April 15, 2022 | Institutional Perspectives | 11 min read

Investing in Canada: Are We Just Banks and Rocks?

In the mid-1990s, the federal government removed foreign content limits for Canadian pension plans and later made similar changes for individual RRSPs that altered the way Canadians invested. The result has been a continuing trend of investors reducing the Canadian equity weight in their portfolios, in favour of global equities.

Qualitatively, the argument for diversification is easy to make. Canada’s stock market is sometimes described as being made up largely of “banks and rocks,” and dominant companies in other industries like Nortel, Blackberry, Valeant and most recently, Shopify, created worrying concentrations in index focused portfolios, and in many cases, big holes when they lost their luster. Given that Canada makes up only approximately 3% of the MSCI World Index by weight, one may question allocating to Canada at all. Why not delegate that decision to a global equity manager where they can scour the world for investment opportunities?

While much of that assessment is fair and at times dominates the thinking behind allocation decisions, we do not believe that it tells the full story. When analyzing the Canadian market, one that is less covered globally, we believe that it is critical to look beyond the lens of the broad market, and more at the specific opportunity set available within. Canada is often considered a bit off the beaten track for global managers, with more of their resources dedicated to larger opportunity pools in the US, Europe and Japan. We believe that taking this purely global approach will lead to a significant number of missed opportunities in Canada for your portfolio.

We recently did an analysis of the benefits and pitfalls of investing in Canada versus global stocks. The analysis was presented as a webinar which can be found here. The key findings from our analysis follow below.

Over the last 25+ years, an investment in Canadian stocks would have produced a superior risk adjusted return relative to global stocks.

We believe that the prime objective for a typical investor is to earn a real return above inflation, and think a fair test for an equity portfolio, Canadian or global, is whether it can deliver Consumer Price Index (CPI) plus 5%¹ or approximately 7% in absolute return over the long-term². Using both active and passive performance data since 1995, the longest period available with Leith Wheeler’s actively managed funds in Canada, US and EAFE, we measured the experience of a Leith Wheeler investor against this Canadian dollar-denominated CPI plus 5% objective.

Figure 1: Performance of Leith Wheeler Canadian Equity Fund vs CPI plus 5%, Jan 1996 – Sep 2021³

We looked first at the calendar year performance of the Leith Wheeler Canadian Equity Fund against the CPI plus 5% target, and the results were compelling (shown in Figure 1). The portfolio has been very successful in not just meeting, but also exceeding the objective. There were certainly down periods, but those years of negative returns typically bounced back significantly.

Further consideration was then given to how much risk was taken to achieve this outperformance. Figure 2 shows the results of some modeling we did which looked at the historical information ratio, a risk-adjusted score measuring the outperformance against the volatility of the value-add, of various potential portfolios. Specifically, we looked at how a Leith Wheeler global equity strategy would have performed against the CPI plus 5% objective, if it contained either one-half Canadian equities or one-third. In each case the non-Canadian portion was comprised of two-thirds US and one-third international.

Figure 2: Information Ratios for Canadian Equity and Global Portfolios from May 31, 1995 to Sep 30, 2021^4,5

Reading left to right in the table, we see the following:

• The Canadian Equity Fund on its own produced the highest overall absolute performance and the highest information ratio, with a tracking error lower than its S&P/TSX Composite benchmark.
• The Global strategy on its own exceeded the CPI plus 5% hurdle (and its own benchmark), with lower volatility than Canada.
• The Global strategy with one-third Canada carried the lowest volatility, but the 50/50 global portfolio had a slightly higher information ratio. Both IRs lagged Canada on its own, but not by much.
• If you ignore the benefit of having Leith Wheeler as your active manager and look at just the benchmark columns: the S&P/TSX Composite posted the higher absolute return, with slightly higher volatility but net double the information ratio of the MSCI World (Net) Index.

The math clearly illustrates that pushing Canadian allocations even lower than one third would result in a continued decrease in value-add and information ratio, at least within this retrospective analysis.

“Passive” (benchmark-based) Canadian investing dominated global over the timeframe. The median equity manager in Canada was also more successful at beating its benchmark than its US and EAFE peers – thus active, Canadian equity management dominated all other options.

