EWC: Canadian Equities Remain Attractive Relative To U.S. Equities
Summary
- Canadian equities look reasonably priced in light of a fairly expensive U.S. equity market.
- Two key sector exposures of EWC are Financials and Energy, both of which are performing well into the new business cycle.
- While EWC's (and Canada's) greater relative exposure to carbon-based fuels is perhaps "counter-narrative", EWC remains a viable medium-term play.
- However, it is worth noting that recent outperformance of EWC shares has been lifted by a stronger Canadian dollar.
- USD/CAD is likely to trade more firmly going forward, perhaps with a near-term floor around 1.20. Therefore, investors will need to see the appeal in the fundamental case for EWC over FX rates going forward.
iShares MSCI Canada ETF (NYSEARCA:EWC) offers U.S. investors the ability to gain direct exposure to Canadian equities via an exchange-traded fund. Shares in EWC have been rising on the back of more robust energy prices (and probably rising commodity prices in general) as well as increased optimism in the ability of the global economy to bounce back from the throes of the COVID-19 pandemic.
In my last article covering EWC, published November 22, 2020, I was bullish EWC because I thought that the fund would benefit from more stable oil prices, the global vaccine rollout supporting renewed optimism, and the prospects of a new economic cycle for major commodity exporters such as Canada. I also thought the Canadian dollar could rise for similar and related reasons. Since then, EWC shares have out-performed U.S. equities modestly. Based on Seeking Alpha's calculation at the time of writing, EWC has risen by almost 21%, whereas the S&P 500 has risen by 18%.
(Source: TradingView)
EWC shares are now trading firmly above pre-pandemic highs. Oil prices are back to pre-pandemic levels. Clearly, markets have been making a lot of headway. It is perhaps worth revisiting the valuation of EWC shares to see if the market still looks attractive from a U.S. investor's perspective.
The table below is produced to compare forward operating earnings of EWC and Vanguard S&P 500 ETF (VOO), a popular U.S. equity tracker that seeks to replicate the S&P 500. If EWC is "cheap" relative to VOO, an allocation is easier to justify. We use Morningstar data here for forward price/earnings ratios for VOO and EWC.
(Risk premium data from Professor Damodaran for January 2021; note these likely overstate ERPs at present. Forward P/E ratios provided by Morningstar. Bond yield data from Investing.com for the United States and Canada.)
Assuming the same equity risk premia for the United States and Canada, and considering very similar 10-year bond yields at present, the only other factor left to affect the valuation materially is the multiple paid for forward earnings. Canadian equities evidently, as a result, continue to look more appealing. This is a "directional" model as these are operating earnings, although bear in mind that while net income figures for the EWC portfolio will be lower in aggregate, so will more recent equity risk premium calculations. It is difficult to tell how long ERPs will go, however, I would rather own cheaper equities in the case of a correction where ERPs rise in the short term as opposed to already over-stretched equity markets (such as the U.S. equity market).
The U.S. equity market remains the most popular and will probably continue to absorb the bulk of investment flows into equities as an asset class globally over the medium term. However, right now, international diversification remains attractive, and considering we are still probably early on in this current business cycle (post COVID-19), Canadian equities (with their exposure to energy and commodities) continue to look quite good.
(Source: iShares.com)
Key sector exposures include Energy (13.82% of the fund as of April 30, 2021), but also even more prominently Financials (at 37.49%). EWC maintains large portfolio exposures in several major banks in North America, including the Royal Bank of Canada (RY). Considering Financials are likely to continue to do fairly well over the medium term after the chaos that ensued in 2020, with longer-term interest rates edging higher, banks are not bad stocks to hold at the moment. With the combination of banks and energy, Canadian equities look good from a valuation standpoint and good from a cyclical standpoint.
Some caution is warranted though; a narrative that has been built up by our global society in recent times is the "green" story. Bearing in mind Canadian banks will naturally have direct exposures to the Oil & Gas industry too, by virtue of their commercial loan books, etc., and even indirectly through mortgage books tied to employees of the Oil & Gas industry (thinking more widely), with energy representing circa 10% of Canadian GDP historically, perhaps I would stick to EWC as a medium-term play only. It is going to take a long time to move against carbon-based fuels, but governments will no doubt make it less and less rewarding (in attempts to tax the negative externalities).
Therefore, while Canadian equities look appealing in terms of valuation and cyclicality, and while I would be unsurprised to see EWC out-perform in the medium term, being more risk averse I would not recommend a large allocation to Canadian stocks on the basis that it is "counter-narrative"; and sentiment, as we know, affects prices. Flows matter more than prices. See for example Russian equities, which continue to look super cheap. We want to swim along with the tide rather than against it (although as a side note, Russian equities I have justified allocating to, given just how cheap they are).
Still, the "green" narrative may be overestimated, and perhaps the energy sector will mature nicely as does the current, new business cycle. The energy sector has historically performed well late-cycle, and as such we could in fact see a longer-term out-performance of Canadian equities.
It is also worth noting that the Canadian dollar has been strengthening versus the U.S. dollar since my last article, which has provided a tailwind to EWC, whose holdings are denominated in Canadian dollars (while its shares are denominated in U.S. dollars). I anticipated CAD strength in my previous note, and think that there is further potential for CAD strength, although perhaps the potential is now muted as USD/CAD is probably now trading at close to fair value after dropping around 5 to 6% since my last article. This is a relevant point as it can exaggerate EWC's performance in USD terms. Since the March 2020 lows, EWC has out-performed the S&P 500 by circa 14% (see below), but USD/CAD has also fallen by around the same amount.
Nevertheless, if we assume a far more stable USD/CAD exchange rate going forward, which I think is probably fair (as shown in my table above, the U.S. 10-year yield still beats its Canadian counterpart at present, which would support a firmer exchange rate, although U.S. inflation remains elevated relative to Canadian inflation), the other key factors are still valuation and cyclicality. I think EWC probably beats U.S. equity trackers on both points at present, and as such I remain mostly bullish on Canadian equities.
This article was written by
Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.