EWC: I Don't See Canadian Stocks Outperforming Going Forward (Rating Downgrade)

seekingalpha08-12

Canadian equities have underperformed US stocks in 2024, and I expect that to continue.The theme for 2024 has been AI - and EWC is an ETF that is not well positioned to capitalize on that theme.The ...

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This is a significant headwind for the fund's largest sector, which is Financials.   R.M. Nunes/iStock via Getty Images Main Thesis & Background The purpose of this article is to evaluate the iShares MSCI Canada ETF (NYSEARCA:EWC) as an investment option at its current market price. This is a fund that is exclusively focused on Canadian equities, with a bias towards large and medium-sized companies. My followers know that EWC has been a foundational part of my non-US portfolio for many years. I have used developed stocks – both in Europe and North America – to balance out my US-centric portfolio, and that strategy has generally been favorable over time. However, when 2024 got underway, I continued to believe Canadian equities (and EWC by extension) was a smart way to deploy new cash. Looking back, I have made some gains with the fund, but those have been dwarfed by the return of the S&P 500:   Fund Performance (Seeking Alpha) Given this underperformance coupled with the uptick in equity market volatility, I thought it was time for me to take another look at EWC. After careful review, I believe the themes of 2024 will continue to play out and that will leave EWC falling short of US equities in the latter stages of the year. While I see merit to owning this theme as a hedge, I don't see outperformance as likely to occur. Therefore, I am downgrading my rating to \"hold\", and I will dive into the details behind this decision below. Expectations Are High - That's Lofty One of my primary concerns when it comes to Canadian equities has to be the disconnect between reality and market expectations. What I mean by that is, analysts are expecting Canadian corporations to deliver strong results in terms of earnings and profit margins. While that very well may come to pass, it isn't the type of investment backdrop I want to be a buyer in. I want to buy when investor expectations are muted, and I see inherent value where the market doesn't – that isn't the case here. In fact, the average analyst estimate for profit margins is well above current levels. This means investors are pricing in quite a bit of upside:   Expected Profit Margins (Average - TSX Index) (FactSet) The bottom-line to me is that contrarian investors won't have much to love here. The optimism baked into Canadian equities suggests that any company or sector that falls short of these lofty expectations is ripe to see their stock fall quite a bit. I don't love this risk-reward proposition. I want to be the contrarian who buys when expectations are too low, not the other way around. To me, this is central to why I see a downgrade to \"hold\" for EWC as the right play at this moment. Financials And Lower Rates Ahead Another factor to consider when buying EWC specifically is the fund's heavy weighting towards the Financials sector. This should not surprise followers of this ETF, because Canada's largest banks make up a significant portion of the large-cap index in that country. This extends to EWC – with over 1/3 of its total assets allocated to this sector: Sector Breakdown (iShares) This is critical to understand before buying this product, especially in this macro-environment. The reason being is that Financials and bank stocks tend to be quite cyclical and are certainly one of the sectors most exposed to interest rate movements. This matters right now because the Bank of Canada has been one of the first central banks to cut interest rates. Just a few weeks ago the second .25 basis point cut was announced for the country:   Interest Rate Decision (Bank of Canada) (Seeking Alpha) What I see going forward is a more competitive and challenging environment for banks. Economic growth and inflation are slowing in Canada, which means it is likely that consumer demand and loan activity will also slow. That is negative for lenders, all other things being equal. Further, a lower rate environment can often challenge interest rate spreads – which is how banks and financial institutions make their profit. While these moves by the central bank could spur economic activity and ultimately stave off a recession, I would still view it cautiously for funds like EWC. The heavy weighting towards Financials means this fund is highly sensitive to central bank decisions, and that heightens the risk profile. Whether or not this exposure makes sense for any individual investor is subjective, but we must be aware that it is highly concentrated to this reality. That supports a hold/cautious view in my opinion. Canada Lacks The \"AI\" Frenzy Continuing with the sector discussion, a look at EWC's top holdings reveals a nice diversification benefit compared to US equities. While the S&P 500 is Tech-heavy, EWC's top three sectors are Financials (as discussed in the prior paragraph), Energy, and Industrials. These three sectors combine to represent about two-thirds of the index EWC tracks. The benefit here is that it can provide diversification both geographically and sector wise, which I have found helpful over the years as a US-centric investor. I imagine other readers will find the same benefit over time. While that is an important consideration, it is also worth exploring because it helps explain why EWC has lagged the S&P 500 by such a wide margin in 2024. As readers are likely aware, the