In this edition of ‘Stock Teasers’ we are going to be looking at a submission to /r/CanadianInvestor on Reddit where the user is asking whether it makes sense for Canadian investors to continue to invest in Canadian stocks given the underperformance relative to the US market. Let’s dive in!

Investors should always be well aware of the importance of diversification not only in terms of sectors and industries but also in geographies and currencies. However, given the significant outperformance of the US market, investors are questioning whether there is any benefit to invest in Canadian equities. Let’s look at the relative performance between the US market and the Canadian market, for which we use the S&P 500 and TSX index, respectively as the proxy for each.

Source: Reddit

The impressive performance of the US market

Here is the performance in terms of compounded annual growth rate (CAGR) of the S&P 500 within different time horizons with dividends reinvested:

3-year: 10.2%

5-year: 14.9%

10-year: 12.8%

On the other hand, here is the performance of the TSX index in the same time frame:

3-year: 5.7%

5-year: 9.0%

10-year: 7.1%

The outperformance of the S&P 500 relative to the TSX on three, five and ten-year horizons is quite significant. The S&P 500 performance was predominantly driven by a few large technology companies. These companies have performed so well in the last decade and will likely continue in the near term.

This question of whether investors should ignore the Canadian market becomes a totally legitimate question.

We think investors can think about portfolio allocation in terms of defensive and offensive sectors. The US market which is heavily dominated by large technology names tends to do much better in a bull market.

On the other hand, the Canadian market is heavily dominated by well-established companies in traditional industries like financials and energy. These sectors tend to not perform as well in a rising market but would be resilient during a market downturn due to their durable cash flow and predictable dividends. Similar to the cash allocation of the portfolio, which tends to be a drag on performance during a bull market. The defensive portion of the portfolio sometimes feels unnecessary until the next bear market.

The rationale for investing in the Canadian market

1.   Owning the TSX is similar to buying insurance for the portfolio against a market downturn. This is because the Canadian market is heavily dominated by defensive sectors which could act as a hedge against market downturn.

2.   Discrepancy between the two markets has never been wider than before. For example, the TSX is trading in the range of 17x – 19x multiples, the S&P 500 is trading in the range of 25x – 27x multiples.

3.   The opportunities set for Canadian investors are even more attractive in the small and mid-cap space, where we think there are tremendous opportunities for undervalued long-term compounders that if being traded in the US market would see a much higher multiple.

Overall, portfolio allocation is a personal decision, however, we think a decent portfolio should balance well between offensive and defensive portions. Only when the market faces challenges, do investors start to value predictability and stability once again.

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Authors, directors, partners and/or officers of 5i Research do hold a financial or other interest in VFV at the time of publishing. The i2i Fund does not hold financial or other interest in the above companies or ETFs at the time of publishing