If you look at our regular portfolios, you'll notice that they don't contain a Canadian stock ETF. This might surprise you, given that many advisors will recommend holding some Canadian stocks.
Over the next 2 articles, I'll explain why I chose to omit Canadian stocks in regular portfolios. In this article, I'll talk about the risks that I see that are specific to the Canadian market.
Resource Sector
The Canadian stock market is a heavily concentrated in resource sectors, namely mining and oil & gas. As of this writing, the energy companies take up 28% of Canadian stocks invested in the ETF. Another 12% are invested in mining companies. Together, resource companies take up 40% of Canadian stocks. This compares with just 14% for the U.S. stock market.
I don't think it's healthy to have such a heavy concentration in resources. That's because resource companies are risky.
History has shown that resource prices can be quite volatile. In 2008, from peak to trough, oil prices went from $140 barrel to roughly $40. Oil prices have remained fairly stable since then, but the possibility of such huge moves still remain. Copper prices sea-sawed from $1.5 to $4 and back a couple of times since 2004.
But as volatile as resource prices are, profit margins of resource companies are even more volatile. While resource companies receive sales in direct proportion to resource prices, their costs remain pretty rigid. For example, a copper company that can produce copper at $3/lb will enjoy a very healthy 25% profit margin when copper prices are at $4, but will lose a big $1/lb when copper prices hit $2.
As a result, resource companies have the potential to both win big and lose big. Therefore, the heavy concentration in the resource sector could give conservative investors pause.
Financial Sector
The Canadian stock market is also heavily concentrated in financial companies, namely banks and insurance companies. The financial sector takes up roughly 37% of Canadian stocks.
Many people think that Canadian banks are very safe. After all, it weathered the storms of the last financial crisis very well. However, I also find reasons to remain cautious on this sector as well.
Financial crisis are often caused because people take out too much debt relative to how much they can pay. For example, the last financial crisis happened because too many people took out mortgages to buy houses. Once interest rates went up and housing prices went down, borrowers started defaulting on their mortgages, which incurred losses for the banks. Before you knew it, the banks lost more than they could handle on their own.
Since over-indebtedness causes financial crisis, it's reasonable to think that bank stocks become more risky as its borrowers become more indebted.
Over the past few years, Canadians have been becoming more indebted. The average Canadian now has a debt to income ratio of about 164%. By comparison, the average American carried a debt to income ratio of around 130% before the crisis, and has started trending down ever since.
Now, I'm not saying that Canada will definitely have a financial crisis. But I believe that the risks are there, and conservative investors should keep that in mind.
The Rest
The resource and financial sectors take up a combined 77% of Canadian stocks. The rest consist of industrials, consumer sectors, telecommunication and the like. While some of these companies are definitely stalwarts that carry little risk (the telcos come to mind), I'm not so sanguine about some of the other sectors.
Take industrials, for example. Traditionally, U.S. companies based many of their manufacturing plants in Canada. They did so primarily for one reason: cost.
Not only did Canadian workers often have lower base salaries compared to their U.S. counterparts, but Canadian workers didn't need the expensive healthcare insurance that many U.S. workers demanded. This, combined with the close geographic proximity, made Canada a great place to set up manufacturing plants.
However, with the rise of the resource sector in Canada, the cost advantage began to disappear.
In order to buy Canadian resources, the U.S. and the rest of the world needed Canadian dollars. This drove up demand for the loonie, which made it expensive. As a result, U.S. companies are now finding that having Canadian manufacturing plants don't make much economic sense any more, so they've been closing up shop.
On the other hand, Canadian manufacturers and consumer companies are finding that their products cost more in the eyes of the U.S. consumer, so they have a harder time selling their products. If Canada becomes more dependent on the resource sector, its industrial and consumer sectors will suffer.
Conclusion
When I look at the risks involved in each of the sectors, I can't escape the conclusion - Canadian stocks today look risky to me. This is part of the reason why I've made the decision to remove Canadian stocks from MoneyGeek's regular portfolios, despite the fact that many other advisors would recommend holding Canadian stocks.
However, even risky stocks are worth investing in if potential returns are high enough. For example, imagine a bet where you could lose half your money 50% of the time. This is undoubtedly a risky bet. However, what if that bet returned 10 times your money the other 50% of the time? Would you take that bet?
I would.
Therefore, when it comes to investing, we shouldn't only look at the risks, but the potential returns as well. In the next members only article, I will look at the potential returns from investing in Canadian stocks.