Artificial Intelligence (AI) trend has been on fire this calendar year. Investors have been looking for exposure in this realm, primarily through Tech companies, as it dominates headlines and looks to be the next generational trend. Even utility companies in the US have benefited as the demand for electricity and data storage has grown markedly. This shows just how diverse this trend has been in pushing US indices higher. The challenge for Canadian investors is they are being left behind with this catalyst driving market gains. The three sectors I mentioned that EWC is long are not traditional beneficiaries of the AI-boom. Meanwhile, corporate leaders are increasingly getting on the AI bandwagon and that is what analysts and investors are clamoring to hear: AI Mentions (Corporate Earnings Calls) (FactSet) What I am driving at here is that Canadian equities are falling behind due to macro-trends that don't seem to be abating. Will AI fervor exist forever? Of course not – and I'm not going to suggest the S&P 500 will always dominate the large-cap Canadian equity market. But I see the AI buying spree as having legs for the time being, and that has left EWC behind, and I see that scenario continuing in the second half of the year. For this reason alone, I don't believe EWC is going to outperform. That means I must downgrade to \"hold\" now. Zero Dividend Growth - I Don't Love That Another factor I examine critically when it comes to EWC is the fund's dividend. With this ETF being long a host of Financial and Energy names, I expect a positive dividend story. In fact, yield is often one factor I look at when branching outside of the S&P 500 – since that isn't why one invests in that index! Other developed markets, such as the UK, have been unloved for a while and sport a competitive yield, but that isn't the case for much north of the border. EWC's current yield at just over 2% is not much to get excited about. But I wouldn't mind if the distribution was seeing steady growth. Unfortunately, the June payout (this ETF pays twice a year) showed almost no growth from the 2023 distribution payout:   EWC's Dividends (iShares) This doesn't give me much confidence when it comes to the underlying companies in EWC's portfolio. The fact that the dividend hasn't grown represents some challenges, and that is clear to me when I see the weakness in the labor market underscoring other positive metrics (such as economic growth and population growth):   Canadian Employment Picture (Reuters) My takeaway from this is I see an economy that is struggling and an ETF whose companies are not confident enough to boost their dividends. Is that a backdrop I want more exposure to? For the time being, the answer is no. The US Remains Dominant My final point is a relative one and helps explain why I remain US-focused for the short-term at least. Simply put, the US is dominating other world markets when it comes to both equity gains, stability, and economic growth. While the past few weeks have been challenging and volatile, I am not going to take my eye off the prize. US markets have been leaders this year – and justifiably so – as the economy has a marked edge over its peers:   Real GDP (Developed Markets) (TD Bank) The message I am conveying here is that investors always have options, and we don't invest in Canadian equities (through EWC or any other product) in isolation. I will only add to my EWC position when I see a strong case for it – and that is usually when my outlook begins to sour on US markets. With the correction having already occurred in the NASDAQ, I think the time to sell-off US positions to add to Canadian ones has passed me by. For now, I see a stronger economic backdrop in the US with a more favorable asset mix to capitalize on trends, such as AI. With Canadian growth lacking and the central bank seeing enough weakness to cut rates, I am not very optimistic on Canadian stocks to wrap up the year. So my \"hold\" rating has as much to do with what I see in that country as it does in viewing other countries (like the US) as more favorable investment opportunities. Bottom-line  EWC has pumped out modest gains, and that is probably not going to change in the final stages of 2024. While a positive return is always welcome, I think the underperformance against US equities will continue and that warrants a downgrade to \"hold\" for me. I see a challenging economic backdrop and a worsening labor market in Canada as reasons to be very cautious at the moment. Therefore, I would suggest to my followers that they approach any new positions in EWC very selectively at this time.","kind":null,"is_publish_news":true,"is_publish_highlight":false,"is_publish_live":false,"is_publish_wemedia":null,"editions":null,"column":"","sentiment":"0","news_tag":"","news_rank":0,"symbols":[],"gpt_button":1},"commentList":[],"isCommentEnd":true,"newsSizeData":{"likeSize":0,"commentSize":0,"repostSize":0,"favoriteSize":0,"likeStatus":false,"favoriteStatus":false},"APP":{"userAgent":"Mozilla/5.0 AppleWebKit/537.36 (KHTML, like Gecko; compatible; ClaudeBot/1.0; +claudebot@anthropic.com)","isDev":false,"isTTM":true,"deviceId":"web-server-community-laohu8-v3","version":"4.29.1","shortVersion":"4.29.1","platform":"web","vendor":"web","appName":"ttm","isIOS":false,"isAndroid":false,"isTiger":false,"isTHS":false,"isWeiXin":false,"isWeiXinMini":false,"isWeiBo":false,"isQQ":false,"isBaiduSwan":false,"isBaiduBox":false,"isDingTalk":false,"isToutiao":false,"isOnePlus":false,"isHuaWei":false,"isXiaomi":false,"isXiaomiWebView":false,"isOppo":false,"isVivo":false,"isSamsung":false,"isMobile":false},"href":"/m/news/2458244987"}