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Diversifying your stock investments into the US stock market will greatly enhance your retirement savings and improve the consistency of your returns.
Peter McMurtry, June 6, 2013
Canadians are wondering why their domestic stock market is not performing nearly as well as the US market and many are afraid that they may have missed the rally in equities. The simple explanation is that there are major differences with the composition of the US S & P 500 stock index and Canada’s TSX Composite index. These variations are not always readily transparent to the Canadian retail investor and are the principal reason for the wide divergence of investment performance and increased market volatility in the Canadian market.
For many years Canadians avoided investing in the US altogether with poor investment returns combined with a weak Greenback. The collapse of the US banks during the last recession and the major economic malaise in Europe that is still unfolding also did not help convince Canadians to diversify their investments internationally. Although it is readily apparent that our banks are much stronger than their US counterparts, this is old news with the American financial industry very much on the mend. Low interest rates and a dramatic improvement in the US housing industry have helped the US banks improve their balance sheets. It is ironic that Royal Bank divested most of their US retail branches in 2012 in the early stages of a major turnaround in the American housing sector. It is also interesting to note that the loonie has actually fallen from a 7% premium in 2007 to a small discount today and this has further exacerbated many Canadian retail investors who have not benefitted from their currency devaluation.
Analyzing the sector component weights of each market is the best place to start in our discussion. Canada’s cyclical exposure represents 39% of the index weight compared to only 14% for the US market. Energy and Basic Materials make up the cyclical component of both indices. The financial sector, that includes banks and insurance companies, highlights another wide variation in the two countries with Canada at almost 34% compared to the US 17%. The collapse of Nortel and more recently Blackberry have exaggerated the weight differences in the technology sector with Canada at just under 2% compared to the US at over 18%. It is interesting to note that Nortel at its peak represented 33% of the Canadian market. At that time, the market volatility of the Canadian market was greatly exaggerated by the massive weight in Nortel.
Apart from investment professionals, many Canadian investors remain largely unaware of the wide divergences of equity markets and the much greater price volatility of the TSX Composite that continues to exist today with the large cyclical exposure. The ten largest weighted Canadian stocks represent 34% of the Toronto index compared to only 18% in the US.
Despite the increased volatility, Canadian institutional money managers have historically had more success in outperforming their domestic equity index than their US counterparts have done. The principal reason for this is that the only investment decision they need to make is to over or underweight the cyclical and financial stocks relative to the index. As highlighted previously, the combined weight of cyclical and financial stocks total 73 % of the Canadian equity market relative to only 31% in the US. This makes it much easier to beat the index in Canada as the decision is more based on sector weight exposure as opposed to individual stock selection as is the case south of the border. For example if cyclical stocks are expected to do better than financial ones, the Canadian portfolio managers simply structure their equity portfolios to have proportionately more cyclical exposure and less financial weight compared to the overall index. If one thinks of the benchmark index as one large stock portfolio it is easier to envision this. In the US it is much harder to outperform the benchmark S & P 500 index as the sector weights are much more diverse, making stock picking more important on a relative basis.
However most clients are not simply trying to outperform their benchmark domestic index, but are attempting to achieve strong investment returns over time combined with low risk or volatility. This is why it is essential to diversify internationally. The late mutual fund guru, Sir John Templeton, always selected the best companies to invest in the world, no matter where they were located. This philosophy still makes a lot of sense and super cedes any overly nationalistic sentiments. Domestic nationalism really has no place in investing for your retirement and never should.
During my many years managing retail portfolios, I frequently met opposition from clients when I advised diversifying into the US before it was readily apparent that the US was recovering. I met the same type of response when I recommended a switch out of GIC term deposits into equities .The lesson from all of this is that it is imperative to be flexible and diversified with your investments. No market- stock, bond, commodity or real estate goes up or down forever. Over the long term investment returns revert back to their long term average returns regardless of their short term performance.
Despite the major differences between the US and Canadian equity markets, most US investment research analysts principally use the Price Earnings multiple (PE) as their only valuation method to choose their stock investments. Unfortunately for cyclical companies the Price Earnings ratio is not particularly useful with companies that have very volatile earnings that can at times fall into losses. Buying a mining company with a low PE is not advised as the earnings may have peaked. It is preferable to buy a cyclical company where the PE is very high or infinity meaning that there is a loss. Timing cyclical purchases when corporate earnings are bottoming is a much better strategy. The Price / Book ratio is a more informative valuation measure for cyclical companies with book values traditionally not nearly as volatile as corporate earnings. However PE ratios can still be used effectively for non cyclical companies.
Over the last five years US equities have materially outperformed Canadian stocks and this difference is even more exaggerated by the weakness in the loonie over this period. Despite the massive US central bank quantitative monetary stimulus that continues to keep interest rates artificially low, inflationary expectations remain depressed. It is too early to predict which market will perform better over the next five years, but the important factors to consider are the world economic growth outlook, especially China and India, the currency movements – US dollar vs. world currencies and US dollar vs. our loonie and the outlook for inflation. Historically Canadian companies have benefitted by a weak Canadian dollar and this is especially true for the energy and material sectors. Over the last month, basic defensive sectors in both countries such as utilities, telecoms and consumer staples, have just begun to underperform the more volatile cyclicals, after having experienced superior investment returns since the market rebound. As you now know from this article, the Canadian stock index has a much higher cyclical component and this may well help to see our markets recover.
The most important message is that it is never a good idea to ignore an equity market simply because you are either afraid of or have limited knowledge of the market in question. Setting up a diversified portfolio for the long term that includes US equities will only help you enhance your retirement nest egg and lower your annual volatility of returns.