Canadian Stocks vs. US Stocks: In Search Of Quality by Evergreen Gavekal
“To buy when others are despondently selling and to sell when others are euphorically buying takes the greatest courage, but provides the greatest profit.”
– John Templeton
Tyler’s Intro: In Search of Quality
- Just as the best chefs customize their menus to feature the finest quality ingredients in different seasons, the best long-term investors tend to tilt their portfolios to where the greatest value lies.
- In this week’s EVA Exchange, I’ve asked three members of our investment committee to share their thoughts on what could be the most exciting investment opportunities for the next three years… within the context of a diversified portfolio, of course.
Jeff’s Pick: Emerging Market Debt
- Local currency debt in emerging markets has fallen by more than 27% over the past three years and has seriously underperformed other income asset classes as a result of extreme outflows, spread widening, and currency weakness.
- While the near-term downside in this asset class is materially higher than developed market bonds, Jeff believes the long-term returns are likely to outpace most other income assets in the coming years as extreme outflows eventually give way to powerful investor inflows.
Dave’s Pick: Master Limited Partnerships and Other Energy Crash Victims
- Master Limited Partnerships (MLPs) are currently trading 40% below their 2014 peaks and have become toxic in the minds of many investors. That said, the fact that these typically reliable owners and operators of “mid-stream” oil and gas assets have continued to grow their distributions amid the turmoil suggests that investors are largely over-reacting to what will likely prove to be a short-lived collapse in oil prices.
- Dave believes that not only will energy prices eventually recover as excess supply corrects, but that a geopolitical shock in the Middle East could send prices soaring in the run-up to the 2016 US Presidential elections. In either event, those who buy into weakness into energy crash victims like MLPs – which continue to offer attractive yields in the high single digits – may soon look like the masters of the investment universe.
Worth’s Pick: Canadian Energy Stocks
- A series of attractive 3-5 year investment opportunities are starting to emerge in Canada as a function of commodity-driven currency weakness, structural improvements in manufacturing competitiveness, and the welcome prospect of government-led infrastructure upgrading… not to mention an eventual recovery in oil and other key resource markets.
- While large cap Canadian stocks are modestly attractive versus the S&P 500, the most compelling opportunity may lie in Canadian energy stocks which have dramatically underperformed their beaten-up US peers over the last 18 months. Even in the event of another major drop in global oil markets, Worth believes these assets are priced to outperform over a medium time horizon.
TYLER HAY / Chief Executive Office
To contact Tyler, email:
[email protected]
In Search Of Quality
There’s an old saying that there are two types of people: those who eat to live and those who live to eat. I’m the latter. During a recent trip to the Napa Valley, I was fortunate enough to join Mark Nicoletti, who runs the Family Office at Evergreen, to dine at The French Laundry. Throughout dinner, I was blown away by the amazing variety in the foods we ate. Toward the end of the meal, as I was loosening my belt, the chef and owner of the restaurant, Thomas Keller, sat down at our table. Mark and Thomas have bonded over their mutual love for golf and, as a result, Mark served more as a curator of the restaurant than a dining guest throughout the meal. At one point, I wondered aloud if Mark knew how Mr. Keller goes about creating his legendary menus. Expecting some type of answer about the chef’s imagination, cooking techniques, or patron’s palates, he gave a more succinct answer: “they use the best quality ingredients imaginable.”
This seems like such an obvious response. However, not all restaurants approach food this way. In most cases, a chef is forced to cook a rigid menu leaving them at the mercy of the ingredients’ quality.
We face a similar paradox in investing. Like a chef who’s forced to pick the freshest of the not-so-fresh ingredients, investment managers are often forced to stay within an asset class knowing it’s overvalued. Here’s a chart of the valuation of the Nasdaq during the late 1990s.
We face a similar paradox in investing. Like a chef who’s forced to pick the freshest of the not-so-fresh ingredients, investment managers are often forced to stay within an asset class knowing it’s overvalued. Here’s a chart of the valuation of the Nasdaq during the late 1990s.
NASDAQ PE VS. S&P 500 PE
Source: Bloomberg, Thomson Reuters, Haver Analytics, and Citi Research-US Equity Strategy
If you were a manager of a technology-oriented mutual fund in those days, would you have walked in and told your boss it might be time to close it down and send investors their money back? No! That would have been an occupational death sentence. Even if your boss agreed, how hard would it have been to get clients to sell an asset that had catapulted almost straight up?
At Evergreen, we don’t confine ourselves to any single area of the market. Clients like the idea of going where the best value lies. Sometimes, we are early to the sectors that have gone from on-sale to fire-sale but over the long run this discipline has proven effective.
