Strong TSX returns haven’t stopped pension funds from cutting domestic stock exposure as bond yields shift the calculus, says CIO
Each month at BPM, we offer a slate of articles and content pieces that go deep on a particular topic. This month, we're focusing on Public Equities.
According to one chief investment officer, the Canadian equity market has delivered returns that few institutional investors expected and many may have missed.
The S&P/TSX Composite Total Return Index rose roughly 20 per cent over the year ending September 30 and compounded at about 25 per cent over the previous three years, outpacing the S&P 500 even after converting into Canadian dollar terms.
For Paul Carter, CIO at Langley-based Capstone Asset Management, the numbers speak for themselves.
“The Canadian equity market has been fantastic the last few years. Quite honestly, it exceeded my expectations as a Canadian equity investment manager, and I think exceeded most people’s expectations,” he said.
Financial services fuels rally as valuations look stretched
According to Carter, financial services drove much of the rally. The Bank of Nova Scotia’s stock rose 44 per cent over the year, Royal Bank gained 36 per cent, Manulife climbed 40 per cent and Great-West Lifeco surged roughly 59 per cent. Carter pointed to OSFI’s decision to reduce capital ratios, strong earnings growth and contained loan losses as fundamental reasons for the run.
But those gains have pushed valuations well above historical norms, particularly as financial services now accounts for almost 35 per cent of the S&P/TSX Composite’s total weight, Carter noted. Combined with materials and energy, the three largest sectors make up roughly 70 per cent of the entire index.
Carter believes the companies remain solid but questioned whether current prices are justified.
“More than a third of the entire market in Canada are the banks, the insurance companies, and then a few other select financial services companies so valuations arguably are a little bit stretched right now there. For what it’s worth, we're underweight in the financial sector relative to the index, but we still think that these are generally rock-solid companies that deserve premium valuations, but maybe not in certain cases to the level that they're currently showing,” said Carter.
That concentration problem runs deeper than sector weightings. The S&P/TSX Composite has shrunk to about 221 companies, down from the 300 that made up the old TSE index under its previous methodology.
Carter noted his team has been forced to look beyond the index to find value, pointing to PetValu Holdings – trading at roughly $19 to $20 and about 11 times forward earnings – and BCE (Bell), which has dropped to the $28-$29 range after a dividend cut and increased wireless competition.
“We’ve been finding ourselves hunting for ideas more and more outside of the index stocks, which forces us to sort of dip our toe into the small cap market a little bit more and more,” he said.
Why institutional investors are reducing Canadian equity allocations
Still, the performance hasn’t stemmed the outflow. A Crisil Coalition Greenwich study published earlier this year found that a quarter of Canadian institutional investors surveyed planned significant reductions in their Canadian equity allocations, while only eight per cent intended to increase them.
While Carter acknowledged the trend, he agreed that Canada represents just three per cent of global GDP and that large allocators have good reason to diversify beyond their home market. He disagreed, however, that the timing made sense.
“We do believe that the Canadian market is fairly well positioned right now relative to non-Canadian markets for the next 5 to 10 years,” he said. “I think there's a lot of longer-term tailwinds for the Canadian economy and for the Canadian stock market that should argue for institutional investors to actually increase their domestic equity weights rather than decreasing them.”
Among the tailwinds, he pointed to government infrastructure and defence spending that the OECD expects to fuel growth, a Canadian dollar he considers undervalued at roughly $1.42 US against a purchasing power parity closer to $1.15 or $1.20, and valuations that remain attractive relative to non-Canadian equities.
Home bias debate intensifies as allocators diverge
Carter doesn’t see the problem as a new one. Rather, he said the Canadian market’s lack of depth has been a persistent complaint for as long as he has been in the industry, and he saw no evidence that the challenge is materially worse than it was five years ago.
He expected that many of the index’s constituents five years from now will be companies that are not household names today – a sign, in his view, that Canada still produces market leaders even when the pipeline is not visible.
The implication for institutional allocators, he suggests, is that passive exposure to the Canadian market leaves investors fully at the mercy of whatever concentration risk the index carries. He believes active management and rigorous stock selection are a necessity in any institutional investor’s playbook.
To that end, Carter resisted prescribing a single target allocation, arguing that every investor operates within a different set of return expectations and risk frameworks. The range among Canada’s leading pension funds illustrates the point. OMERS holds around 18 per cent of its public equity portfolio domestically, while La Caisse sits at roughly 20 per cent.
PSP Investments, meanwhile, has been moving in the opposite direction from the broader trend, increasing its Canadian equity exposure partly on the view that a resource-heavy market offers better long-term correlation with inflation.
“To say that an investor should have X percent in Canadian equities is a little bit too prescriptive,” he noted.
Capstone’s own model portfolios lean more heavily toward domestic equities than many of the large institutional managers. Carter attributed that in part to confidence in the firm’s active management process – a conviction that disciplined stock selection in a market the team knows well can generate outperformance more reliably than in less familiar jurisdictions.
He acknowledged the anecdotal nature of some of the counter-trend positioning but said the fact that certain allocators are bucking the exodus and adding to Canadian holdings suggests the case for domestic equities isn’t as settled as the headline data implies.
Rising bond yields challenge the case for equity allocations
The key risk Carter flagged isn’t the equity allocation debate at all, but rather around bonds. He emphasized how the S&P/TSX Composite’s weighted average dividend yield has fallen to roughly 2.1 per cent – its lowest level since 2006 and well below the three to four per cent range investors saw just a few years ago. Meanwhile, the Canadian 10-year government bond now yields about 180 basis points above that, a spread not seen in years, he noted.
“A few years ago, nobody wanted to talk about bonds because the yields that you would get on government or even corporate bonds were not terribly attractive, especially the first part of COVID But now with interest rates going up so much, bonds, broadly speaking, are looking a lot more attractive. That’s maybe the one risk the global market is really underpricing, and I would not be surprised if at some point you see a material shift in allocation away from equities and toward fixed income as a result,” said Carter.
