5 reasons why the Canadian stock market is underperforming

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As of the time of writing this column, the S&P/TSX Composite Index is up almost 4% this year. The S&P 500 is up about 14.7% and the Nasdaq is up 18%. Of all the large developed markets, the Canadian index is the absolute worst performing with the exception of France.

For U.S. investors, the Canadian market looks even worse. In U.S. dollar terms, the S&P/TSX Composite Index is up just 0.7% this year. Investors could have made nearly four times that amount, without the worry, risk or stress, by investing in a six-month guaranteed investment certificate.

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Let’s look at a longer time frame. Looking at annual returns since 2012, the S&P/TSX Composite Index is up 68.6% cumulatively (not including dividends). This seems good enough, but the S&P 500 Index over the same period has returned a staggering 234.5%. Over this period, the US market has outperformed the US market by almost 4 times. Add in the effect of currency, and the US market has returned just 27% in US dollar terms over the 12-year period.

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So what’s going on in the Canadian market? Why is it so bad compared to the global market? Here are five reasons why.

Economic Performance and Currency

Of course, you can’t discuss the stock market without discussing the economy, and frankly, Canada’s economy is terrible compared to the US: less competitive, higher taxes (which have recently been raised), lower productivity, and higher spending.

Without immigration spending, the Canadian economy would have already been in recession. Despite the economic slowdown, inflation rose this week. Canada’s gross domestic product is estimated to grow about 2% this year, after narrowly avoiding an official recession with growth of 1.1% in 2023.

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Because Canadian stocks are tied to the economy, when the economy is weak and the dollar is weak as a result, foreign investors are unable to buy more Canadian stocks and the S&P/TSX Composite Index falls. Imagine a broker’s sales pitch to a U.S. investor: “Would you rather earn nearly 15% returns on U.S. stocks or nearly zero returns on Canadian stocks?”

The index is misconfigured

The S&P/TSX Composite Index is currently at 30.7% financials, 18% energy and 14% industrials, compared to 32.4% technology, 12.4% financials and 11.8% healthcare for the S&P 500.

Sure, Canadian banks are a big part of the economy, but what about the fact that they make up nearly a third of the index? If the financial sector wasn’t doing well, the index would never outperform. And what about energy? Everyone seems to hate carbon emitters, but they make up 18% of the index compared to just 3.6% in the S&P 500. I think we can all agree that technology is likely to grow faster than banking and energy over the next decade, so why can’t the S&P/TSX Composite Index reflect this?

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Multiple Voting Shares

While perceptions in the U.S. are changing somewhat, Canada overwhelmingly sees management exerting control over the company through the use of super-voting shares. For example, Teck Resources Ltd. has Class A shares with 100 votes and Class B shares with one vote (Teck’s structure is set to change in the coming years).

“Generally speaking, global investors cannot and should not tolerate multiple voting share structures. Management with voting power but no control over the shares is meaningless. Management should be fully aligned with shareholders, i.e. one share, one vote. We believe this structure makes the Canadian market less attractive to international investors.”

Canadian companies are too small

Of the 226 companies currently included in the S&P/TSX Composite Index, only eight have a market capitalization over $100 billion. More than half of the index, a total of 125 companies, have a market capitalization under $5 billion. There are four companies with a market capitalization under $1 billion.

The smallest company in the S&P 500 is Invesco, with a market capitalization of $6.8 billion. There are 36 companies larger than Canada’s largest company, Royal Bank of Canada. For international investors, the Canadian market is too small a playing field.

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There are too many contradictions

The S&P/TSX Composite Index is primarily a market cap weighted index. As such, some stocks with billion dollar market caps tend to move in and out of the index periodically. If a stock does well in a given year, it gets added to the index. Then, if it has a bad year, it gets dropped from the index.

Now, this isn’t necessarily unique, but it seems like some of the stocks in the S&P/TSX composite move in and out of the index in a revolving door fashion, which can make it very difficult for investors to keep track of, especially those who are trying to match the index.

Speaking of consistency, the government has reversed policy many times in the past, such as the 2006 Income Trust fiasco and the increase in capital gains tax this year, which comes at a strange time given our sluggish growth. None of this has made our markets more attractive to foreign or domestic investors.

Peter Hodson, CFA, is founder and head of research at 5i Research Inc., an independent investment research network helping individual investors achieve their investment goals. He is also a portfolio manager for the i2i Long/Short US Equity Fund. (5i Research staff do not hold Canadian stocks. The i2i Long/Short Fund may hold non-Canadian stocks mentioned.)

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