Stock Rally Fuels Analyst Caution on Valuations

Analysts ratings for Canadian stocks have sunk to a five-year low amid concern prices have outpaced earnings after the longest string of monthly gains in three decades.

Companies from TransCanada Corp. to Canadian Oil Sands Ltd. have seen buy ratings reduced after 10 months of advances boosted valuations in the Standard & Poor’s/TSX Composite Index to a three-year high. Equities have gained 21 percent during the rally, the most among the 10 largest developed markets. The average stock in the benchmark for Canadian equities has matched the lowest analyst rating since the middle of 2009, quarterly data compiled by Bloomberg show.

“The numbers coming down are a reflection of the TSX moving up as much as it has,” said Andrew Pyle, a fund manager at ScotiaMcLeod Inc. in Peterborough, Ontario, in a May 5 interview. He manages about C$220 million ($202 million). “You’re simply not going to have as many buys at the top of the market as you would in a market a year ago when things looked like they were underperforming.”

Analysts are tamping down expectations for further gains as stocks trade at 20 times reported earnings, up 26 percent from the end of June and higher than the price-to-earnings ratio of 17 for equities in the S&P 500. The Canadian index reached its highest in almost six years this month, even as almost half of the gauge’s members that have reported first-quarter earnings fell short of analysts’ estimates.

The S&P/TSX fell 0.6 percent to 14,588.89 at 4 p.m. in Toronto today.

Fewer Buys

While buy ratings still outpace sells and holds on the S&P/TSX, the number of sell and hold ratings has increased 11 percent since the rally started at the end of June, while buy recommendations fell 1.7 percent, data compiled by Bloomberg show. The shift has left the average stock in the index with a rating of 3.88, based on a Bloomberg system that assigns each sell a 1, each hold a 3 and each buy a 5. That matches the total in June 2009, the data show.

Energy shares in the index have an average rating of 4.08, down from 4.12 at the end of 2013. The industry has rallied 14 percent this year, the most among 10 groups in the S&P/TSX, as the price of West Texas Intermediate oil climbed above $100 in New York. The gains pushed the price-to-earnings ratio for the group to 29.5 at the end of March, the highest in three years and more than double the low of 14.68 in June 2012.

TransCanada’s average rating has fallen to 3.94 from 4.41 at the end of March, as its shares rallied 16 percent from an October low. The stock’s advance and persistent delays in the approval process for the company’s Keystone XL pipeline led Pierre Lacroix of Desjardins Securities Inc. to cut his recommendation to hold from buy on May 5.

Energy Ratings

First Energy Capital, a research firm that focuses on Canada’s oil and gas industry, reduced its recommendation on May 6 on Canadian Oil Sands to the equivalent of a sell after the exploration company lowered its projections for how much oil it would pump in 2014. The average rating on the company is 2.45, down from 2.7 at the end of 2013.

Canadian stocks are beating U.S. shares for the first time since 2010 and David Rosenberg, chief economist at Gluskin Sheff & Associates Inc. in Toronto, predicts the outperformance will continue. The S&P/TSX is up 7.7 percent in 2014, compared with a 2.2 percent advance for the S&P 500.

The decline in the Canadian currency versus the U.S. dollar will boost profits for companies that make goods locally and sell them in the U.S., he said. The loonie, named after the bird that appears on the Canadian dollar coin, has dropped as much as 5.5 percent this year to a five-year low of 0.8894 cents on March 20.

Relative Advantage

“Canada offers a significant relative advantage compared to the U.S. right now,” Rosenberg said in a May 2 phone interview. “This is a powerful stimulative boost.”

Estimates from equity strategists show the gains may not be sustainable. The median year-end projection of six forecasters in a Bloomberg survey is 14,175, implying the S&P/TSX will decline 3.4 percent through December from yesterday’s closing level.

Kash Pashootan, a portfolio manager at First Avenue Advisory of Raymond James Ltd., says Canadian companies will have to show earnings can grow to justify higher valuations and better share-price performance than their U.S. counterparts.

“The market rally isn’t about some new growth catalyst but rather as catch-up in the spread between the U.S. and Canadian markets,” Pashootan said in a May 6 interview from Ottawa. His firm manages about C$200 million. “Now that that catch-up has been played, we’re starting to trade more based on fundamentals and that’s why the outlook isn’t as compelling.”

Before it's here, it's on the Bloomberg Terminal.