O Canada – Your Market Is A Buy!

Brendan is a member of The Motley Fool Blog Network -- entries represent the personal opinion of the blogger and are not formally edited.

Note: This article has been amended to better reflect Canadian National Railway's geographical reach

After a strong first half in 2013, the S&P 500 has outperformed nearly every stock market index this year. Expanding valuations have driven the rally, and the S&P 500 is presently valued ~10% more dearly than in January 2012. Many international markets have lagged the U.S. and are now tempting investment candidates, with Canada being perhaps the most compelling due to strong economic fundamentals and a modest valuation. This article will summarize the bull case for Canada along with several investment ideas.

Understanding the Canadian Economy: Why is it a Good Time to Buy?

Canada derives a large share of its GDP from international trade. In 2011, exports accounted for $462.4 billion of Canada’s $1.577 trillion GDP, a whooping 29.2%. Nearly three quarters of trade is conducted with the United States, largely in the agriculture, energy, forestry, mining and energy sectors.

At the present time, three positive factors are in place:

  • The U.S. economy is improving, which should increase exports.
  • The Canadian dollar is weakening, meaning more Loonies are brought home for every dollar sold abroad.
  • Natural resources (particularly oil) are increasing in price and the shale oil boom should continue to contribute to economic growth.

So the fundamentals of the Canadian market appear to be good -- but what of its valuation? In June 2012 the 10-year normalized earnings of the Canadian stock market were 17.31, versus a median of 19.85. At approximately the same price as one year ago, the Canadian market is cheaper than its historical average.

How does that compare to the S&P 500? The 10-year normalized earnings of the S&P 500 are presently 23.9, versus a median of 14.6. Thus, the United States is roughly 37% more expensive than its northern neighbor. Canada appears to be a very good mix of valuation and economic fundamentals. Furthermore, the Canadian market has provided strong returns over the longer term, outperforming the Dow Jones Industrials by 11% since 2000.

So what are the Best Investments Today?

The Canadian National Railway (NYSE: CNI) is the operator of the largest Canadian railroad, which crosses the continent east to west and north to south, linking customers in Canada to the United States. Canadian National is well-situated to capitalize on a shift to rail-based transportation of oil, which is expected to account for half of an expected 8.2% revenue growth in 2013.

Out of all North American railroad operators, Canadian National is best in breed in three important respects. First, it is the least exposed to coal as a percentage of freight revenue, at 8.0%. Second, Canadian National has the best operating ratio – operating profits compared to revenues – at 62.9%. Third, it sports the highest return on equity among the major railroads at 24.9%.

Canadian National has consistently repurchased shares to decrease its float by 8% over the past four years, while paying a 1.7% dividend that has increased by 500% over the past 10 years. The company is slightly expensive currently trading for 17.2 times TTM earnings. However, Canadian National is at least worth a spot on your watch-list and is probably the best-buy among railroads at the present time.

PotashCorp (NYSE: POT) is an industry leader in the production of fertilizer, which should benefit from secular trends toward increased demand for agricultural commodities. Declining revenues and a 33% drop in earnings per share year over year have hit the company over the past year, and its price reflects these difficulties. Potash trades for 15.6 times TTM earnings, or 24 times 10-year normalized earnings -- as cheap as it has ever traded in the past 10 years.

The time to buy a company in the business of supplying commodity chemicals is when prices and revenues have dropped.  If you have the patience for a turnaround investment, Potash is worthy of consideration. Being paid a 3.7% dividend while you wait also sweetens the deal.

TransCanada (NYSE: TRP) has pulled back by over 10% recently and could represent a timely buy. The company is comprised into three segments: Natural Gas Pipelines, Oil Pipelines and Energy and is a major beneficiary of the shale oil boom occurring in Canada today.

One reason to buy TransCanada is because uncertainty regarding the Keystone pipeline may be lifted in the near future. In January 2012, TransCanada applied for a permit to build the Keystone pipeline in order to transport heavy crude from the Bakken Shale to Gulf Coast refineries. If completed, the pipeline would be capable of transporting 1.1 million barrels per day.

At 21.9 times TTM earnings, TransCanada is priced a bit higher than would be optimal, but the company is an excellent, stable dividend growth stock, with a predictable business model and a 4.1% current dividend that has more than doubled over the past 10 years.

Toronto-Dominion Bank (NYSE: TD) is a Canadian bank offering retail, commercial banking, wealth management services and wholesale banking with an emphasis on Canada and the United States. Consumers in the United States have most likely been exposed to the bank through TD Ameritrade and the mutual funds that the company offers.

Even though Toronto-Dominion has not run up along with the market in the past year it sports metrics that are competitive with the most successful U.S. based banks. The company has a 14.51% return on equity, is priced at 1.66 times book value and 11.2 times TTM earnings, with an expected PEG value of 0.93.

As the Canadian economy improves, the stock of Toronto-Dominion should rise. If interest rates continue to move higher, that should also prove to be a significant boost to the company’s profitability. Furthermore, the weakening of the Canadian dollar this year should boast profitability, as the bank’s operations in the United States should yield an added contribution to the bottom line. After a recent dividend increase, Toronto-Dominion shares yield more than 4%.

Conclusions

Canada offers a number of wonderful investment opportunities, and my favorite is Canadian National Railroad.  It may be worthwhile to wait for a 5%-10% pullback, but Canadian National is a business worth owning for the long-term.  Alternatively, a $95-January put fetches around $5 and would either provide a cost-basis of $90/share or an annualized 11.1% return on at risk capital.


Brendan O'Boyle has no position in any stocks mentioned. The Motley Fool recommends Canadian National Railway. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy. Is this post wrong? Click here. Think you can do better? Join us and write your own!

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