Valeant Pharmaceuticals International Inc. became the heavyweight champion of the Canadian stock market on Thursday.
For its shareholders, Valeant's meteoric rise to most-valuable-company status is not necessarily good news.
Over the past two decades, a couple of other fast-growing enterprises also burst past the big banks to take bragging rights as the biggest stock in the Toronto index. Nortel and Research In Motion (now BlackBerry) both hit the skids shortly thereafter.
Of course, Valeant's future may turn out to be brighter than those of the previous upstarts. It reported strong earnings before markets opened on Thursday and surged 5.8 per cent to hit $112.7-billion in market capitalization, putting it slightly ahead of the previous front runner, Royal Bank of Canada, which finished the day with a market cap of $108.6-billion.
But the ascent of the aggressively managed drug company comes at an awkward juncture for the index. As Valeant, a controversial stock, takes over the top position in the S&P/TSX composite, other sectors of the market indicator are wrestling with problems. The result is a market benchmark that is growing treacherous, even for play-it-safe index huggers.
"It's an index that people should use with great caution," said Jim Giles, chief investment officer at Foresters, a Toronto-based fraternal benefits organization with more than $25-billion in assets under management. "It's definitely not the only equity investment you should own."
Mr. Giles expects the index's mediocre performance of the past couple of years to continue, as its lack of diversification weighs on results.
The composite index rests on three main pillars: the financial sector, the mining industry and the oil patch. The trio account for roughly two-thirds of the index's market capitalization. The financial sector by itself makes up a whopping 35 per cent of the index's market cap.
In comparison with its global counterparts, the Toronto benchmark is ludicrously unbalanced. The S&P 500, the most widely followed index in the United States, has no single sector accounting for more than 20 per cent of its value.
Another worrisome sign of the Toronto index's top-heavy structure is the enormous weight it puts on a handful of big stocks, mainly banks. The top 10 stocks in the S&P/TSX composite make up more than 35 per cent of the benchmark's market cap. In contrast, the 10 largest companies in the S&P 500 account for only about 17 per cent of that index's value.
The Canadian benchmark's emphasis on a handful of sectors and a tiny cluster of big companies makes it vulnerable to economic gusts. An investment in the S&P/TSX composite is really a bet on only two factors: the global interest rate picture and the outlook for inflationary growth, according to Adam Butler, a vice-president and portfolio manager at Dundee Goodman Private Wealth in Toronto.
In a world where rates are falling and inflationary growth is strong, Canada's banks and commodity producers tend to do well. "But if neither of those factors is working in your favour, you don't have many places to run in the Canadian market," Mr. Butler said. "It's a very concentrated bet on essentially two things."
Right now, with the U.S. Federal Reserve poised to raise rates against a backdrop of slow global growth and subdued inflation, the world is not smiling on Canadian stocks.
Canadian miners are mired in tough times as metal prices swoon, while the collapse in petroleum prices has hammered the energy sector. Canadian banks face their own hurdles to growth, most notably a frothy housing market and heavily indebted consumers.
Bank of Canada Governor Stephen Poloz is pinning his hopes for economic growth on a rebound in manufacturing exports, but that brings up yet another issue with the S&P/TSX composite: It's not really representative of Canada's economy.
The benchmark's obsession with the financial sector and its relative disregard of industrial and consumer stocks would suggest to a naive observer that Canada is a nation of bankers, with only a tiny smattering of factory workers and sales clerks.
In fact, the opposite is true. The financial sector may loom more than twice as large in the index as industrial and consumer discretionary offerings put together, but in the real world it's factories and retailers that rule. They are responsible for more than double the economic production of the financial sector.
Our branch plant economy is primarily to blame for the discrepancy between the stock market index and the real economy. Increased auto production at GM or Ford plants isn't reflected in the Canadian index, because neither company is listed in Canada. The same holds true for many other foreign enterprises with big Canadian presences.
As a result, even if Mr. Poloz gets his wish for an export-led recovery, the index may not show it, because the businesses doing the exporting will be foreign companies that operate in Canada but aren't listed here.
Valeant is one of the few stocks to lean in the opposite direction: It's a Canadian-listed company with largely foreign operations.
While officially headquartered in Montreal, the company's senior management is based in New Jersey. The vast bulk of its sales and production take place outside of Canada.
Yet it's this distinctly un-Canadian business that has been by far the biggest single positive influence on the S&P/TSX composite index in recent months and now accounts for roughly 6 per cent of the benchmark's value. While many domestic sectors have weakened, Valeant stock has nearly doubled in value since the beginning of the year.
Skeptics, such as Mr. Giles, question the company's bottomless appetite for acquisitions and soaring debt levels, but for now those who are invested in funds that track the S&P/TSX composite can be thankful it's there.
Ian McGugan