The market has been on a rollercoaster ride for weeks, with some saying things could get worse before they get better. Last week, the Morningstar Canada Index and the S&P TSX Composite Index ended the week down 4% — less than the S&P 500, which was down over 5% for the week.
This latest downturn is being driven by rising interest rates and rampant inflation. The US Federal Reserve hiked the federal funds rate by 0.75% last week for an unprecedented third straight session, raising the funds’ target range to 3.0% to 3.25%. At the same time, Fed officials said they expect more rate hikes that could take this key short-term rate to 4.6% next year.
“We have to get inflation behind us. I wish there was a painless way to do this, but there isn’t,” said Fed Chair Jerome Powell. That pain, he said, includes higher interest rates, slower growth and a weaker job market.
And while Powell didn’t say it outright, my colleague Tom Lauricella writes, it’s increasingly expected to involve a recession, not just a so-called soft landing, where the economy is cooling but not contracting. He outlines six takeaways for investors:
- Prices will continue to rise
- A recession is more likely
- Investors need to keep an eye on the earnings prospects
- Uncertainty means volatility
- Forget a “V-shaped” jump
- It pays to stay defensive
Look for volatility, not risk
The doomsday scenario for many is stagflation, a period of high inflation and slow growth not seen since the 1970s. In this environment, it makes sense to remember that risk, not volatility, is the real enemy.
As Christine Benz, Morningstar’s director of personal finance, points out, it’s helpful for investors to create a mental distinction between volatility and risk. Volatility includes changes in the price of a security, portfolio or segment of the market, both upwards (see 2019) and downwards (see 2008). So it’s possible to make an investment with a lot of volatility that has so far only gone in one direction: up.
The most intuitive definition of risk, on the other hand, is the possibility that you won’t be able to meet your financial goals and commitments, or that you’ll have to recalibrate your goals because your investment piggy is falling short. “Through this lens, risk should be the real concern of investors; Volatility, not so much,” explains Benz.
What’s wrong with Canadian stocks?
After last week’s correction, there are still more opportunities for investors. Of the 66 Canadian stocks in our coverage universe, 47 are currently trading below our estimated fair values (FVEs). As has been the case for over a year, the cheapest of these are cannabis, and none have an “economic moat”.
The Morningstar Economic Moat Rating represents a company’s sustainable competitive advantage. A company whose competitive advantage we expect for more than 20 years has a big moat; A company that can hold off its competitors for 10 years has a narrow moat, while a company that either has no advantage or one that we believe will quickly dissipate has no moat.
Today we look at the 10 cheapest Canadian stocks, all of which are trading 35% or more below our fair value estimates. Of these, six are active in the cannabis sector, with the rest spread across various sectors. You have a “narrow” economic moat. Here is the list:
For details on cannabis companies, see our article on the top cannabis stocks. Here’s a look at the other stocks on this list.
Lithium America Stock
Lithium Americas aims to become a low-cost, pure-play lithium producer. The Company currently has no lithium sales volume but is developing three resources that are expected to eventually be in production with the first project expected to be in production by the end of 2022. Cauchari-Olaroz and Pastos Grandes are brine resources located in northwestern Argentina. Thacker Pass is the company’s Nevada sound resource. As EV adoption increases, we expect continued double-digit annual growth in lithium demand. Lithium Americas should benefit as there should be more than enough demand for the company’s three resources to start production and add capacity over time. LAC is considering splitting the company into two businesses geographically. Argentina business would include Cauchari-Olaroz and Pastos Grandes, while US business would include Thacker Pass.
-Morningstar analyst Seth Goldstein
Newcrest Mining shares
Having reviewed our production and cost assumptions, we maintain our fair value estimate of $31 per share for No-Moat Newcrest Mining and it remains one of our best ideas. Newcrest shares are trading at approximately half our estimated fair value. We believe this is due to concerns about a stronger US dollar and rising interest rates, which are potentially negative for gold prices. Physical gold offers no cash flow to its holders, and rising yields make bonds relatively more attractive. However, we view rising interest rates as temporary and see gold prices relatively well supported by the cost curve. We are also more optimistic about a recovery at Cadia and Lihir and believe that the extensive development pipeline including Havieron, Red Chris and Wafi-Golpu in Papua New Guinea is likely to be underestimated. In our view, Newcrest’s main attraction is the low-cost, long-lived Lihir and Cadia mines in Papua New Guinea and New South Wales, respectively. Both mines are likely to produce for decades as resources are converted into reserves. We also believe that production at Lihir will recover and together with the acquisition of Brucejack and the likely development of Havieron, we forecast average annual gold production of approximately 2.4 million ounces through fiscal 2027.
-Morningstar analyst Jon Mills
Canfor stock
We begin coverage of Canfor Corporation with a fair value estimate of $37 per share and a no-moat rating. While the company’s commodity businesses, lumber and pulp, can be immensely profitable during periods of strong demand, margins crumble during periods of weak demand because Canfor’s operations lack structural competitive advantages. Basically, wood is a commodity. Building a moat in a commodity business typically requires a low-cost manufacturing position or a transportation cost advantage — something Canfor, along with its North American peers, fundamentally lacks. We assign a Moat Trend Stable rating to Canfor Corporation as we do not expect the company’s competitive advantages to materially strengthen or weaken over the next five years. We expect competitive dynamics in lumber to remain unchanged as producers are price takers and have no material competitive advantage. While the importance of lumber in housing and other construction projects is unlikely to change, producers have no pricing power and their profitability is tied to lumber prices.
-Morningstar analyst Spencer Lieberman
Shopify stock
Shopify strives to be a one-stop shop for small retail businesses, particularly those that are primarily, exclusively, or first e-commerce. The company offers a simple yet robust e-commerce platform with a variety of associated add-on features, including the Shopify Fulfillment Network or SFN, ultimately converging into a turnkey solution for small to medium businesses or SMBs. Shopify’s meteoric rise since its IPO in 2015 underscores an emerging software niche that’s growing rapidly and is a winning solution. We believe the company has carved a fine line as switching critical e-commerce platforms comes at a financial and operational cost for an already resource-constrained SMB. We forecast robust revenue growth over the next few years, which will benefit from e-commerce trends.
-Morningstar analyst Dan Romanoff
