The S&P/TSX Composite Index has been falling in and out of official correction territory for several weeks now. As of Jan. 7, the index was down 9% from its 2014 high of 15,685 last summer.
Despite all the gloom and doom surrounding the oil sector and, to a lesser degree, the banks (which underwhelmed the market's expectations with recent earnings reports), the critical issue is to assess market fundamentals and determine what to do now. The median price-to-book-value ratio among our universe comprised of the largest 750 stocks in Canada is just 1.28 times, which is its lowest point in the past 30 years other than the 1990-91 recession and the 2008-09 financial crisis. The lowest median P/B values seen during those tumultuous periods were 1.07 times and 0.94 times respectively.
In recent memory, the previous P/B bottom was 1.32 times in June 2013. Over time, it has been rare that the median stock trades below 1.35 times. In short, on valuation alone, the Canadian market is dirt cheap. Can it become cheaper? In the short term, anything is possible, but in the mid- to long-term, this market valuation on its own represents exceptional value.
What are we getting for this valuation? The median return on equity of stocks in excess of Canadian T-bills is at 4%, which is in the middle of the pack since the end of the 1990s -- perfectly normal, in other words. The only time the gap between the P/B and the ROE has been greater was during the financial crisis.
Does the earnings picture support the median ROE? Currently the median year-over-year reported earnings-per-share growth is 5% -- down from 10.2% last July but still positive. If all analysts' earnings estimates for fourth-quarter earnings come true, EPS growth will rebound to 9.8%. This means that, despite what the headlines say, Canadian stock analysts expect corporate earnings to continue rising in the near future. EPS growth has been nicely positive for the last three years and is expected to continue this way.
In our view, the main reason that Canadian stock prices in 2012 and 2013 have gained less than the U.S. market was the level of earnings estimate revisions we saw in this country. The average three-month earnings estimate revision for the 750 largest stocks in Canada now stands at -9%, where -2% to -4% is considered normal and healthy.
But the pullback is primarily due to the tumble of analysts' estimates for the oil sector, not for the market as a whole. The median three-month estimate revision for the 164 largest publicly-traded oil and gas stocks in Canada is a frightening -22.6%. But if we look at the CPMS Canadian Universe without the energy sector (a total of 571 stocks) the average estimate revision is -4.9%. Therefore, almost half of the -9% estimate revision is due to oil and gas.
And finally, if we remove the gold sector as well, leaving 490 stocks, the average estimate revision is -3.6%. So, without energy and gold-related stocks, estimate revisions for all other sectors of the Canadian market collectively are normal. Not only is the Canadian market extremely cheap, the underlying fundamentals for most sectors are completely reasonable.
It has been no fun at all to have owned Canadian equities for the past several months, and sentiment is bearish. However, for investors in Canadian stocks having a long time horizon, there is fabulous value in this market.
--With files from Mike Leonard
