IVE - EWC: Don't Blame Canada - ETF Offers Fresh Alternative For U.S.-Centric Portfolios

2023-12-05 04:14:48 ET

Summary

• iShares MSCI Canada ETF is concentrated in the financial sector, with the top 10 holdings comprising 42% of the fund.
• EWC is dominated by the financial and energy sectors, providing a diversification opportunity for investors looking to move away from the tech industry.
• I rate the Fund a Buy relative to the S&P 500 Index. It represents an intriguing diversifier at a time when value sectors are showing signs of a comeback.

Those kids from South Park were wrong! Don't blame Canada, as they did in the 1999 Oscar-nominated song. The US's northern neighbor is forever an afterthought for global investors. It doesn't have to be, especially now that the value sector orientation of the Canadian economy may be higher up on the wish lists of investors. When metals, energy and financials become inexpensive, having an alternative to the tech and consumer spending orientation of the US market can be a nice diversifier, as it has been in the past.

With the usual disclaimer that my ratings on ETFs are relative to the S&P 500 (since it is likely that all equities will suffer further downside before the next bull market can begin), I rate the biggest Canada-focused ETF a Buy. On a reward/risk tradeoff basis, looking out over the next 1-2 years, I see EWC's portfolio construction being more attractive than SPY.

iShares MSCI Canada ETF ( EWC ) is focused on large and mid-sized Canadian companies. It is a sizeable fund at more than $3 billion in assets, and is quite liquid, trading around $70 million a day in volume.

As is the case with many single-country non-US ETFs, it is concentrated in a relatively small number of companies. Many ETF analysts view that as a negative, but I view it the opposite way. I want to know what I own, be able to track it easily, and view the ETF as a small collection of stocks, not an over-diversified index where winners and losers offset each other. For reference, see the equal-weighted S&P 500 for 2023. Its performance is well under that of the S&P 500 capitalization-weighted index because most of the 493 stocks that are not part of the "Magnificent 7" have essentially cancelled each other out this year.

EWC: concentrated in value sectors

EWC holds more than 80 stocks, but the 10 largest accounts for 42% of assets. And while investors might jump to the idea that Canada's culture is not terribly different from that of the United States, its stock market's emphasis is entirely different. Lacking the high-tech giants that we have in the US, EWC tilts strongly toward the financial sector. Four of Canada's "big five" banks are represented in the top 10 holdings of EWC, and financials are about 1/3 of the fund's current portfolio. Energy is close to 20% of the ETF, so EWC has the feel of a US-centric value portfolio when it comes to sector allocation.

Besides Real Estate, these two sectors are also the biggest drivers of the Canadian economy and EWC is exclusively domestic focused. This could be a welcome change to an investor looking to diversify from the tech industry which dominates the S&P 500, and the majority of the ETF's based on that index. As seen in the following graphs, the biggest differences between SPY and EWC are the tech, financial, and energy industries which is a reflection of the differences in the two neighboring economies overall.

Canada's financial industry is considered relatively stable, though real estate/housing concerns persist. However, banks have acclimated to the new, higher interest rate environment. While growth is likely to be low in the financial sector for 2024, recession expectations have moderated.

Canadian oil and gas are expected to see positive growth and profit in 2024, at least partly due to increased access to global markets by Canadian producers with the Trans Mountain Pipeline expansion coming online in the first quarter of 2024, transporting an extra 590 000 barrels of crude oil daily from oil-rich Alberta, to the west coast. Natural resources are a current and future staple of the country's economy.

The chart below shows that EWC typically performs in line with the value segment of the S&P 500. This shows the past 5 years, a period where the US ruled all, and the US Dollar has been perpetually strong. I see reversion to the mean potential here, which favors EWC over US value, or at least makes it a good currency-driven diversifier.

Potential American investors in the Canadian market should consider that the Canadian dollar has been consistently trading between $0.68 per $1 US and $0.83 per $1 US over the past 5 years. There are no apparent big issues that I would expect to cause the Canadian dollar to dramatically fluctuate in the near future.

According to a recent BMO financial report, the Canadian economy is expected to continue to trail behind the US economy over the next 18 months. This is partly due to decreased consumer spending, as Canada's consumers currently have record-high levels of household debt, particularly mortgages.

But while US mortgage debt is mostly locked up in 30-year mortgages, all Canadian mortgages renew every 5 years at the current interest rate. So depending on interest rate movements, that may help or hinder Canadian borrowers versus those in the US. Interest rates would need to decrease quickly and significantly for consumer spending to return to pre-pandemic levels.

EWC: worth a look

So unless your definition of "America" excludes the huge land mass above the United States, the less popular portion of North America for investors in recent years, EWC is worth further tracking going forward. Canada is non-US investing but close to home in terms of cultural similarities.

Trading at 13.6x trailing earnings and 1.6x trailing sales, EWC makes my shortlist for looking outside the usual suspects. My interest will increase further if we see sectors like mining lift off and energy start to recover.

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