For the past six months, the conclusion from our analysis has been that Canadian equities are very inexpensive historically and offer numerous opportunities for mid- to long-term investors. That remains true today, with the notable exception of the energy sector.
As of March 26, the price-to-book-value ratio of the median stock in Canada has increased ever so slightly to 1.3 times from 1.25 three months earlier. That's still cheap, since over the past 30 years it has been very rare for this metric to slip below 1.4 times. Even during the 1991 recession -- one of the most severe in Canada in decades -- the market's P/B was 1.07 times at its nadir.
The current low P/B of the market as a whole is primarily due to the dramatic drop in the price of oil, and the resulting plunge in energy stocks. Excluding the energy sector, the median P/B value for the remaining 580 largest stocks in Canada is 1.45 times, which is near the normal floor for Canadian stock valuations historically. This clearly represents exceptional value for investors in most Canadian stocks.
As for what investors get in return, the median return on equity (ROE) of Canadian stocks net of T-bills is slightly higher than 4%, which is also normal historically. If all equity analysts’ earnings estimates for 2015 are realized, and T-bills yields remain constant, this value will rise to 4.6%, which is perfectly reasonable. The caveat is that a surprise upward spike in T-bill rates would be bad for stocks, causing the net ROE to go down.
Earnings growth, which fuels ROE, is a cause for concern. The average year-over-year earnings growth for Canadian stocks currently stands at a very respectable 4.5%. However, if analysts’ earnings estimates for the current quarter come true, earnings growth will be a paltry 0.2%. Therefore, it is looking worrisome that market ROE will deteriorate in coming quarters if earnings growth turns negative. It's reasonable to assume, however, that current market valuations are factoring in some slowdown, and maybe even contraction, of earnings growth this year.
Further complicating matters is the fact that earnings estimates are being slashed so quickly that reported year-over-year earnings growth could be negative by mid-May. The average three-month earnings estimate revision has plunged to -21% from -9% in December (which was bad enough then). To put this abysmal trend in perspective, there have been only three occasions during the past 30 years when quarterly estimate revisions were worse: during the recession of 1991, in 2001 following the Sept. 11 terrorist attacks in the U.S., and during the 2008-2009 financial crisis.
The current severe deterioration in earnings revisions is most evident in the oil and gas sector. At last report, the median estimate revision for the sector is -56.7%! Excluding the impact of negative analyst revisions in the energy sector, the average estimate revision of the remaining 580 largest Canadian companies is -5.5%. That's only slightly worse than the "normal" range of -3% to -5%. (Analysts are almost always too optimistic initially and eventually need to lower their estimates.)
For the broad Canadian market, significant gains appear to be unlikely in the short term, even if the poor earnings metrics have already been largely factored in by investors. It's likely to take a few months, or perhaps quarters, for earnings and earnings estimates to stabilize.
Weighed against this are very low valuations for the Canadian equity market after excluding oil stocks, and with earnings growth and earnings-estimate revisions remaining normal. This suggests that at some point, patient investors will be amply rewarded because improving earnings will cause valuations to normalize. In the meantime, Canadian stocks have limited downside because valuations are already so cheap.