In this week’s Exchange, three of the members from our Investment Team have singled out certain investment areas they believe offer an attractive return profile over the next three years. While it’s dictated by compliance that we do not offer specific securities advice, the following sections point to segments of the markets investors should be searching for opportunistic entry points. It’s essential to express that we believe the following investments should be limited to a portion of a larger diversified asset allocation strategy and not as stand-alone investments.
JEFF DICKS, CFA / Portfolio Associate
To contact Jeff, email:
[email protected]
Jeff’s Pick: Emerging Market Debt
When thinking about the investment opportunities that will outperform over the next three years, it’s helpful to survey the areas that have underperformed the most over the preceding three years. In fact, legendary value investor Benjamin Graham highlighted that, “[asset classes] that have underperformed (over three- and five-year periods) subsequently beat those that have lately performed well. In other words, value investing works!” Emerging market (EM) debt would fit that mold almost perfectly. Over this time frame, contrary to its name, emerging market debt has completely submerged. As the table below shows, EM debt has fallen each of the last three years, and cumulatively by over 27%. This has been one of, if not, the worst areas to be invested within income markets. The remainder of this piece will focus on why EM local currency debt could be one the best performing asset classes within the income areas below over the next three years.
Income Return Summary
Source: Morningstar
During the previous three-year period, we’ve seen emerging market bond yields rise, currencies plunge, and investor sentiment turn from bullish to blatantly bearish. In terms of valuation, emerging-market bonds now pay 4.2 percentage points more than US treasuries. This compares to the five- and ten-year averages of 3.8% and 3.6% respectively. The disparity illustrates that today—in terms of relative cash flow—investors are being compensated more for EM risk than they have been historically. And, as you can see in the second chart below, EM currencies have taken an absolute nosedive. According to the JP Morgan EM currency index, they are even more depressed than they were during both of the last two US recessions. So, while spreads are only marginally above their long-term average we believe if you include extremely depressed currencies this makes for an attractive combination. What’s more, according to Deutsche Bank, EM debt funds have experienced pronounced outflows over the last three years. What we have found through extensive research is that when there are extreme outflows over an extended period of time, a recovery almost always follows.
Source: Evergreen GaveKal, Bloomberg
Source: Evergreen GaveKal, Bloomberg
Source: Deutsche Bank
The previous figures illustrate that today’s emerging markets are without a doubt being perceived as more risky on average than they have been historically. But is that really true? Are these economies really more “at-risk”? That is a tough question to answer when you consider the entire emerging market debt complex. On the positive side, we have seen a surge in foreign exchange reserves within these economies over the last decade. These FX reserves now stand dramatically higher than they were during both the Asian financial crisis, as well as the housing crisis. Essentially, this means they’re much more equipped to withstand financial shocks. Emerging markets are also growing at a faster clip than their developed peers. According to the International Monetary Fund (IMF), emerging economies are expected to grow at over double the rate of developed economies in 2016, at 4.5% relative to 2.0%.
That said, the growth gap has narrowed in recent years and, despite higher growth relatively speaking, slower absolute growth makes it more difficult to service debt. Further, we have seen a surge in emerging-market corporate debt issuance, which has more than doubled since 2009. This has driven ratios of total debt-to-GDP in many countries to approach levels that have historically coincided with banking strains.
Overall, while we believe the risks are likely inline for the asset class as a whole, we also think they vary drastically by country. This is why it’s crucial when selecting a manager to analyze the country-specific allocations. Given the space constraints of this truncated version of EVA, we won’t be diving into a country-by-country analysis. In general, though, we do like countries that have cost advantages, relatively low inflation rates, less credit growth than peers, improving or manageable current account deficits, and the ability to implement critical reform. On the flip side, we are trying to avoid countries with large budget deficits, high inflation rates, worsening current account deficits, and a limited ability to implement reform. This is why we think it makes sense to select a vehicle that can actively manage their country exposure, as opposed to a broadly-based, passively managed fund with exposure to the entire emerging market universe.
Once you find the right country exposure, it comes down to position size. Currently, after years of selling down our EM debt exposure to a relatively small position, we are beginning to slowly add some back. While we believe the long-term returns are likely to outpace other income areas, we do concede that the near-term downside is materially higher than most income alternatives. And, since this asset class tends to overshoot on the downside during panics, being patient in reaching a target allocation is key. Our plan—as it’s almost impossible to time the bottom in these areas—is to begin accumulating incrementally during further weakness. This method, given how beaten up the area is currently, should add relative return versus other income asset classes over the long-run.
