Canada’s Earnings Upside

By Ari Charney • October 1, 2012 • Canadian Edge Weekly

Amid global economic uncertainty, stocks from resource-backed economies such as Canada still enjoy advantages over their developed-world peers. Although the market rarely proves rational in the short term, there’s still a fundamental argument that Canadian equities have room for further earnings upside.

Should that be the case, it would be a boon for the Canadian market, which has lagged the US market so far this year. The dividend-reinvested return of the S&P/TSX Composite Index (SPTSX) was 5.4 percent year to date through the end of September, compared to the 12.7 percent gain for the S&P 500.

Canadian stocks have underperformed the US this year because their heavy commodities exposure has put them at greater risk of a global economic slowdown. Additionally, the strength of the Canadian dollar has crimped the country’s exports.

Peter Buchanan, a senior economist with CIBC World Markets, issued a research note last week that said Canadian firms’ pre-tax profits as a percentage of gross domestic product (GDP) are still four percentage points below their all-time high. The peak for this figure was set back in 2008 when Canada’s energy sector was riding the parabolic rise in energy prices. By contrast, this same ratio is currently at an all-time high for US firms.

Canadian firms also enjoy a comparative advantage in terms of profit margins, with average margins almost two percentage points wider than at US companies. Although US firms boast superior productivity, Canadian firms’ fiscal conservatism has given them a modest edge in margins.

Non-financials have successfully deleveraged to the point where their debt-to-equity level is at a record low of 53.3 percent, which is a gulf of 15 percentage points below the level for US companies. In a strong economy, such an approach might curb a company’s growth potential, but it seems prudent during a period of continuous market and economic turmoil.

And unlike US firms that have boosted profits via cost cutting, Canadian firms have been less dependent on cost cutting to widen margins. Instead, Buchanan notes that operating leverage and greater efficiency have been responsible for 54 percent of the rise in earnings since the recovery began in 2009.

So should the situation warrant, management teams at Canadian firms still have cost-cutting measures as a tool at their disposal to preserve profits. US firms, by contrast, have little to no room to pare costs further.

So how does the SPTSX compare to the S&P in terms of other valuation metrics? The SPTSX has a price-to-book value (P/B) of 1.8, which is 18.3 percent below the S&P’s P/B of 2.2.

However, the price-to-earnings (P/E) and price-to-sales (P/S) ratios for the S&P are slightly lower than the SPTSX. The S&P has a P/E of 14.7 compared to 15.3 for the SPTSX, and its P/S is 1.4 versus 1.6 for the SPTSX.

Meanwhile, for income investors, the TSX offers an attractive yield of 2.9 percent, which is almost 40 percent higher than the S&P’s current yield of 2.1 percent.

The bottom line is that Canadian firms are better prepared than US firms to endure another downturn, and may have additional upside ahead in the interim.

The Roundup

Here’s where to find second-quarter earnings analysis and outlook for all Canadian Edge Portfolio Holdings.

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