In this podcast, Motley Fool analysts Nick Sciple and Jim Gillies talk about the macro environment in Canada and opportunities investors can find in a messy housing market.
They also discuss:
- The deceptive nature of "static" mortgages.
- Six bank stocks that are long-term, growing winners.
- And a company that "specializes in the absurd."
To catch full episodes of all The Motley Fool's free podcasts, check out our podcast center. To get started investing, check out our quick-start guide to investing in stocks. A full transcript follows the video.
This video was recorded on Dec. 09, 2023.
Jim Gillies: Banks are hunkering down. They are preparing for loans to go bad, and this all sounds bad. I'm going to take another mongerism here, and I'm going to go invert. Always invert. You want to be a buyer of these types of assets when things look bad.
Mary Long: I'm Mary Long, and that's Jim Gillies, a senior analyst for Motley Fool Canada. Today we're hitting the road and putting the spotlight on Canada to get a sense of what investment opportunities exist in America's northern neighbor. Nick Sciple, another analyst for the Fool's Canadian service caught up with Jim in late November. They discussed how to find upside in a messy housing market, accidental tech companies, and a quality business that specializes in the absurd.
Nick Sciple: Let's set the stage. Most of our listeners here today are going to be American listeners on the Motley Fool. [inaudible] how do you compare and contrast the Canadian economy with the US economy our listeners are probably more familiar with?
Jim Gillies: Sure, thanks Nick. The real quick rule of thumb is we're generally about a 10th of your size. Pick any metric you want. GDP, Population, whatever, we're generally about one-tenth of your size. We are the size, population-wise of one of your larger states. We are rich in land mass, but we tend to cluster a lot. I believe it's got about 90% of our people, myself included, live within 150 miles of the US border, or 240 kilometers, if you prefer. We go to McDonald's as much as you do kind of thing. We watch the same movies, have the same pop culture, yada yada, yada. Where we differ though is our economy is very tied to a few specific things that tend to go boom or bust. We don't have much of a tech sector, frankly, and even when we have had a tech sector Nortel Networks, Research in Motion, that also favors the bust side of things, but we tend to be very focused on finance, so big banks, life insurance companies, that sort of thing. We tend to be very focused on resources. You may have heard, Alberta, one of our western provinces, has the largest oil reserves in the world. Yes, more than Saudi Arabia. It just tends to be in very thick, black, goopy bitumen and not in very easy to access, light sweet crude. We have that exposure to resource prices that can sometimes be a bit of a feast or famine up here. Then finally, and I think this is where we're probably going to take the conversation, Canadians fell in love with housing round about the time you all did in the early part of the 2000s. The key difference is you had your come-to-rationality moment somewhat forced upon you in 2008, 2009, and Canadians, as a collective, went the other direction and put their foot down on the accelerator. We're facing some problems today that my American friends are probably already more than familiar with.
Nick Sciple: Lots of similarities between the US and Canada. Some real key differences, and one of those key differences we'll talk about here in the Canadian real estate market. If you pay really any attention to the Canadian economy, it's very clear. Canadians have real estate anxiety. When you compare household income in Canada to housing costs, they're at their highest level since the 1980s. Many folks worry that it could hurt the economy. You talked also about real concentrations of folks in a handful of cities. Really there's not a lot of options to move into other places. Jim, what has caused this housing mess in Canada?
Jim Gillies: Boy, how long do we got? I'm going to start with the premise that, much like our American cousins in the early part of the 2000s, we bought the line, or I'll say collectively the country bought the line that house prices only go up. You can't lose money if you own a house, and so there's a bit of a propensity to pay any price. That's the seeds of FOMO, or fear of missing out. You start to have that plying on people's thought processes. Look when house prices are going up, everything's great. You feel richer. Maybe you spend a little more, so that goes into the economy. Maybe that spending is financed by your borrowings on your HELOC, for example, on your home. There's that mentality certainly during COVID as well. It was already nascent, that house prices were rich, before COVID. Then COVID just touched the match off, unfortunately. That's one of the drivers. But then as we've come through COVID, and we're now on the other side of it, and you're talking about derail in the economy, the first thing I would say is interest rates have done Canadian housing no favors. This is not something that Americans really understand because I like to tweak my American friends, and I like to say how it's so nice that you guys live in a socialist country where you have 30-year mortgages. The rest of the world is not like that, where we have government standing behind our mortgages, so Canadians, for example, have to reset or renegotiate their mortgage. Generally every five years, you can get a one-year mortgage. You can get a 10-year mortgage. Rates differ. Most people do five-year increments.