It’s also worth noting that even if you had purchased a fund tracking this asset class at the peak preceding the last financial crisis your three-year returns would have still been solid. These same funds are already down 15%-40% this cycle, which means you are not even close to the previous peak. This is a key distinction, on a forward looking basis, why future return potential looks solid. If this plays out, investor sentiment will likely turn from bearish to bullish, and EM debt will once again re-emerge!
Example Emerging Market Funds Performance From 2007 Peak
Source: Evergreen GaveKal, Bloomberg
Same Emerging Market Debt Funds Trailing 3-Years
Source: Evergreen GaveKal, Bloomberg
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DAVID HAY / Chief Investment Officer
To contact Dave, email:
[email protected]
Dave’s Pick: Master Limited Partnerships And Other Energy Crash Victims
Numerous past EVAs have discussed MLPs, more formally known as Master Limited Partnerships. These typically reliable owners and operators of “mid-stream” oil and gas assets—such as pipelines, storage facilities, gas processing plants, and other elements of America’s energy plumbing—have become toxic in the minds of many investors, judging by their price action. At one point late last month, MLPs were down nearly 50% from their 2014 peaks. Even after a rousing rally since then, they remain nearly 40% below last year’s high water mark.
Regardless, what we’ve seen with this once-hallowed sector over the last year and a half has been nothing short of a bloodbath. Of course, it’s not just MLPs that have been taken to the wood shed and punished by a metal ruler-wielding nun (you can tell what this Catholic-raised boy still has nightmares about!). Anything either directly or indirectly energy-related has simply imploded, notwithstanding a powerful counter-trend rally that began on September 30th.
In fact, as the third quarter was coming to a close, blue-chip energy stocks were approaching valuations remarkably close to their 2009, end-of-the-world, levels. Dividend yields were in the 6% to 8% range, causing Evergreen to begin re-accumulating some of the issues we had parted with at higher prices. (While we’re glad to see the recent recovery, we wish we’d had a bit longer to buy back even more than we did.)
Despite reducing our MLP exposure in 2014 to the lowest level in the past 10 years, our income portfolios still felt a performance drag from their cliff dive. We recently did a study to see how much of our underperformance was tied to energy and found that around 85% of the lag was due to the collapse in oil and gas prices!
Clearly, and often indiscriminately, the ripple effect of falling energy prices has spread far beyond the Chevrons or Shells of the world. For example, Canadian REITs, one of our favored areas for producing superior cash flow, are also far below their 2014 highs. Canada’s currency has come under intense pressure as their resource-based economy is perceived to be closely correlated to oil prices.
Naturally, clients who haven’t been with us for a longer timeframe are questioning the worth of MLPs and other equity-income investments in their portfolios. However, those who were with us through the 2008-2009 panic recall that our income portfolios were actually hit much harder despite the fact we were loaded up with conservative yield instruments at that time. Back in 2007, we had positioned—wisely, we had felt—for a recession and falling interest rates, only to be absolutely clobbered by the mass liquidation of almost everything that wasn’t government-guaranteed. In fact, it was this panicked and widespread selling–much like we are seeing today in many parts of the yield world–that allowed us to make some once-in-a-lifetime returns for clients as the markets recovered.
For sure, the situation isn’t nearly as dire this time around and we certainly aren’t hoping for a full-blown repeat. Yet, due to the relative stability of the stock market, most investors don’t realize how brutal the past year has been for a wide range of income securities, including many corporate bonds. It’s hard to blame one of the most severe spread-widening* episodes of the last 12 years (excluding the aforementioned global financial crisis) on oil prices crashing but there certainly has been a correlation. This also includes the severe pounding emerging market bonds have endured, driving their yields up close to double-digit territory.
Credit Spreads Over 10 Year Treasuries
High yield bonds yielding over 6% more than treasuries (616 basis points), emerging market bonds yielding over 4% more (41 basis points) and investment grade US corporate debt is 2.2% above treasury yields (220 basis points).
Source: Evergreen GaveKal, Bloomberg
These days, there are plenty of pundits who are bearish on oil prices and they may be right—for awhile. In the October 9th, 2015, Evergreen GaveKal Chartbook issue, we gave plenty of reasons why crude may find a bottom soon, so we won’t rehash those. However, we didn’t go into the geopolitical aspect, a real and present threat that seems to be escalating on a daily basis given the utter chaos in the Middle East.
