When it comes to investing in Canadian stocks, two sectors overwhelmingly dominate the market landscape: financials and energy. The former, comprised of banks and insurance companies, has long been the backbone of Canada’s economic strength.
But it’s the latter – epitomized by our extensive network of pipelines, oil and gas companies – that adds a certain dynamism to Canada’s stock market. This concentration in energy isn’t merely an historical accident; it’s a natural consequence of Canada’s abundant natural resource endowments, ranging from the oil sands of Alberta to the natural gas reserves of British Columbia.
If you had an overweight position in Canadian stocks during the high-inflation period of 2022, chances are you navigated those choppy waters with a relatively steady hand, courtesy of the robust energy sector. As inflationary pressures led to higher commodity prices, Canadian energy companies saw an uptick in profitability, translating into stronger stock performance compared to other sectors.
Today, I’ll unpack two compelling reasons why Canadian energy stocks should occupy a distinguished place in your investment portfolio. I’ll also recommend a way to gain exposure to this high-performing sector via an exchange-traded fund (ETF).
As if a challenging 2022 wasn’t enough, Canadian consumers appear to be in for more of the same this year. Recent data from Statistics Canada revealed that the inflation rate again surged to an annual increase of 4%, with gasoline prices being a significant contributor.
These pump prices jumped by 4.6% in just August and are up by 0.8% year over year. Given that energy prices often have a ripple effect, influencing everything from production costs to the transportation of goods, the high inflation environment seems poised to stick around.
The silver lining is that energy companies typically benefit from higher commodity prices, which is often the case during periods of high inflation. As energy prices rise, these companies usually experience an uptick in profitability, allowing for potentially higher dividends and capital gains.
As a result, your investment in energy stocks could increase in value, offsetting the eroding impact of inflation on your purchasing power. Given the macroeconomic conditions that seem to favour sustained inflation, having an overweight position in Canadian energy stocks could act as a financial cushion, partially shielding your portfolio from inflationary woes.
Valuations are a cornerstone in the art of stock picking, providing investors with a measure to evaluate how cheap or expensive a particular stock – or sector – is relative to its intrinsic value or performance metrics.
Various ratios, such as the price-to-book (P/B) ratio and price-to-earnings (P/E) ratio, serve as barometers for these valuations, allowing investors to make informed decisions and, ideally, realize better returns.
Let’s dig into some current numbers. The S&P/TSX Capped Energy Index sports a P/B ratio of 1.8 and a P/E ratio of 6.9%. In contrast, the broader S&P/TSX 60 Index has a P/B of 2 and a P/E of 13.3. This suggests that Canadian energy stocks are currently undervalued relative to the general market.
In other words, you’re getting more ‘bang for your buck’ when investing in the energy sector, paying less for each dollar of book value and earnings. This situation presents an attractive opportunity for investors looking for value plays that could offer substantial upside potential.
My ETF of choice
I really like the BMO Equal Weight Oil & Gas Index ETF (TSX:ZEO). This ETF holds 10 notable Canadian energy stocks in an equally weighted fashion. This means that the ETF’s performance is not dominated by one or two companies, unlike a market-cap weighted sector ETF.
The other reason I like ZEO is because of its dividend potential. As of September 15, investors are looking at a 4.51% annualized yield. As a bonus, this ETF pays monthly dividends, giving you more frequent income compared to individual energy stocks.