled in price. In fact, the nearly year-long slide in the S&P/TSX Composite Index was the worst period for the index since the 2008 financial crisis.
But with the very sharp rebound in the prices of many commodities recently, the Canadian stock market has quickly gone from chump to champ. It is now the best-performing stock market in the developed world in 2016.
Source: Bloomberg
Sentiment changed so much that Brian Belski, chief investment strategist for BMO Capital Markets, told Bloomberg, “We believe Canada will likely outperform U.S. equities for the first time in five years.”
Let’s take a deeper dive into whether that optimism is justified.
Oil Still Hurts
For Canada to outperform other markets, the slide in commodities would have to be at an end. Especially oil. For instance, the correlation between the price of oil and the Canadian dollar between May 2015 and February 2016 has been 0.97.
To me, it doesn’t look like the commodity slide is over. The recent rally has all the dynamics of a short-covering rally in a bear market. These are characterized by very sharp moves higher in a very short period of time. Bull markets usually start a bit more tamely.
Let’s even say the bottom in commodities is in and prices stabilize. Stabilization does not really improve the dire straits the Canadian energy industry is in.
In the core of the oil sands industry, Alberta is the only Canadian province with a negative gross domestic product. And it is now forecasting a deficit in the fiscal year beginning April of CA$10.4 billion ($7.75 billion).
And, as in the United States, energy’s problems have spread straight to the banking sector.
Let’s look at Canadian banks, including the “big five” banks: Royal Bank of Canada (NYSE: RC), Toronto-Dominion Bank (NYSE: TD), Bank of Nova Scotia (NYSE: BNS), Bank of Montreal (NYSE: BMO) and Canadian Imperial Bank of Commerce (NYSE: CM).
Bloomberg reports that Canadian banks’ exposure to Canada’s struggling energy industry is about $80 billion. That is more than double what the banks said their exposure was back in January. It’s a very similar situation to U.S. banks under-reporting their oil and gas exposure.
Bloomberg’s figure doesn’t include credit lines, which troubled firms can tap. So we can probably add another $40 billion to $50 billion more in exposure.
Canadian banks set aside CA$259 million ($193 million) in provisions in the first quarter. That is higher than all of last year. But more set-asides are very likely.
Oil’s Tentacles
The oil story is more than just about bad loans, too. The good times in energy and other commodities also made Canadians overconfident.
Canada’s consumers are overextended. Canadian household debt is at a record 165% of disposable household income. That’s a tough situation if job losses enter the picture.
And the oil boom pushed up real estate prices as well. The rating agency Fitch says Canadian homes are overvalued by about 20% on average. If Canada’s housing bubble is punctured, it won’t be good for Canada’s economy or its banks.
The bottom line for investors: Avoid any Canadian stocks with exposure to these sectors. And avoid the poster child for “squishy” accounting, Valeant Pharmaceuticals International (NYSE: VRX).
A Pair of Canadian Stocks to Consider
But that doesn’t mean you should avoid Canadian stocks altogether. Here are two of my favorites.
The first is Canadian National Railway (NYSE: CNI), which has outperformed other railroads.
Instead of a drop in revenues, Canadian National Railway actually saw revenues rise by 2.4% in 2015. I believe that’s due to its operational efficiency, which is better than any of its peers – not to mention its diversity in customers away from Canada and the commodity sector.
The company is also a dividend play. Every year since it went public in 1995, Canadian National Railway has raised its dividend on average by 17% annually.
The second stock on my list is the world’s largest and most successful gold royalty and streaming company, Franco-Nevada Corp. (NYSE: FNV). Fund manager Frank Holmes of U.S. Global Investors calls it the “royalty of the gold industry,” and I agree.
Since 2008, it has outperformed both gold and the S&P/TSX Global Gold Index, which includes producers of gold and related products. And that’s without the risk of a gold exploration and mining company. All Franco-Nevada does is provide project financing to miners in exchange for royalties on the gold produced.
Its business model allowed Franco-Nevada to raise its dividend from $0.04 a share in 2011 to $0.21 a share in 2015. That’s a 424% increase. All while gold declined 38%.
In this environment, I like companies that are steady dividend raisers. It’s one reason I believe both Franco-Nevada and Canadian National Railway should continue to outperform both the Canadian and U.S. stock markets for the foreseeable future.
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