Which Canadian Manufacturers Are Poised to Outperform?

In recent months, we've written about the challenges facing Canada's manufacturing sector, particularly among exporters. One of the reasons we're focused on this area is because the Bank of Canada believes a rebound in exports will help the country's economy shift away from its dependence on debt-burdened consumers.

But Canada's export-oriented manufacturers were decimated during the downturn, as well as, until recently, by the strong Canadian dollar. Indeed, the country's manufacturing shipments are still 10 percent below their pre-Global Financial Crisis levels. While a high exchange rate helped enhance returns for our Canadian Edge Portfolios, it was having a deleterious effect on exporters competing in an increasingly global marketplace.

The loonie's persistent weakness during much of the 1980s and 1990s actually helped insulate the country's manufacturers from the sort of deindustrialization that was underway throughout the developed world. In fact, in a recent research report, economists with CIBC World Markets observed that during the currency's long slide from USD0.88 in late 1991 to USD0.63 in early 2002, this sector's share of gross domestic product (GDP) actually increased.

But as the loonie climbed above parity with the US dollar over the past decade, manufacturing's share of GDP declined by four percentage points, to 12 percent. By comparison, US manufacturers experienced a similar erosion during the 1970s and 1980s, with their share of GDP relatively stable since then, at around 13 percent.

Meanwhile, during the past decade, the number of Canadian manufacturing firms fell by 20 percent, even as the number of companies in other sectors of the country's economy rose by 10 percent. In particular, the number of larger firms, defined as companies with 500 or more employees, declined the most, by more than 30 percent from 2006 through 2012. Bigger companies tend to ! be more export-oriented, so the relatively high exchange rate hit them the hardest. By contrast, the number of firms with fewer than 50 employees dropped by roughly 12 percent over that same period.

As we've noted in previous articles, one of the ways in which Canadian manufacturers have lagged their peers in other first-world countries has been in terms of productivity, in part because of lower investment in machinery and equipment. But CIBC says that output per worker has climbed by more than 9 percent since 2009, which is double the pace of the economy's productivity as a whole.

In this leaner and meaner business environment, CIBC looked to see which areas of the manufacturing sector have adapted best to these macro factors and are, therefore, poised to outperform. Among their criteria were industries that have experienced productivity growth since the downturn, while operating in markets where foreign competitors face a disadvantage due to the weaker exchange rate.

So which subsector is tops? According to CIBC's ranking, it's the wood products industry, which has seen strong growth in productivity during the recovery and boasts a nearly 50 percent export penetration of the US market. The US absorbs about three-quarters of Canada's exports, so Canadian manufacturers remain very much dependent on cross-border demand. The primary metals, machinery, and aerospace industries also garnered top rankings.

Interestingly, the relative fortune of Canada's forestry products industry has also caught the attention of bond-rating agency Moody's Investors Service. The credit rater notes that the Canadian dollar's decline has been a boon for the industry because most of its products are priced in US dollars. The loonie currently trades near USD0.9063, down about 14.5 percent from this cycle's high in mid-2011.

Of course, certain currency-related expenses will also partially weigh on the industry's performance, including higher prices for fuel, which is priced in US d! ollars, a! s well as financing.

Within the forestry space, Moody's highlights pulp and wood products companies as being the biggest potential winners, with dollar-denominated expenses for these firms limited to chemicals used during the pulping process as well as freight fuel.

For pulp manufacturers, the weak exchange rate means these companies now occupy the low end of the global production cost-curve, and the higher margins that result afford greater operational flexibility. Meanwhile the makers of wood products, including lumber, plywood and other materials, not only benefit from substantial exposure to the US market, but their currency advantage means they'll also face less competition from US exporters on the domestic front.

Canadian Edge subscribers get to read the full update, which lists companies in our coverage universe with direct exposure to these trends, including a firm whose shares currently yield 6.3 percent.