Newsletter July 16, 2018

A Brief Overview of the Canadian Economy

This popular article is updated for the 2017 figures. The information on the nature of Canadian imports and exports may be of particular interest given the current festering trade wars. The article concisely answers the following questions:

What is the meaning of Gross Domestic Product (GDP)?
What is the percentage contribution of each major industry to Canada’s GDP?
Who consumes Canada’s GDP?

What products (and services) does Canada export?
What products (and services) does Canada import?
How large are Canada’s imports and exports in relation to GDP?
What is the percentage of Canada’s exports going to various countries?
What is the percentage of Canada’s imports coming from various countries?

Stock Market Performance in 2018 to date

As of Friday, the Toronto Stock Exchange Index is up 2.2% year to date. And the S&P 500 is up 4.7%. These gains exclude dividends which would have added about 1% to the returns.

Stock markets are often volatile but on average they tend to rise over time. It is sometimes thought that the stock market is a zero-sum game; that one investor’s gains must come at the expense of another investor’s loss. That is simply not true. In fact, stock markets rise over time as there is inflow of money from customers of businesses to the owners of stocks (the owners of publicly traded businesses).

Of the companies that I track the best performers so far in 2018 include a trucking company that is up by 28% and a software company that is up 37%. Both of these have also made very strong gains in previous years. Stocks that I thought should do well but which have declined include an auto parts company that is down 23% on tariff-war fears and a company that owns auto dealerships that is down 33% for a variety of reasons.

Canadian Bank Profitability and Other Facts

It’s well known that the Canadian Banks collectively make billions in profits. Actually, tens of billions! Royal Bank of Canada alone made $11 billion dollars in net income in 2017.

For context, it is useful to convert those profits to return on share holder equity. Shareholder equity measures the money that the banks have raised from share holders plus the accumulated profits that have been earned but retained by the banks rather than paid out. Return on equity (ROE) therefore measures the net profits that the banks earn for their shareholders as a percentage of the book value of the share holders’ ownership of the banks.

The ROE of the six largest banks in Canada averaged 15.7% in 2017. This bottom line after tax return on equity of 15.7% is a very attractive return. Going back to 2016, the average return on equity for these six largest banks has ranged from 14.31% (in 2016) to 16.58% (in 2014). The sustained achievement of these high returns on equity is the reason that investors in Canadian banks have done so well over the years.

In 2017, these six large banks charged an average interest rate on loans of 3.09% and paid an average of 0.94% on deposits for a “spread” of 2.14%. After expenses and taxes their average return on assets was only 1.09%. This modest return on assets of 1.09% generated the attractive 15.7% return on share holder equity because the vast majority of the funds loaned out are funded by deposits as opposed to share owner money. That is, banks are highly leveraged. In 2017, these six banks averaged $16.40 in assets for each dollar of share owner equity.

Number of Branches and Automated Banking Machines:

The nine largest banks in Canada had a total of 6,190 branches at the end of 2016. This was down 1.8% compared to the prior year and was virtually unchanged compared to 2012. Due to technology, customer vists to bank branches are declining. The Canadian banks will reduce thier branch counts. Royal Bank indicates that it will cut its branch square footage by 20% over the next five years. There will be fewer branches and the average size of each branch will be smaller.

The eight largest banks in Canada had 18,550 bank machines at the end of 2016.This was down 0.9% compared to the prior year and down 1.2% from 2014 which was the peak. Given the decreasing use of paper cash and ability to deposit cheques using a phone, it seems safe to say that the number of bank machines will continue to decline.

With fewer branches, fewer employees and fewer bank machines, the Canadian banks seem well positioned to continue to make high returns on equity.

Why Gasoline Prices Are Often The Same At Every Gas Station

When people see that gasoline prices rise and fall by exactly the same amount and on the same day across an entire City it is easy to suspect that the various gasoline brands must be colluding. However, this price behavior is actually largely driven by the commodity nature of the product.

For the most part, drivers treat gasoline as a commodity product. Most drivers seem to believe that one brand of gasoline is either identical to or basically the same as another. Many driver do habitually buy the same brand of gasoline. This could be to collect “points” or because of a convenient location. But the vast majority of drivers will purchase other brands if they see a materially lower price or if it simply more convenient on some occasions.

Imagine three gas stations located together on a busy road, say Esso, Petro Canada and Shell. And imagine they are all bright, large modern locations with similar convenience stores and wash rooms. As is always the case in Canada, all three will have their prices prominently displayed on large illuminated signs. If the Esso raises its price by 10 cents, and the other two do not then then it is likely that the Esso will see a large decline in its business. In that case the Esso will likely drop its price back down.

If the wholesale price of gasoline has increased then it is likely that when one station raises its prices the other two will follow. And the same tends to happen when one station lowers its price. Collusion is not necessary for this price behavior to occur.

But those who are convinced that gasoline retailers and/or refiners and/or oil companies in general are colluding to push prices higher can always consider investing in the shares of such companies.

Off Topic – Seatbelts on coach buses:

Okay, this is way off topic but with four of the victims of that horrible Humboldt hockey team bus crash being from St. Albert where I live, I feel compelled to use my newsletter here to urge several things:

  1. If anyone is involved in booking a coach bus, insist of getting one with seat belts if at all possible.
  2. If you are ever on a coach bus that has seat belts , wear your seat belt and encourage anyone you are traveling with to do so as well. Adults in charge of kids should absolutely insist that seatbelts be used.

The Humboldt team bus apparently did not have seat belts. In response to this tragedy, Transport Canada, has just announced that all new highway coach buses starting in the year 2020 will be required to have seatbelts. That is a welcome development but won’t do much good unless people actually use the seatbelts.

It’s been my experience that adults on coach buses including when they are in charge of groups of kids don’t always wear their seat belts or insist that any kids or young adults that they are in charge of do so. In the wake of this tragedy, one good thing that can come out of it is that we all use seatbelts whenever they are provided.