All asset mix studies that seek to maximize portfolio return or minimize volatility require a set of assumptions and parameters. Forward-looking modelling is informative, but al so has limitations that include a bias to recent performance, high sensitivity to inputs (preference for low volatility asset classes) and the absence of value-add assumptions by strictly using broad market projections. In our experience, the inclusion of value-add opportunities and fee assumptions materially increases the recommended weight for Canadian equity.

Using the same 25+ year period of analysis, the median manager in Canada has been able to generate the most value-add against its benchmark when compared to the US and EAFE markets. The US, despite being the leading market performer over the past decade, has been a difficult area to add value given its broad market coverage and recent growth led by a subgroup of “FA ANG” technology stocks⁶. Value-add in the international EAFE market has been more in-line with Canada and is the most consistent. The median manager was able to outperform the index 100% of the time on a rolling 5-year basis. However, actively managed fees for the EAFE market are typically higher for Canadian investors.

Figure 3: Experience of Median Manager in Beating the Index from May 31, 1995 to Sep 30, 2021⁷

Canadian stocks are very attractive in their own right, from an opportunity and valuation standpoint.

We believe that the case for Canada continues to ring true as it has a great governance and legal structure and transparent information to gain a differentiated insight on businesses. With that said, the market remains less efficient relative to US and E AFE markets, allowing experienced investment teams on the ground to better identify opportunities and look through short-term issues. At Leith Wheeler, our long-tenured Canadian Equity team has in many cases analyzed businesses for longer than the company management has been in place. Our deep knowledge of companies also provides us with an edge for effectively assessing ESG issues, particularly in relation to governance matters.

Canada has several world-class businesses that warrant material weightings relative to their foreign comparables. Going back to the notion that Canada is all “banks and rocks,” we believe that Canadian banks today are an opportunity, not a problem. Canadian banks are oligopolistic businesses with pricing power operating in a favourable regulatory environment. Their dominant businesses span across banking, insurance, capital markets, and wealth management, and can generate consistently high returns on capital while maintaining conservative balance sheets. They tend to carry lower price to earnings multiples and higher capital ratios⁸.

Figure 4: Canadian Banks are Competitive Relative to the Biggest in the US

For our Canadian equity portfolio, our active management approach results in a high active share⁹ and consists of two types of business that we typically hold:

• “Compounders,” such Royal Bank and Constellation Software, are effective long-term businesses that have consistently reinvested and compounded shareholder value. These types of companies are extremely competitive globally and compare very well against their global peers.
• “Out of favour ” stocks, like NFI Group, are another category of investment that we tend to hold (note these two are not necessarily mutually exclusive). Out of favour companies are more of the classic “value” opportunities, where a temporary cloud suppresses its share price. In these situations we have assessed, through our deep knowledge of the company and management, that the long-term value of the business remains intact. The temporary issues provide us with an attractive entry point.

Due to our size, we are able to hold our “compounders” in meaningful weights without reaching public float constraints. We can also be nimble when it comes to adding “out of favour” names.

Canadian stocks are also currently trading at a large discount to US ones. While the two markets have tracked fairly closely for many years, US stocks are currently about eight multiple points higher – considerably more expensive. While Canadian stocks are trading in line with their long term average at approximately 15x earnings, the margin of safety is much lower in the US.

Figure 5: Forward Price to Earnings Ratios for Canadian Stocks Decoupled from US

The problem with overpaying for stocks is you sacrifice future potential gains. Despite equity markets being quite correlated, market leaders do change. In May 2012, we gave a presentation to our clients titled, “Well Into the Future: Foreign Equities – A Decade of Frustration” where we recommended patience when it came to global equities after a decade of negative returns. We pointed out that a diversified equity portfolio remained important and reminded clients that cycles change.

Now, we find ourselves advising clients with a similar message regarding Canadian equities. We would like to remind clients that the strength in the US market and weakness in the Canadian market is priced into their multiples. Reducing Canadian equities in favour global equities today would be tantamount to selling low and buying high.

