NEW THINKING Across the pond and beyond It s no secret that Canadians have had a preference for domestic investments 1. And who can blame them, based on historical equity returns, Canada has been a great place to grow financial wealth 2. Whether it was judicious risk management in the banking sector that avoided some of the worst pitfalls of the financial crises, high quality energy stocks that participated in the last resource boom or the AAA rating of Canadian Government debt that supported fixed income returns, Canadian investors have been well-compensated for taking risk. But is this home country bias the right strategy moving forward? We would contend not. There are ominous clouds on the horizon, such as elevated household debt in the economy and an equity market that is cyclically geared with an overconcentration on financials and resources. There are also
political concerns including the fate of the North American Free Trade Agreement and the U.S. having lowered corporate taxes to help make their firms more competitive. So while we are confident that Canadian investments can weather the storm, we think a smart alternative is to increase diversification by adding exposure to global equities. Not only are they often uncorrelated to domestic developments, global equities are enjoying tailwinds of faster economic growth, fundamental operational improvement at the company level and a policy environment that remains favourable 3. We believe these benefits can lead to higher risk-adjusted returns. risk predictions. A world of choice Global equity opportunities outside of Canadian markets, including those of developed and emerging markets, account today for 97% of global market capitalization 4. However, Canadian investors only allocate approximately 40% of their portfolio of equity investments beyond Canada1. While Canada has many successful companies to invest in, the vast majority of the world s best-managed and profitable companies are located outside of our borders. What s more, many of the world s leading companies - such as Microsoft, Roche, and Honda - are international businesses generating significant revenue outside their home market 5. By combining Canadian and non-canadian securities, an investor can access a wide investment universe and potentially benefit from enhanced real returns over the long term. The increasing globalization of financial markets supports an approach that evaluates companies on a global basis rather than regional or countryspecific measures. In a world market economy, portfolio construction should not be limited by regional barriers or rigid market weightings. Active management can exploit inefficiencies, especially across global markets. An integrated global approach provides the ability to invest opportunistically among regions, countries and sectors and take advantage of the most attractive valuations and prospects for growth. This article focuses on the top reasons TD Asset Management Inc. (TDAM) feels Canadian investors should consider global exposure within their portfolios. Structural challenges within domestic market sectors Canada s stock market is highly concentrated in three, low-growth sectors of the economy, with almost two thirds of the market being concentrated in the Financials, Energy and Materials sectors. As a result, Canadian investors Canada's market is highly concentrated in three low growth sectors S&P/TSX Composite Index 33% Financials MSCI World Index 17% Financials 7% Energy 5% Materials 12% Materials 20% Energy Financials + Commodities = 65% Financials + Commodities = 29% Source: FactSet Research System Inc. As of June 30, 2018. New Thinking Across The Pond And Beyond PAGE 2
are exposed to unintended risks, including sector, concentration, financial and commodity risk. Over the past 10 years, companies in developed global economies have grown their earnings per share (EPS) by 28%. This growth was largely driven by secular growth sectors including, Information Technology (130%), Healthcare (42%) and Consumer Discretionary (111%). During the same time period the S&P/TSX Composite Index grew EPS by 20%. Combined, these three high growth sectors comprise close to 43% of the MSCI World Index, compared to only 11% of the Canadian market 6. The structural underweight in the Canadian market of these high growth, high cash generating businesses in favour of traditional capital intensive sectors is an ongoing challenge for Canada, and a compelling reason for global diversification. Given that innovations in these areas may drive the economy for years to come, we anticipate earnings growth in these sectors can continue to be strong. Canada's market is structurally underweight in three high growth sectors 10Y EPS Growth MSCI World Index S&P/TSX Composite Index 28 % 20 % Information Technology Health Care Consumer Discretionary Consumer Staples Industrials Real Estate Utilities Telecommunication Services Materials Energy Finanaicals -20.0% -15.0% -10.0% -5.0% 0 5.0% 10.0% 15.0% 20.0% Source: Bloomberg Finance L.P. FactSet Research System Inc. As of June 30, 2018. New Thinking Across The Pond And Beyond PAGE 3
Strong performance When it comes to performance, global markets typically alternate turns at the top. Since the financial crisis, no single market has been the top performer more than once. Canadian markets were the top performer once in 2016 whereas U.S was never on top during that time period. Investors who focused solely on Canada and the U.S. during this period sacrificed by missing out on stronger returns from other markets around the world and decreased their level of diversification. The chart below also illustrates the relative performance over the past decade using indices as proxies and helps to show how global markets have performed better than a purely Canadian equity portfolio. A simple portfolio with 50% domestic and 50% foreign equities would have also improved returns while reducing risk. Adding global equities has improved risk-adjusted returns Value of $100 investment in MSCI World Ex-Canada Index vs. S&P/TSX Composite Index vs. 50/50 Portfolio $250 $230 Return* 9% 5% 7% $236 $210 Volatility* 12% 13% 11% $200 $190 $170 $165 $150 $130 $110 $90 $70 $50 Mar-08 Mar-09 Mar-10 Mar-11 Mar-12 Mar-13 Mar-14 Mar-15 Mar-16 Mar-17 Mar-18 S&P/TSX Composite Total Return Index MSCI World ex-canada Net Total Return Index 50/50 Portfolio *Annualized Source: TD Asset Management Inc., Bloomberg Finance L.P. Data as of June 30, 2018. 50/50 Portfolio is a mix of 50% S&P/TSX Composite Total Return Index & 50% MSCI World Ex Canada Net Total Return Note: All return data is in Canadian Dollars New Thinking Across The Pond And Beyond PAGE 4
