The Canadian Stock Market Suffers a Reality Check

The subprime debt debacle emanating from the United States has caused plenty of trouble for investors both inside and outside of the U.S., including Canadian investors, who have seen the benchmark S&P/TSX Composite Index drop almost 11% (as of publication) since July 19. This may have caused pain for some: Margin debt in Canada hit an all-time high in May, the latest month for which we have data. However, Canadian investors are typically a pretty conservative lot, and most are still sitting pretty, as this decline came only after the market reached an all-time high of 14,625. Indeed, through the end of July, Canadian investors had enjoyed a total annual return of almost 19% in the previous five years, well above the 11.8% return for the U.S. benchmark S&P 500 Index.

While there may be more short-term weakness ahead for the Canadian market, we suspect that the current period of market volatility will be a mere blip when looking back five years from now. Subprime mortgages make up only 5% of the Canadian mortgage market compared with 20% in the United States, so any escalation in subprime defaults in Canada will have a fairly limited impact on the Canadian economy.

This past week's meltdown in the Canadian asset-backed commercial paper market was prompted by the inability of leading sponsor Coventree Inc. to place new commercial paper to pay off maturing debt, and then exacerbated by the reluctance of Canadian financial institutions to provide emergency financing to Coventree. This will undoubtedly sort itself out--Caisse de depot and National Bank of Canada are already leading the effort--and likely with little significant or lasting impact, given the solid balance sheets of Canada's households, corporations, and financial institutions.

A Top-Down Look at Canada's Market
As Canada's minister of finance stressed to market participants this past week, the fundamentals of the Canadian economy are quite strong. At 6%, Canadian unemployment is at a 30-year low. At slightly more than 2%, inflation is not a concern. Housing prices in Canada's 25 largest markets gained 13% in July, compared with a year ago, while unit sales increased 10%. Unlike the U.S., Canada's government finances are in very good shape, with federal budget surpluses every year since 1998 and net debt to GDP declining 12 straight quarters (to the lowest of the G7 countries).

Canada is in this great economic situation in part because of a still-booming market for commodities. While mining and oil and gas extraction combined represent less than 4% of Canadian gross domestic product, these industries contribute about 35% of Canadian exports. Rising demand and prices in recent years--largely caused by China's emergence--have fueled growth in Canadian exports. This, in turn, has boosted other industries in Canada, especially financial services and construction, which combined represent more than a quarter of Canada's GDP.

Growth in exports to countries other than the U.S. has been particularly strong, up 31% since May 2006. This lowers Canada's dependence on the U.S. for trading and more than offsets softness in Canada's manufacturing sector, which accounts for more than 15% of GDP. The manufacturing sector has suffered from increased competition from abroad and a 35% appreciation in the Canadian dollar against the U.S. dollar since its all-time low in early 2002. However, this appreciation in the loonie has allowed Canadians to buy even more imports with their export dollars, pushing domestic consumption higher.

While the higher loonie will likely continue to weigh on manufacturing, Canada's economy should continue to perform well as long as demand for its natural resources exports remains firm. With China focused on modernizing its infrastructure while sitting on more than $1.2 trillion (U.S.) in foreign exchange reserves, we suspect that this will be the case for several years. Global energy firms are finding it increasingly difficult to maintain their energy reserves, which only increases our confidence that demand and pricing for Canada's natural resources will remain firm in the future.

Are Canadian Stocks a Bargain?
Up until the recent correction in stock prices, we had thought the Canadian market had priced in all of these positives (and then some). We found it difficult to find bargains, and as recently as three weeks ago, we reckoned that less than 3% of the stocks in Morningstar's Canadian stock coverage universe were good values. Even with the recent correction in prices, we still don't think the Canadian market as a whole is a screaming bargain. About 70% of the Canadian stocks we cover are fairly valued or overvalued according to the Morningstar Rating for stocks, which is based upon discounted cash-flow valuation of every stock we cover and requires an adequate margin of safety before recommending a stock.

At Morningstar, though, we focus on bottom-up stock research, so we're less concerned with the valuation of the market than we are the valuation of the stocks in the market. In the past week, we have seen the number of 5-star stocks in our coverage universe expand to 10%. For each of the six 5-star stocks listed below, the market has become too fearful--which is exactly when investors should become greedy. The risk associated with each of these investments ranges from below average to above average, providing investors with opportunities across the risk spectrum to profit from the recent drop in Canadian stock prices. To learn more about these stocks, visit us at Morningstar.com.

5-Star Canadian Stocks
	U.S. Ticker	Canadian Ticker	Recent Price
Angiotech Pharmaceuticals		ANP	$5.58
Fairfax Financial Holdings	(FFH)	FFH	$180.00
Compton Petroleum		CMT	$9.69
Nexen		NXY	$26.19
Talisman Energy		TLM	$16.37
Enbridge	(ENB)	ENB	$32.38