Figure 6: Market Leaders Over the Years: 10 Year Annualized Returns by Decade

With many world-class businesses trading at a discount to global peers and a demonstrated history of producing superior risk-adjusted returns, the Canadian equity market is not one to dismiss. Fads may come and go, but quality and value are what will best serve every portfolio.

¹A real return of 2 to 3% is a typical target of total portfolio return for institutional investors. Assuming a typical 60/40 balanced portfolio, the equity return target would be a real return of 5%.
²Assuming long-term growth of the Consumer Price Index to be approximately 2%.
³Source: Leith Wheeler, Statistics Canada. Fund and index performance are total return and gross of fees expressed in C$ Currency. The Leith Wheeler Canadian Equity Fund is based on Series B return to September 30, 2004, then Series A returns thereafter.
⁴Source: Leith Wheeler, Statistics Canada, Standard & Poors, MSCI Inc., eVestment. Fund and index performance are total return and gross of fees expressed in C$ Currency. Information Ratio is calculated using monthly data between May 31, 1995, to September 30, 2021, and is annualized. The start date of May 31, 1995 represents the earliest available data for the relevant Leith Wheeler pooled funds. Foreign index returns are converted to C$ based on the Bloomberg FX rate as of June 30, 2020. The Bank of Canada noon rate was used prior to June 30, 2020. Please see endnotes regarding hypothetical performance and important information at the end of the presentation. The Leith Wheeler Canadian Equity Fund is based on Series B return to September 30, 2004, then Series A returns thereafter. The Leith Wheeler Global Equity Strategy is a hypothetical portfolio based on a constant 2/3 weight in the Leith Wheeler/Barrow Hanley Global Advisors US Equity Strategy and 1/3 weight in the Leith Wheeler International Equity Pooled Fund Series C. The Leith Wheeler/Barrow Hanley Global Advisors US Equity Strategy is a hypothetical portfolio based on the Barrow, Hanley, Mewhinney & Strauss Diversified Large Cap Value asset-weighted composite of fully discretionary portfolios between October 31, 2000 to September 30, 2021. Performance prior to October 31, 2000 was based on the Leith Wheeler US Equity Fund Series B. The annualized return of the Consumer Price Index (CPI) +5% from May 31, 1995 to September 30, 2021 was 7.1%. Returns are illustrative.
⁵The analysis was done using two asset mixes for the Leith Wheeler All Equity Portfolio. The Leith Wheeler All Equity Portfolio A is a hypothetical portfolio with a constant 1/3 weight in the Leith Wheeler Canadian Equity Fund and 2/3 weight in the Leith Wheeler Global Equity Strategy. The Leith Wheeler All Equity Portfolio B is a hypothetical portfolio with a constant 1/2 weight in the Leith Wheeler Canadian Equity Fund and 1/2 weight in the Leith Wheeler Global Equity Strategy.
⁶FAANG stocks are represented by Meta (formerly Facebook), Amazon, Apple, Netflix, and Alphabet (formerly Google).
⁷Source: Leith Wheeler, eVestment. Fund and index performance are total return and gross of fees expressed in C$ Currency. Foreign index returns are converted to C$ based on the eVestment FX rate. Please see endnotes regarding hypothetical performance and important information at the end of the presentation. Alpha of annualized return using eVestment monthly data from May 31, 2005 to September 30, 2021. Number of observations: All Canadian Equity Universe (37), US Large Cap Equity Universe (203), EAFE Large Cap Equity Universe (29). Rolling monthly 5-Year performance data in from May 31, 2005 to September 30, 2021.
⁸Capital ratio indicates the amount of cash held as security against loans – higher is better.
⁹Active share reflects the degree to which a portfolio’s stock weights vary, relative to its benchmark. Low active share represents benchmark hugging and high active share reflects higher conviction among fewer investments.

IMPORTANT NOTE: This article is not intended to provide advice, recommendations or offers to buy or sell any product or service. The information provided is compiled from our own research that we believe to be reasonable and accurate at the time of writing, but is subject to change without notice. Forward looking statements are based on our assumptions, results could differ materially.

Reg. T.M., M.K. Leith Wheeler Investment Counsel Ltd. M.D., M.K. Leith Wheeler Investment Counsel Ltd. Registered, U.S. Patent and Trademark Office