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It’s hardly surprising that Canada’s equity market is performing as if the end of the COVID-19 environment is close at hand.

Spurred by growing consumer confidence and strengthening economic data, including higher purchasing managers’ indexes, investors have had good reasons to begin rotating out of high-flying technology equities and long-term bonds, and into cyclical stocks over the past few months. One might also reasonably think, given this great rotation, that Canada’s industrial sector, which offers an eclectic mix of deep cyclical names, defensive yield stocks and higher-beta companies, would be enjoying a new-found favour among investors as well.

But it hasn’t. While industrial companies look well-positioned to capture incremental capital flow over the coming months, the S&P/TSX Industrials Index has returned roughly 8-per-cent year to date, according to Bloomberg data, and underperformed the S&P/TSX Composite Index, which is up closer to 10 per cent.

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Instead, investor attention has been largely focused on energy and financial companies – sectors that also have high correlation to improving economic conditions, but trade at cheaper valuation multiples as sector earnings have already started to turn materially higher. However, when we look at historical data sets that correlate well to industrial performance and earnings estimates, it appears that a turn in sector expectations – and earnings – could be right around the corner. That might make Canadian industrials an overlooked cyclical play in an increasingly crowded trade.

On the surface, the factors contributing to industrials’ underperformance are easy to see. Forward earnings-per-share estimates for the group, relative to forward earnings per share for the TSX composite, have been trending lower in recent months. That has occurred even as other parts of the Canadian equity universe, led by energy companies, have seen earnings expectations rise at a much faster rate.

Why the disparity? One reason lies in the composition of the industrials group, where railroads have a very large weighting. For them, poor weather conditions in the first quarter have resulted in negative revisions to earnings estimates – a short-term condition that has dragged down expectations for the entire sector.

That could be set to change soon. Leading economic indicators and U.S. capital expenditure intentions – two of the key forward-looking data sets for industrial earnings expectations and price performance relative to the TSX composite – have bottomed in the past six months, suggesting an upturn is coming. As well, 65 per cent of the group’s revenue comes from outside Canada, and the anticipated surge in global growth should strengthen the outlook for industrials. Taking into account all those factors, earnings estimates for the sector could grow materially higher in 2021 than the broader market.

So where can investors look for ideas within the sector? Let’s explore some options.

The railroad companies are the largest weights, and they offer stable earnings, free-cash-flow growth and the potential of further upside despite share prices that are now near historic highs. Of note, the recently announced merger of Canadian Pacific Railway Ltd. and Kansas City Southern will give investors the opportunity to own a unique company, one that has exposure up and down North America as a single-line operator. The appeal among customers and investors for this kind of asset should be high.

Outside of the rails, waste companies also look attractive, as economic reopening spurs incremental demand for their services. Revenue and earnings expectations are expected to increase significantly in 2021.

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The industrial subindex also offers a great mix of thematic names that are often overlooked in Canada. Among them are ATS Automation Tooling Systems Inc. and Boyd Group Services Inc., which are market leaders in automation systems and automotive repair, respectively. They both should continue to vastly outgrow other options within Canada over the coming years.

Finally, perhaps the ultimate recovery play is Air Canada. Clearly, the national air carrier has faced an extremely challenging operating environment brought on by COVID-19 and domestic and global air travel restrictions. However, as mass vaccinations continue to ramp up globally, travel restrictions should ease in the months ahead, and Air Canada could be in a strong position to capture consumer demand for vacation and business travel.

Opportunities such as these suggest that while Canada’s industrial stocks have lagged the broader index even as investors undertake a cyclical rotation, their time in the sun might be at hand. Yes, valuations have been elevated, but that is largely owing to temporary short-term factors weighing on revenue. If history provides any guidance, then we can expect a sharp rebound in earnings expectations as the year unfolds. That could make today’s high prices look like relative bargains, once more investors start to take notice.

Mike Archibald is a vice-president and portfolio manager at AGF Investments Inc.

AGF owns stock in Canadian Pacific Railway Ltd., Kansas City Southern, ATS Automation Tooling Systems Inc., Boyd Group Services Inc. and Air Canada.

The views expressed are those of the author and do not necessarily represent the opinions of AGF, its subsidiaries or any of its affiliated companies, funds or investment strategies. References to specific securities should not be considered as investment advice or recommendations.

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