3 Reasons Why Canadian Stocks are Bound to Under-perform

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Investors in Canada may be forgiven for being a bit excited.

Canada’s stock market recently reached a record high, surpassing even a January high before the United States stock market.

However, if you look at the longer-term picture, you will realize that there isn’t a lot to get excited about. The S&P/TSX Composite Index rose 117 percent since March 9, 2009 financial-crisis low compared to an increase of 309 percent for the S&P 500 Index.

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Canada is once more expected to lag in 2018, with strategists projecting a full-year gain of just 5 percent compared to the S&P 500’s 10 percent.

The Canadian index dropped 0.2 percent to 16,392 in Toronto. It is hardly a secret that the stock market in Canada lacks diversification, is exposed too much to cyclical commodity stocks and lacks enough drivers of growth such as healthcare and technology. However, some of the business leaders in the country say that the reasons for the long-term under performance are actually deeper than that: an non-competitive tax policy, too few independent investment dealers, and a lack of risk capital.

It isn’t easy to introduce new companies to market in Canada. In the last 5 years, independent investment dealers (close to 50) have closed shop citing weak commodity markets, higher operating costs, and the consolidation is only likely to accelerate over the next few years, according to Ian Russel, who is the president of the Investment Industry Association of Canada.

It means that companies wishing to go public have fewer options, which pushes them to other funding sources such as venture capital and private equity or even acquisitions by their larger competitors.

Investors have fewer opportunities for diversifying into high-growth but underrepresented sectors such as technology, which is the real standout in U.S, markets.

Last year, there were 14 initial public offerings on the Toronto Stock Exchange worth more than US $75 million and 4 so far this year, which is down from 30 in 2017 when commodities were booming, according to data that Bloomberg compiled.

Dan Daviau, CEO of Canaccord Genuity Group, which is an independent dealer said in an interview earlier in the year that there is a fundamental problem with the lack of partners to help entrepreneurial companies raise funds and help small-cap IPOs happen. Daviau added that he didn’t believe that this is healthy for the capital markets in Canada. He also added that if their company was in the United States, it would have 30 competitors all doing different flavors of what it does.

The listed companies find it harder to raise equity capital to fund growth and acquisitions, which keeps the stock prices depressed, says Russell. According to data from Bloomberg, there have been 7 secondary share offerings in Canada worth a total of US$756 million year-to-date compared to 23 worth US$2.2 billion in 2007.

The banks have stepped in where the investment dealers have shrunk, but they often ignore the smaller companies, according to Russell.

The largest 5 banks in Canada accounted for about two-thirds of equity and equity-linked issuance’s in 2017 compared to less than 50 percent in 2008, according to the data.

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Take the cannabis sector for example. Canaccord leads equity financing in the industry that the big banks don’t like getting involved with. Now that the industry is properly established and Canada has legalized marijuana for recreational use, the big banks have started elbowing in.

Tom Caldwell, CEO of Urbana Corp. and chairman of Caldwell Financial Ltd is blunter when it comes to the implications of the creeping influence of banks and the shrinking pool of independent dealers in Canada. He says that they have a tendency to absorb, acquire, and obliterate and that he believes it will have a significant impact on economic growth, job creation, and even innovation.

The tax regime in Canada also stunts corporate investment through special subsidies and tax breaks only given to small businesses, which discourages them from growing beyond a particular size, says David Rosenberg, who is the cheap strategist and economist at Gluskin Sheff & Associates Inc. Last year, Bill Morneau the Finance Minister tried cracking down on the use of private corporations, which is frequently used by owners of small businesses to lower taxes, but he was forced to retreat after facing too much backlash.

Rosenberg says that businesses in Canada stay small because the system rewards small.

To be sure, the growing cannabis sector has led to the creation of a new stable of publicly traded companies that helped the S&P/TSX to reach a record high after the upper house in Canada voted to approve the legalization of recreational marijuana. Canopy Growth Corp. gained 6.7 percent to $45.36, which is a record high that gave it a market value of $9 billion.

Still, Canada has produced some innovative and successful companies such as Shopify Inc. The tech sector, which accounts for about 4 percent of the Canadian benchmark is actually leading its peers by a long shot, up 31 percent year-to-date.

Canada is ranked at number 5 out of 54 countries for perceived opportunities for entrepreneurs in the Global Entrepreneurship Monitor, but it has not been successful in transforming that innovation into commercial success, according to Jos Schmitt, the CEO of Aequitas Innovations Inc. that runs a stock exchange based in Toronto.

According to Schmitt, the blame lies squarely on the lack of risk capital and the fact that there aren’t too many Canadians with the right commercialization and managerial skills. He suggests making it easier for broker-dealers in the United States to access the Canadian market thus offering more support to publicly traded companies. In the absence of that, the stock market in Canada is bound to continue under-performing, he said.

The lack of risk capital can either lead companies to move elsewhere, which is often the United States where they can find the private risk capital where the talent they need is available. Or it may lead them to go public too fast, says Schmitt.

He also added that neither of the two solutions is good for the Canadian economy.