A Favourable Environment for Canadian Equities

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Greg Zdzienicki

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Greg Zdzienicki, client portfolio manager, equities, with CIBC Asset Management.

Canadian equities have a very positive setup right now given what’s going on in the world. A couple things. If we think about the immigration boom that Canada has, it’s one of the fastest growing developed countries in the world due to this immigration. And the immigration coming into Canada is well-educated, well-to-do entrepreneurial immigrants, and this creates more jobs, positive jobs in the economy.

We have a Canadian energy sector that is not dirty carbon. Canada’s renewable sector is about 3% of the TSX, and Canada’s energy sector is actually one of the cleanest oil producers in the world when we look at things like carbon emissions.

Global tech companies have set up offices in Canada to take advantage of the human resources that we have and the intellectual capital that Canadians have. And I also think that small-cap companies and the TSX overall are really primed for a commodity super-cycle as we see things like higher copper prices. This is going to benefit Canada versus other economies, like for example, the U.S. that’s more geared into these technology stocks and bank stocks, for example.

I also think that valuations, if we’re looking at the markets, valuations are at trough levels in Canada. And if you compare that to something like the United States, the U.S. is actually above their long-term average. So in terms of regionally, compared to Europe, which is also trading a little bit cheaper, but Canada is trading much cheaper than the largest economy in the world, cheaper than the United States. We’ve also got a higher dividend yield.

And as we look across this investment landscape here in 2023, I think there’s great opportunities for Canadian equities, one in terms of the growth potential, the relative valuations, and the relative stability, I think, of the Canadian economy. And although we’ve seen flows moving outside of Canada for over the last decade, I think that the current backdrop of a strong ESG commitment in our energy industry, OECD leading population growth, broadening of our economic base, should really set Canada up very well for 2023 and beyond.

So a positive view on a number of different sectors, energy as well as the financials. And specifically the financials, I’ll talk a little bit about our view on banks. It really depends on the portfolio manager and the strategy that we’re looking at. Banks, I’m not going to deny the fact that these are oligopolies. They have pricing power, cash flow generative. So within our growth strategies, we are selective in picking the bank stocks that we want, but they’re also trading at a discount to their long-term intrinsic value. So you will see across our value strategies that we have an overweight across most of the banks. So very positive positioning in the banks. They’re stable dividend growers, generating a ton of cash flow, and trading at a discount to their long-term intrinsic value.

When we position banks within, specifically within the financial sector… I think when we look across the financial sector, we see things like property and casualty insurance. So our number one pick would be in the P&C space. Secondly would be in the non-bank financials, diversified financials. You can think of things like Brookfield, for example. Within the banks, we think… It would be sort of our third ranking, generally speaking, within the financial sector. And some of the ones that we like there are BMO and National Bank from a growth perspective. But as I said, within our value strategies, we are overweight probably in all the banks, whereas within our growth strategies we’re very selective. And then finally, in terms of pecking order from the financial sector, I think life insurers would be our number four pick. So we have P&C insurers, non-bank financials, banks, and then life insurance companies.

Within the energy space we have, in some of our strategies moved from an underweight a couple years ago to an overweight or a market weight within the energy space. For example, within the oil sector, we do like things like Cenovus, for example. Within gas, we like companies like Tourmaline and Arc Resources. All these companies are very low-cost producers, and they have very strong management teams, very good balance sheets. When we think about Canadian energy compared to other parts of the world, I think we have a much stronger commitment to ESG and reducing carbon emissions, and we also have very long operating lives for these assets. When you set up an operation in the oil sands, for example, there’s a tremendous upfront cost, and then those marginal costs are a lot smaller. But you’ve got very long-term life, whereas if you think about a well that you’ve got to drill, set up, quickly drill, and those have much shorter lives in terms of the reserves that are there, and you’ve got to pick up and go somewhere else.

And another reason that we like Canadian energy is the strong balance sheets and the capital discipline. What we saw happen in 2020 when energy prices went down, we saw a lot of large energy companies actually cut dividends and preserve cash and stop some of their share buyback programs. If you think of what happened in 2021, we saw a resumption in dividends, and we saw a big jump in buybacks, share buybacks. And then in 2022, that continued again as we saw another very big jump in dividends from energy companies and buybacks again more than doubling as they resumed these aggressive share buyback programs that they have. And I think that speaks to the strong discipline, the cash flow, and the strong management teams to identify those opportunities when we needed to preserve cash. But as energy prices went up, these companies are in a very positive position to return cash to shareholders going forward.

Some of the areas that’ll be a little riskier and may be a bit more challenged are the areas of the market that have long-dated cash flow, so things like technology. As interest rates have moved up, we see some challenges within technology because those cash flows are discounted at much higher discount rates given higher interest rates. Now, technology in itself is not necessarily inflationary. If you think about technology, technology is usually the opposite of that because it helps increase efficiency for companies. However, a lot of these things take a long time to play out. So we do see technology companies or long-dated cash flows tend to be impacted as interest rates rise. Also, the consumer discretionary sector. There’s going to be less purchasing power there, so that’s going to be an issue when it comes to inflation. So I would think we’d probably have things like discretionary and technology, also some of the communication services area due to their tech-like returns within that particular sector.

In terms of the current environment where we see higher inflation, we’re thinking about volatility. We certainly don’t know what the market is going to bring, and we can’t predict what’s going to happen in the first six months or the second six months, and whether or not we’ll see a recession in the first six months or the second six months of the market. So how do we prepare for this type of environment? One way to do this is through managed solutions. Managed solutions do give a broad, diversified exposure to various different asset classes, to various different sectors.

And if we’re looking to drill down a little bit more to the type of companies, how would we prepare some of our investment strategies or individual funds? We’re looking for companies that have competitive advantages. So in an inflationary environment, companies that have these competitive advantages are more likely able to pass off the price increases, and they can do that if they do have these competitive advantages, compared to companies that are going to be strapped for cash that need to go out and borrow, particularly as rates have gone up, to combat this inflationary issue.

Now also, when we’re thinking about inflation, historically, stocks have been a good hedge for inflation as cash flows tend to be tied to rising prices. Areas of the market, like materials and energy, they often offer a hedge against inflation as well, because the price paid for a resource or a commodity often increases with inflation.

One other thing to look at in these environments is dividends. Dividends have started to matter again. When you think about the period pre-2001 and the market was on a tear, dividends didn’t matter. People weren’t looking at dividends. When we got into the period from 2001 to 2013, we saw an environment where your price return without dividends would’ve been virtually flat over that period of time. However, picking up that yield, that dividend yield, generated a tremendous amount of cash flow and was a big component of the actual total returns that clients have felt. Then since 2014 up until about 2020, dividends were again ignored as the market was moving towards its 10-year bull run. So in a period of uncertainty right now, I think dividends are another thing to focus on, given what we’re seeing in the market, given the inflation, and given the volatility.