That's a way of the banks sloughing off some of the interest rate risk onto citizens. Now of course, if interest rates go down in your five-year mortgage, you can renew for your next five years. Most houses are at the 25-year amortization, so if you're a basic standard Canadian, you're going to do five five-year mortgages over 25 years, no extra payments, and that's when you pay it off, but you are going to carry some of that interest rate risk. The other thing that has come up, and again, stop me, Americans, if you've heard this one before, you have seen the rise of what I'm going to call exotic mortgages. What that means here in Canada is you generally used to have a choice between a fixed rate mortgage or a variable rate mortgage. The old bog standard variable rate mortgage would be if the Central Bank raised interest rates, your mortgage payment would go up that next payment date. If they lowered interest rates, your payment would go down. The problem is the innovation. I should probably do air quotes around the word innovation. The innovation a few years ago was that four of the Big Six banks introduced a new product, which I'm going to call a static payment variable rate mortgage. That means when interest rates move, your payment stays the same. That's the whole static payment thing.
The problem is mortgage math is actually deceptively easy. There's basically, three inputs into determining your payment: the amount you borrow, the interest rate, and the amortization period. The amount you borrow, you know that upfront, so we're done there. We're going to hold the payment steady. That's the whole static payment thing. When interest rates go up, the only thing that can move is amortization. In other words, the length of time of your mortgages. That also shifts the balance of how much of your payment is going to principal and how much is going to interest. We have just lived through a year and a half of the interest rate going up 1900%, from 25 basis points, the key Fed rate, to 5 percentage points, so 25 basis points, 5 percentage points. When you tell people interest rates have gone up 1900%, their eyes will glaze over, but what that's done on the static payment variable rate mortgages, it has exploded the amortization period now.
You can go to the four of the Big Six banks here in Canada that offer that type of product, and you're now seeing 30 and 40% of mortgages with over 30-years of amortization, quite often, over 40 years of amortization. That is putting a lot of stress on people, but they're not yet feeling it because their payment hasn't changed, the whole static payment thing. The static payment, as they start renewing, remember, you need to renew every five years, as you renew your payment, if you overpaid for a house, you chase the house at any price because, of course, house prices only go up, they never go down, as was the thinking. Five years after you bought, let's say you bought in 2019, so it's going to be 2024 coming up, how enthused are you to hear that your monthly payment could go up 30, 40, 50% even? Can your household budget sustain that? I think what's dawning on a lot of Canadians is that a lot of household budgets won't sustain that, and the cure for that is for house prices to fall, but for everybody who maybe doesn't have a mortgage and is living in their house, that's fine. People who bought a house within the last five years, who stretched to pay up, who took a variable rate static payment mortgage because the rate was lower and that meant that they could buy more house, those people their budgets are going to be imploded. A non-zero number of them are going to lose their houses again.
Go back and look at what happened to the US in 2007-2009. That is the single biggest problem right now in the Canadian mortgage market. The other thing is, much like the US, a lot of people are sitting on mortgage rates of 1.5-2.5% and they're, like, we don't want to sell or move because we'll be renewing. The new house we'll be buying, mortgage will be at 6%, six-and-a-half, five-and-a-half, whatever. That will, again, jack the price up so people are sitting. A lot of these things, so there's not a lot of supply. Then as well too, we do have a supply issue in Canada. The supply issue is a housing supply. That issue is tied to the fact that we're at record immigration. People have got to live somewhere. We have a non-zero number of housing units, particularly condos, essentially coming onto the market as Airbnbs, or short term rentals, and then as well development costs, like we are on pace this year, 2023, even though we have the supply issue. We are on pace to deliver less housing units than we delivered last year because dirty little secret, higher interest rates. Most development is also interest-fueled, or it's financed.
