Canadian equity fund managers are generally tilting their portfolios toward sectors that tend to perform better as the economy improves. But, mindful of slower growth, some money managers are also keeping in touch with traditional defensive industries.

Martin Ferguson, director and portfolio man-ager with Mawer Investment Management Ltd. in Calgary, says he expects the economy to continue to recover but growth will be “substandard and subdued” — a common sentiment for many money managers looking ahead.

True, the Canadian and U.S. economies emerged from their recessions in the second half of 2009, and the S&P/TSX composite index has gained by more than 60% since its low in March 2009. But stock markets historically tend to lead economic data by six to nine months, and corporate earnings have not yet caught up to stock prices in many cases.

A lot of companies look expensive by the price/earnings measure, says Kim Shannon, president and owner of Toronto-based Sionna Investment Managers Inc. and a value investor: “We could have another retesting of lows or we could continue to rally, and it’s totally unforecastable.”

“We’re watching, very closely, the revenue line to see if companies actually grow their earnings,” says Stephen Carlin, senior vice president and head of equities at Toronto-based AEGON Capital Management Inc., a subsidiary of Netherlands-based AEGON NV.

For equities to continue moving upward, the U.S. consumer needs to increase spending and China needs to continue growing at a strong pace. The risk in the U.S. is that consumers will focus too much on paying down debt and will not have enough money left over to push their retail purchases higher. Continued high unemployment may also be a drag on consumption.

Still, most money managers are betting there will be moderate growth in U.S. consumer spending. Canadian companies that export to that market should see increased demand, says Charles Jenkins, senior vice president of Canadian equities with Standard Life Investments Inc. in Montreal: “My view is that there is still demand from consumers. But it’s a muted recovery in North America, and the rest of the world keeps on going.”

China has had a quick and strong recovery, partly as a result of great monetary and fiscal stimulus. The risk in that situation is that the stimulus will have to be reversed at some point to ensure that inflation doesn’t get out of control. If that’s done too soon or too quickly, China’s economy could slow significantly.

Indeed, keeping a close eye on China will be crucial; it is China’s demand for natural resources that gives Canadian markets a bounce, notes Martin Hubbes, executive vice president and chief investment officer with Toronto-based AGF Management Ltd. and manager of AGF Canadian Stock Fund. “Even though, long term, I’m quite optimistic [about resources], I think we’re in quite precarious times. If China stops, I wonder if our story stops, too.”

This inflation risk is not confined to China. Many governments have huge fiscal stimulus programs, and interest rates are at historical lows. If central banks start to worry about the speed of growth and raise interest rates too quickly, global economies could be pushed back into recession.

For now, most money managers are assuming that none of these risks will materialize and are favouring sectors they expect will grow as the recovery progresses. These include consumer discretionary, industrials and technology. But they are also keeping a foot in more traditionally defensive investing areas, such as consumer staples.

Here’s a look at the companies favoured by money managers in the non-financial services and non-resources sectors. (For the outlook on resources and financials, see pages B6 and B8, respectively.)

> Consumer Discretionary. Clas-sic plays in a stronger economy, Canadian stalwarts Astral Media Inc. and Corus Enter-tain-ment Inc., both of Toronto, should benefit from better advertising revenue flowing from all media. “We own [shares in] them for a mid- to late ad recovery in 2010,” Carlin says.

Tim Hortons Inc. offers a defensive play for a soft economy, notes Hubbes. His prediction is for recovery, but at a relatively slow pace in 2010. Coffee, he notes, is “an affordable expense.”

The darling in the sector is Thomson Reuters Corp. That company is mostly a play on the anticipated revival of the financial services industry, because its financial data gathering software competes with New York-based Bloomberg LP, the long-entrenched financial data company. “The financial services sector has downsized too much,” says Jenkins. “They’re going to rehire in New York on Wall Street.”

@page_break@Thomson Reuters also owns legal, scientific and educational units that provide recurring revenue as well as a defensive cushion, given economic uncertainties. “It’s a fantastic secular growth opportunity,” adds Tim Caulfield, vice president of Canadian equities with Calgary-basedBissett Investment Management Ltd.

Jenkins also points to Rona Inc. and Canadian Tire Corp. Both could outperform if the economy exceeds expectations. At the same time, these companies continue to feel the benefits of the federal government’s stimulus package, which grants tax credits to consumers who are making home improvements.

> Consumer Staples. Money managers invested in this sector tend to be of two minds when it comes to the economic recovery. On the one hand, Hubbes likes grocery-store chain Metro Inc. — not just as a long-term hold but also because he prefers to diversify away from financials and resources for now.

On the other hand, Carlin is watching Loblaw Cos. Ltd. as a growth play; he wonders if it will continue to improve its recent positive performance.

The sector’s heavyweight, Shoppers Drug Mart Corp., is still in a dispute with the Ontario government. The province wants to pay Shoppers less to dispense drugs, a major source of revenue. It’s not clear if the issue will be resolved in 2010. As a result, money managers are reluctant to weigh in heavily here.

> Technology. Research In Motion Ltd., maker of the BlackBerry smartphone, still dominates this sector. Money managers, however, have mixed feelings about this company, wondering whether its strategy to sell cheaper handsets aimed at the broader public will continue to surprise on the upside or eventually eat into margins.

The contrarian view, held by Carlin, is that even small penetration into the huge and growing base of retail clients can only boost RIM’s earnings.

> Industrials. Another cyclical sector that should perform well as the global economy moves out of the doldrums is industrials, and money managers tend to overweight it.

That is partly because this sector is a derivative play on commodities — as emerging markets grow, Jenkins explains, the companies that service and supply commodities producers will be more likely to profit. Accordingly, Canadian National Rail Co. is the top weighting in this sector for several money managers. CNR ships a lot of commodities, and money managers also like the company’s management team.

Using the same logic, Jenkins holds Finning International Inc., a supplier of equipment to oilsands players.

SNC-Lavalin Group Inc., similarly, is a global leader in mining engineering. “The stock has already performed well,” Carlin says, “but we’re not concerned because SNC has proven for more than a decade now that it provides excellent performance to investors.”

Hubbes, who has only a modest overweighting in this sector, points to Toromont Industries Ltd., which owns Caterpillar dealerships in central Ontario, along with a second line of business in compression equipment. “As infrastructure for natural gas builds out,” Hubbes says, “you need compression.”

> Telecommunications. Investors are pondering the long-term effects of increased competition in this sector, which is normally considered to be defensive.

“I don’t think telecom stocks will do that much in the next six months to a year,” says Hubbes, who adds that valuations are well off their highs. “The market is anticipating some price erosion. It’s now a question of trying to understand the degree.”

It is too early to tell with any certainty, he adds, but new entrants, such as Globalive Wireless Management Corp., should not affect the high end of the market for data and smartphone services for BCE Inc. and Rogers Com-munications Inc., which he prefers.

Jenkins says industry competition is enough to keep him underweighted in this sector, but Caulfield, who is slightly overweighted, sees the uncertainty as an entry point for long-term investors. IE