It’s our view that Russia and Iran are trying to beat the clock and make their self-interested plays before there is a new man or woman in the White House. Both countries are behaving in a much more assertive manner in the Mid-East and each would love to see oil prices far higher than they are now. We would not put it past either nation to attempt to sabotage Saudi Arabia’s oil production and/or export capabilities. (It’s unlikely they will do so directly but rather through the surrogates they support and finance.)
If so—and even if not—all those nooks and crannies of the investment world that have been so brutalized by oil’s slippery slide down to the 40s, are likely to emerge from the deep well into which they’ve tumbled. For energy securities like MLPs that have 9%-type yields, a 20% to 30% additional price recovery, should it occur, will produce extremely satisfying returns, exclusive of any kind of supply disruption in the Mid-East. And if oil were to surge back toward $100, you can be fairly confident Canada’s currency will be tracking toward 100 cents to the US dollar, meaning Canadian real estate securities should also produce the type of returns you typically only get in a raging equity bull market.
Consequently, one of my favorite investment themes for the next three years is energy, particularly those securities that provide the type of cash flow most people thought was gone for good (or bad). Today, a cynic could mockingly call MLPs “massively lagging performers” but in our view, it won’t be long before MLP once again stands for Master Limited Partnerships, making those who buy them during this fire-sale ultimately look like masters of the investment universe.
*Spread-widening events occur when rates rise on corporate bonds versus US treasuries.
WORTH WRAY / Chief Economist
To contact Worth, email:
[email protected]
Worth’s Pick: Canadian Energy Stocks
The Great White North has fallen out of favor in recent years (and for good reason), but I believe a series of 3-5 year opportunities are starting to emerge as a result of commodity-driven currency weakness, structural improvements in manufacturing competitiveness, and the welcome prospect of government-led infrastructure upgrading… not to mention an eventual recovery in key commodity markets.
While Canada is still muddling through a shallow recession – largely the result of the Conservative government’s decision to run a budget surplus in the face of a painful resource slump – the domestic economic outlook is starting to improve on a number of fronts.
First, the 28% fall in the Canadian dollar has finally breathed new life into the country’s notoriously uncompetitive manufacturing sector. While factories are slowly beginning to reopen and/or expand, a full-blown manufacturing revival will take time; but since the loonie is likely to remain weak at least until commodity prices begin to recover, the revival of distinctly Canadian, non-resource export industries is a promising development.
Canada cannot hope to compete against low-cost, low-value-added export economies like Mexico or Southeast Asia, but with sufficient business investment it can certainly hang with higher-value-added exporters like Japan, South Korea, and Germany… especially when it comes to US markets where consumers can still buy Canadian goods tariff-free.
On that note, the still-pending Trans Pacific Partnership (TPP) may be yet another step in the right direction to what my friend, David Rosenberg, describes as Canada’s greatest need: “a real industrial strategy for the 21st century.”
While TPP promises to reduce tariffs and streamline common trade rules across 12 countries that represent roughly 40% of global GDP, the beauty for Canada is that it reinforces and updates the North American Free Trade Agreement (NAFTA). Canada continues to be the only modern, industrial economy with tariff-free access to US markets; and with TPP, significant trade barriers are coming down between Canada and another modern, industrial economy: Japan. Accordingly, TPP provides enormous incentives for Japanese firms to move their factories (particularly in the auto industry, where tariffs on Japanese products will remain in place for 15-25 years) to the Great White North in order to access US markets more freely… which still works for Japanese firms in the event that the loonie once again approaches parity with the US dollar.
From that perspective, TPP could represent a structural boost in Canadian export competitiveness as long as the government in Ottawa (1) approves the trade agreement, (2) works to promote a relatively pro-business environment, and (3) invests alongside private businesses to upgrade the country’s crumbling infrastructure.
With the relatively-moderate Liberal Party’s landslide victory in this week’s Canadian national election, I think there’s a reasonable chance that Canada continues to move forward toward a more competitive manufacturing sector as it waits for a resource rebound. That’s good news for economic growth and good news for the loonie.
While some economists see the prospect of counter-cyclical deficit spending as yet another reason to bet against the Canadian dollar, I see it as a welcome sign for a struggling economy as long as newly elected Prime Minister Justin Trudeau and his incoming administration have the good sense to allocate deficit spending toward productive road and transit upgrading.
Let me be clear, I am not saying the Canadian dollar has necessarily bottomed and I am not saying that the worst is necessarily over for the Canadian economy. As you can see in the chart below, the recent collapse in the CAD/USD exchange rate has largely been a function of oil prices. And since I personally still believe oil prices (along with other natural resource markets) could take quite the tumble in the coming quarters, I’m hesitant to make any market calls that depend on the short-term direction of the loonie.