Underestimated cash flow production At TDAM, we believe that the value of any business is based on the amount of cash flows that an enterprise generates. Since the global financial crises in 2008-09, the market has systematically underestimated the cash flow production of some of the best global corporations. This creates opportunities moving forward. We view companies that generate and grow cash flows as higher quality and have a higher chance to outperform the broad market over time. The key to benefit from this view is to identify high quality companies. When looking to invest in high quality companies globally, it is essential to find corporations that demonstrate cash flow protection and cash flow growth. To protect cash flow, companies need to have sustainable competitive advantages in their respective industries. This can be achieved by higher prices or lower costs. Furthermore, to grow the cash flow requires companies to reinvest them at attractive rates. Our research points to improving returns on invested capital as being a great proxy for such high quality companies. The key word here is improving. Return on Invested Capital (ROIC) represents how much income a company is able to generate from its investment. For example, if a company is earning a higher return on its investment than its peers, and its own history, then by definition it has a competitive advantage. Improving ROIC further identifies companies that can potentially generate more cash flow in the future. Our research shows that companies with improving ROICs have historically outperformed the broad market, as illustrated in the chart below. Companies with improving ROIC have outperformed The value of $10,000 investment in MSCI World Index vs. MSCI World Index with Improving ROIC companies $50,000 $49,000 $45,000 $40,000 $35,000 MSCI World Index MSCI World Index Improving ROIC $35,000 $30,000 $25,000 $20,000 $15,000 $10,000 $5,000 0 2003 2005 2007 2009 2011 2013 2015 2017 Source: Bloomberg Finance L.P. Data as of June 30, 2018 New Thinking Across The Pond And Beyond PAGE 5
Still time to take advantage As the marketplace continues to underestimate the cash flow being generated by the highest quality companies, there are still many opportunities to take advantage of global equity markets. Introducing global equities into Canadian investor portfolios provides not only geographic, sector and currency diversification, but also the opportunity of cash flow diversification. To realize these benefits effectively without taking unnecessary risks in a fastchanging environment, investors are encouraged to work with professional investment managers. ¹IMF Coordinated Portfolio Investment Survey, 2014 2 As represented by the growth of the S&P/TSX Composite Index, based on 20 year rollingreturns since January 1, 1980. 3 TD Asset Management Wealth Asset Allocation Committee Monthy Report, June 30, 2018 4 MSCI World Index, as of June 30, 2018 5 Based on 2018 annual reports 6 TD Asset Management, as of June 30, 2018. The information contained herein has been provided by TD Asset Management Inc. and is for information purposes only. The information has been drawn from sources believed to be reliable. Graphs and charts are used for illustrative purposes only and do not reflect future values or future performance of any investment. The information does not provide financial, legal, tax or investment advice. Particular investment, tax, or trading strategies should be evaluated relative to each individual s objectives and risk tolerance. Commissions, trailing commissions, management fees and expenses all may be associated with mutual fund investments. Certain statements in this document may contain forward-looking statements ( FLS ) that are predictive in nature and may include words such as expects, anticipates, intends, believes, estimates and similar forward-looking expressions or negative versions thereof. FLS are based on current expectations and projections about future general economic, political and relevant market factors, such as interest and foreign exchange rates, equity and capital markets, the general business environment, assuming no changes to tax or other laws or government regulation or catastrophic events. Expectations and projections about future events are inherently subject to risks and uncertainties, which may be unforeseeable. Such expectations and projections may be incorrect in the future. FLS are not guarantees of future performance. Actual events could differ materially from those expressed or implied in any FLS. A number of important factors including those factors set out above can contribute to these digressions. You should avoid placing any reliance on FLS TD Asset Management operates through TD Asset Management Inc. in Canada and through TDAM USA Inc. in the United States. Both are wholly-owned subsidiaries of The Toronto-Dominion Bank. Bloomberg and Bloomberg.com are trademarks and service marks of Bloomberg Finance L.P., a Delaware limited partnership, or its subsidiaries. All rights reserved.. All trademarks are the property of their respective owners. The TD logo and other trade-marks are the property of The Toronto-Dominion Bank. (0918) PAGE 6