Last week, we released our latest Quarterly Outlook Commentary, a report written by our research team providing insight into the global markets and how we’re positioned to continue finding opportunities. The theme we covered this quarter was investors fearing the uncertainty of the markets, therefore seeking safety at all costs. With the markets reacting to this fear, we are finding that high quality, cyclical companies are trading at a discount and therefore taking advantage of the pockets of undervaluation. Below, we share a snippet of our Outlook on Canada in our report.
The Toronto Stock Exchange (TSX) has been the second best performing market this year, up 10%, beaten only by the Brazilian market. Energy (19%) and materials (52%) are the best performing sectors, meanwhile healthcare (-72%) and information technology (-6%) have been the worst. Financials and banks are up modestly, but have been underperforming the TSX.
At the beginning of the year, we added to some of our positions in energy and energy infrastructure stocks as we felt they were very undervalued and ripe for a recovery. We bought names such as Arc Resources, Pembina, Suncor, TransCanada and Vermilion. Since then, the energy sector has rallied and valuations have expanded materially. As seen in Figure 1, the price-to-earnings (P/E) ratio of the TSX (blue line) went from 14x, at the beginning of the year, to 17x, almost reaching the peak of 18x in 2015. The ex-resources P/E ratio, which represents the TSX excluding commodity stocks, (red line) increased from 11x to 13x, which is below the peak achieved in 2015 of 14x. This indicates to us that we are seeing value in non-commodity stocks trading on the TSX, and that is where we’re shifting our focus to finding high quality companies. As an example of this, we have recently added to our position in Magna International. Magna International is one of the largest auto parts manufacturers in the world and yet it a trades at an estimated forward P/E multiple of approximately 6.5x, which is at a discount to the market.
Figure 1: TSX Forward P/E* - All Sectors vs. Ex-Resources
*FT/S&P Canada used from 1987 to 1994, MSCI Canada from 1995 to 2001, TSX Since 2002
Source: Scotiabank GBM Portfolio Strategy, Thomson Financial
With the market focusing on energy and metals- related sectors, we are seeing emerging value in other sectors. For example, consumer staples, such as grocers, have underperformed the TSX year-to-date. Some grocers trade at very compelling valuations and some generate very high levels of return on capital despite relatively slow growth. In addition, despite a sharp rally in materials, agriculture-related stocks lagged the TSX substantially. We continue to research several of names in these sectors as possible holdings.
We want to emphasize that as an investment firm, we don’t manage volatility in the markets – what we can and do manage is how we react (or more importantly, don’t react) to it. Just because a stock is down, it doesn’t necessarily mean the thesis is broken, or that it is a permanent impairment to the value of the stock. When the markets are volatile, or stocks move in a manner we don’t expect, we remove emotional bias and reaction by reviewing our investment process which dictates whether the thesis is still intact or broken, and act accordingly.