Their cost of development has gone up. We've had inflation, particularly wage inflation. The trades have done very well, but the cost to develop homes has been very expensive. Various cities have laid on more and more development charges, which the builders, of course, are happy to pass along to citizens buying their homes. Throughout the whole chain, owning a house, for new buyers at least, it has become, if not economically impossible, at least economically not a great idea because you will be basically servicing your loan for 30, 40, 50 years, given the way that amortizations are gone, and it's going to take more and more of your paycheck. House prices probably have to come down. They have been coming down since the February 2022 peak, but then that, of course, introduces a whole other set of issues, not the least of which is, if you felt wealthier as your house price expanded, guess what you feel as your house price shrinks.
Nick Sciple: Jim, we've talked about a lot of the risks may be being created in the Canadian real estate market, but are there any opportunities that you see, or any companies or banks perhaps, that could emerge from this stronger than others?
Jim Gillies: Sure. This has all been dour and sour and terrible and why would you want to come here. I'm generally one of the most positive people you'll know, but I hide it behind a veneer of cynicism. I like to think of it as mongeresque to do a deep cut right now. The first thing I'm going to say is our banking system. Our banking system is, unlike the US. There you have a couple of giant money center banks, your JPMorgans, your Citigroups, your Bank of Americas, and your Wells Fargos, blah blah blah. Then you have about 78,000 tiny little banks and savings and loans. I'm probably making up a completely silly number, but we don't have that. We have six big banks, and they control basically everything. There are a few smaller, but the Big Six banks and the Big Six banks are incredibly diverse. Yes, they're into mortgage lending, but they're also into business lending, but they're also into wealth management and investments, but they're also into insurance, but they're also into on and on. If you pick a financial business line, they are probably tied to it one way or the other. They control all the deposits, so there's no Silicon Valley style bank runs that are happening. They're all generally well-capitalized. Probably the worst of the bunch would be CIBC, which I like to call the bank most likely to walk into sharp objects, If you need to ask yourself, who has the most exposure to whatever disaster is happening today, it's probably CIBC among the Canadian six banks, but they are very large, very diversified, and they are going to weather this present storm. The banks have just started reporting their most recent quarters. In fact, Bank of Nova Scotia reported the day before we're recording this. The next five of the Big Six will be reporting, I think, over the next two or three days.
What is interesting to me is these are long-term market-beating winners. The Canadian market is, unlike the US market, our long-term annualized return here in Canada is about 8% for the last 20 years. If you want to go for about 45 years, I think, since Capital IQ was keeping data, I believe it's about 8.7%, that is with dividends reinvested. That's a very important distinction because, in the US, the S&P 500 does 10, 11% before dividends, 11, 12% with dividends reinvested, so we have had lower aggregate returns, and that is in large part because of what I talked about earlier, how we have a lot of resource companies, a lot of boom and bust in those areas. We managed to, at one point in time, have the largest company in Canada that would be Nortel Networks. That one went to zero. That was good. Research in Motion, another one, has lost a lot of its value. There's been a lot of hindrances on the index is what I'm trying to say, but the banks are long-term growing winners. They have raised their dividend. Some of them have paid dividends since before Canada was a country. Canada Confederation was in 1867, for those who don't know. Some of them predate the existence of Canada, have been paying dividends uninterrupted since before the existence of Canada, the country officially, obviously, not the landmass.
They have a habit of raising their dividends on the regular. Right now you can see, at least in the Bank of Nova Scotia, report that came out two days ago, they took larger-than-expected provisioning because banks are hunkering down. They are preparing for loans to go bad, and this all sounds bad, but I'm going to take another mongerism here, and I'm going to go invert. Always invert. You want to be a buyer of these types of assets when things look bad. Right now, on my other screen here, I have the valuation of all Big Six banks since 2000, so about almost 23 years, almost 24 years. All six are at valuations that are well below the average valuation. If you look at just the valuation levels over the past 10 years, one is slightly above what the average over the past 10 years is, that is again CIBC, but everything else, the setup looks good. They all pay a dividend.