The Canadian Dollar Vs. Oil Prices Source: Evergreen GaveKal, Bloomberg
Still, I do believe that oil prices are headed higher over the next 2-3 years. As David Hay and I explained in our latest EVA Chartbook, dramatic production cuts in global oil and gas markets should lead to a recovery in energy prices over the course of the next year unless something happens to damage global energy demand.
While I continue to believe the risk of a global liquidity crisis is uncomfortably high (which could send oil prices temporarily below $30 per barrel), it’s worth noting that there are no guarantees in investing. We could just as easily see a Mid-East geopolitical shock (which could send oil prices flying toward $100 per barrel).
With that short-term uncertainty, coupled with a general belief that energy prices are set to recover over the next eighteen months, my colleagues and I at Evergreen GaveKal agree it is prudent to start accumulating deeply-discounted assets today with a plan to keep buying if and when prices continue to fall.
If hard pressed to pick my favorite investment opportunity anywhere in the world over the next three years, it would be Canadian energy stocks… although I do think Canada will offer a number of exciting buying opportunities (including Canadian REITs, gold miners, and maybe even financials) as the next global business cycle begins.
As you can see in the chart on the next page (which shows the growth of $100 since the March 2009 bottom), Canadian energy stocks have dramatically underperformed even their US peers in US dollar terms. While the US energy sector is currently trading at its cheapest levels since 2012 after a nearly 33% decline, Canada’s energy sector is hovering just above its 2009 trough after a nearly 48% collapse.
Canadian Energy Stocks Vs. Us Energy Stocks
Source: Evergreen GaveKal, Bloomberg
If you believe that energy prices and the loonie are both headed toward a recovery in the coming years, and if you have the patience to sit through the price volatility between now and then, these levels are remarkably attractive. I would not be shocked to see average annual returns exceed 25% or more over the next three years.
As an aside for the reader, I should also note that Canada’s broad stock market also looks modestly attractive versus the S&P 500. As you can see from the chart below (which expands on the previous chart), Canadian stocks have sold off almost as much as US energy stocks in dollar terms over the last 17 months. Because earnings per share have fallen more than 40% over the past several years, the Canadian index is not trading at a deep valuation discount to US equities (considering a price-to-sales ratio of 1.6 versus 1.8 on the S&P 500), but it’s a decent (and less volatile) way to play the eventual Canadian earnings recovery. I’m not crazy about the 30% sector weighting to financials, but that should change as the economy diversifies and the resource markets improve.
Canadian Stocks Vs. US Stocks
Source: Evergreen GaveKal, Bloomberg
Perhaps it’s time you booked a trip to explore for yourself. It’s beautiful this time of year and everything is on sale for Americans… especially beaten-up energy assets with tremendous upside in the years ahead.
Our Current Likes And Dislikes
No changes this week.
DISCLOSURE: This report is for informational purposes only and does not constitute a solicitation or an offer to buy or sell any securities mentioned herein. This material has been prepared or is distributed solely for informational purposes only and is not a solicitation or an offer to buy any security or instrument or to participate in any trading strategy. All of the recommendations and assumptions included in this presentation are based upon current market conditions as of the date of this presentation and are subject to change. Past performance is no guarantee of future results. All investments involve risk including the loss of principal. All material presented is compiled from sources believed to be reliable, but accuracy cannot be guaranteed. Information contained in this report has been obtained from sources believed to be reliable, Evergreen Capital Management LLC makes no representation as to its accuracy or completeness, except with respect to the Disclosure Section of the report. Any opinions expressed herein reflect our judgment as of the date of the materials and are subject to change without notice. The securities discussed in this report may not be suitable for all investors and are not intended as recommendations of particular securities, financial instruments or strategies to particular clients. Investors must make their own investment decisions based on their financial situations and investment objectives. “The specific securities and ETFs identified and described do not represent all of the securities purchased, held, or sold for advisory clients, and you should not assume that investments in the securities were or will be profitable. CVS Corp, General Electric, JP Morgan, Accenture, Vanguard Dividend Appreciation ETF, iShares Core S&P 500 ETF and Powershares S&P 500 Low Volatility ETF are used to illustrate examples of market volatility. You should not assume that an investment in any of these securities was or will be profitable. ECM currently holds CVS, General Electric and JPMorgan, and purchases it for client accounts, if ECM believes that it is a suitable investment for the clients considering various factors, including investment objective and risk tolerance.
