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What are we looking for?

Value investments in Canada's most attractive sector.

The screen

Investments can be screened for using either a bottom-up, or a top-down methodology. In a bottom-up screen, company-level attributes that are thought to make a stock a good investment are selected, and then an entire universe of stocks are screened on these attributes. In a top-down screen, macroeconomic or sector-wide forecasts are used to identify the most attractive geographical areas or economic sectors. Stocks are then chosen within these favoured countries or sectors, or exposure can be gained passively by simply buying an index fund.

Looking within Canada, we use forward-looking estimates to identify the most attractively valued economic sectors. SmartEstimate is used for all forward estimates. A Thomson Reuters proprietary measure, SmartEstimate has more predictive value than consensus mean estimates as it gives higher weighting to analysts who have historically been more accurate. We focus on the following:

· Forward price-to-earnings is a classic valuation metric, essentially how much an investor needs to pay for $1 of forecasted company earnings;

· Forward enterprise-value-to-earnings-before-interest-and-taxes (EV/EBIT) is the multiple applied to earnings before interest and tax are deducted to determine enterprise value;

· Price-to-free-cash-flow is a ratio similar to P/E, but it measures how much you pay for $1 of cash flow that can be redistributed to shareholders. This is different from earnings, which can include gains that are only accounting profits and not actual cash generated.

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What did we find?

Based on the three metrics considered, the financials sector is the most attractively valued group. It's also worth noting that the Bank of Canada raised interest rates for the first time in almost seven years at its most recent meeting – and still has another three meetings this year. Higher interest rates are beneficial for financial firms; banks can earn more from investing deposits, insurance companies can earn more from premiums. With the tailwind of rising interest rates combined with attractive valuations, Canadian financial stocks have bright prospects.

Continuing the theme of value investing, the insurer with the lowest forward P/E, at 8.1, is Genworth MI Canada (MIC-TSX), and the bank with the lowest P/E – 9.3 – is VersaBank (VB-TSX). Alternatively, iShares offers an ETF, iShares Equal Weight Banc & Lifeco ETF (CEW-TSX), that equally weights Canada's four largest insurers and six largest banks. It has a management fee of 0.55 per cent.

The lowest P/E in the entire Canadian financials sector (4.1) is a company focused on India. Fairfax India Holdings (FIH.U-TSX), a subsidiary of Fairfax Financial Holdings, invests in businesses – both public and private – that benefit from India's growing middle class and the pro-business political environment supported by Prime Minister Narendra Modi. Last week, the company announced the acquisition of a further 10 per cent of Bangalore International Airport, bringing its total stake to 48 per cent, and the stock has returned 70 per cent over the past year alone.

Disclosure: The author owns shares of CEW and FIH.U.

Hugh Smith, MBA, works in the financial and risk unit of Thomson Reuters and specializes in wealth and asset management.

A sector-by-sector look for value

SectorsP/E (SmartEstimate)Fwd EV/ EBIT (SmartEstimate)Price / FCF Per Shr (SmartEstimate)Dividend Yield (SmartEstimate)
Financials13.1010.139.473.47%
Consumer Cyclicals16.9411.1718.021.34%
Telecommunications Services18.7614.2310.453.82%
Consumer Non-Cyclicals19.1313.7717.301.34%
Industrials19.9915.5529.631.66%
Utilities20.5621.71n/a4.04%
Technology22.1515.9022.880.53%
Basic Materials24.1614.4838.691.14%
Energy27.0221.59n/a3.07%
Health care32.1340.078.760.73%
Canada average17.8816.4921.622.62%

Source: Thomson Reuters Eikon