I believe the average dividend yield at this point is somewhere around five-and-a-half percent ranging from 4.6% for the banks generally considered the higher quality ones that Royal Bank and Toronto-Dominion, TD, and to 7.2% for Bank of Nova Scotia, which again is the one that just reported. What I find fascinating about that is Bank of Nova Scotia is one of the two banks, National Bank of Canada being the other one, one of the two banks that did not engage in those static payment variable rate mortgages. Yet it has the lowest valuation/highest yield. That's interesting to me, full disclosure. I own some myself. Every Canadian owns bank stock through various index funds and mutual funds, but I own some stock directly as well, but the banks are interesting to me because, five years from now, we will get through this. The economy, I presume, because economy is ebb and flow, we will be on an uptick at some point in the next half-decade. I have to assume, since that's how we generally have rolled anyway, that this is a really great time to be a buyer. The only better time I can think of being a buyer of the banks was in 2008, 2009, when of course everything looked like it was imploding worldwide. It's like if you could muscle up and stomach the volatility and the pain of that time, boy, you've had fun with your bank stocks. These are companies that touch every Canadian's life daily, so I like the banks. We do lack what.
Nick Sciple: They were all cross-listed, by the way.
Jim Gillies: Yeah, five of the six are cross-listed. The only one that is not cross-listed on both the TSX and the American exchanges is National Bank of Canada, which is ticker NA on the TSX. It does not have a US listing. Bank of Montreal, Bank of Nova Scotia, TD, Royal Bank, and, who have I missed, CIBC, of course, they are all cross-listed on US exchanges, so Americans can have easy access to this thesis. As we go beyond that though, again, your benchmark in Canada, here's about 8% a year for your stocks, and like I said, Scotia Bank yielding 7.2, so you can almost get average market performance just by buying the dividend and leaving it alone. Scotia Bank will be here frankly. Also too, I should mention, all of these banks have significant non-Canadian exposure. Anyone from the Boston area, if you want to go watch the Boston Bruins play, they play at the TD Bank North Arena, TD being the Toronto-Dominion Bank. I believe the Carolina Hurricanes, yes, I'm doing hockey metaphors here, the Carolina Hurricanes, at least they used to, I believe, play at the RBC Arena, Royal Bank of Canada. Canada has come south. The Canadian banks have come south. They've made various acquisitions. Bank of Montreal has also done one recently, so there's a way for Americans to play. The one thing that we don't have in Canada, we don't have what we traditionally would call Canadian rule breakers. Rule breakers, the motif that's been obviously, made famous among Fools by David Gardner, we lack those types of companies. Again, we're very resource-based, we're very financial-based, but that doesn't mean we don't have interesting companies that I believe you can make good money on.
Nick Sciple: For context, yeah. There is no Magnificent Seven in Canada.
Jim Gillies: No.
Nick Sciple: The Technology sector on the TSX composite, only about 5.6% of the overall components. You compare that to the US, where the S&P 500 over a quarter of that index comes from some of these big tech companies, so without those big Magnificent Seven stocks to go after, Jim, where are the places you go to look to find big winners in Canada?
Jim Gillies: We have a couple technology companies, but I think they're accidents, if I may, more. We don't have sectors. I've already mentioned a couple of past technology companies that had bitter ends. Nortel went to zero. JDS Uniphase effectively did the same. I mentioned Research in Motion now. Blackberry, you can hear the sucking sound from Waterloo, Ontario, from where I live. It's all blown-up, but let me go to a couple of tech companies in Canada. One of course being Shopify. It's a Fool favorite. It came out of Canada. The team Canada found it and put it on a couple of our scorecards when it was a small cap. Now it's $100 billion company I believe, or near enough. It of course got a little crazy during the pandemic bubble, it's come back to earth, but it's still a quality business. It's still working very well, and so we continue to like it. I'll go another tech company here which is sort of a tech company. It's not Magnificent Seven, but it's a company that I consider to be the best company in Canada, and I don't think there's a debate. Nick, I believe you probably know exactly who I'm going to go with.
Nick Sciple: It's Constellation Software, and true to form, in Canada, it's got a little bit of a roll-up quality to it.
Jim Gillies: Exactly, yes. That is the name. I believe I don't have my spreadsheet open now, but I believe the annualized return since its 2006 IPO is somewhere in the 35-40% range, which is good. In a country where, again, over that same period of time, I'm not sure the market has, with dividends reinvested, done much more than eight. Constellation has been fantastic. As Nick says, it is a roll-up. Specifically, they roll-up small and medium-sized software companies that no one else wants, basically, or that have no pretensions of being other than smaller and medium-sized software companies, so rather than big software where you can get a lot of. I'm talking about software that helps run restaurants, and software that helps run dental practices.
Nick Sciple: Pay your parking tickets.
Jim Gillies: Yeah, pay. Thank you. It's a lot of mundane things that we don't think of but you need software to operate from behind the scenes. It's led by the founder who is a recluse, Mark Leonard, CEO and founder. He's absolutely brilliant at what he has done. He's brought a culture in that I think is second to none. For example, you get your bonus paid in cash, if you're an executive there. Then you have to believe, I believe it's about 70% you have to go by. If you got a bonus, and you're an executive of Constellation Software, you then have to take 70 percentage of your bonus and go buy shares of Constellation on the open market because they want you participating in the success of the company, but they're not just going to hose out equity like so many other companies do and just shove brand-new shares into your pocket, and then we'll buy it back later. No. You've got to have real stakes here. It's been a fantastic company. It's a little large now for what they do, and in the recent years, they've started spinning off a few things. Topicus and Lumine are the two major spin-offs they've done, but it's still been an absolutely fantastic investment. There's our tech sector. We don't really have a lot of what I'll call traditional compounders, but we have really great businesses that you can buy at great or fair prices. The next one I'll introduce you to is Alimentation Couche-Tard, or just Couche-Tard, if you want. Americans will probably have no idea who that is until I say they are the parent company and owner of Circle K, the convenience store that you find at the gas station nearest you. If you want to, you buy gas, go in, buy little snacks for the road, maybe pick up a [inaudible] hot dog. Alimentation Couche-Tard has spent years rolling up convenience store chains around the planet. They've now consolidated most things in North America under the Circle K brand, but if you go find yourself, Fools, a long-term stock chart, say 20 years, what ticker ATD on the TSX, the Toronto Stock Exchange, has done, I think you'll be very impressed.
Then just because one of my absolute favorite Canadian companies because it's absurd, and I fully admit I do specialize a little bit in the absurd end of the market. I try to find stories that are off the beaten path, that are maybe misunderstood, so take that for what it's worth. I've mentioned this company before in several places, but it's a company called Stella-Jones, SJ on the TSX. Stella-Jones is basically the world's largest provider of treated wood railway ties and, as my colleague Iain Butler likes to call it, our colleague I suppose because Nick works with me on Team Canada, he likes to call it the state tree of Nevada, the utility pole, the telephone and utility poles. Yes, they make wood-treated products, essentially. That's an interesting business because, who's going to come in and take it? Who gets excited about creosote-soaking utility poles? What this company has done, it's been a great compounding story for about the last 20 years, stock price compounding, but it went through a bit of a renaissance over the last seven or eight years or before 2023.
It reached a valuation that was excited about 2014, 2015, where you're getting close to 30 times earnings for this business, so it traded sideways for most of the next decade. What people didn't realize, or at least ignored, was that 30 times earnings valuation, nearly 30 times earnings valuation almost a decade ago, was a 10 times valuation by about the end of 2021 or early 2022. Subsequently, and that's when we, Team Canada, got interested in it. We've recommended it and a couple of services. Stocks doubled in the last year and a bit, even as a lot of the high fly in tech stuff went splat. It's just they have a niche. They stick to their niche. They make a lot of cash in that niche. They deploy that cash via dividends, buybacks, and prudent acquisitions, and it's wash, rinse, repeat. Again who is excited about starting a competitor to a railway tie and utility pole maker? I'm going to hazard a guess and say very few, if not no one.
Nick Sciple: Yeah, that's right. Some of these Canadian compounders, not as flashy as maybe the big companies in the US, but really find a niche to exploit and have been able to really create value for shareholders from areas of the market that a lot of folks might not have thought big winners would have come from.
Mary Long: As always, people on the program may have interest in the stocks they talk about, and the Motley Fool may have formal recommendations for or against, so don't buy or sell stocks based solely on what you hear. I'm Mary Long. Thanks for listening. We'll see you tomorrow.
