Although Canadian equity markets have regained some ground lost after the past summer’s turbulence, which was brought on by the U.S. subprime mortgage debacle, there are still concerns about the weakening U.S. economy and its potentially negative effect on other countries.

Indeed, some managers of Canadian equity funds argue it’s time to change allocations and shift away from stocks that have a heavy reliance on the U.S.

The overriding concern appears to be uncertainty about the extent of the losses stemming from the U.S. subprime mortgage market. “You want to see two things happen,” says John Smolinski, manager of TD Canadian Equity Fund and managing director of Toronto-based TD Asset Management Inc. “One is a policy response from the government. [The other] is a move by the Federal Reserve Board to lower interest rates and add more liquidity.”

The Fed has proposed phasing in the resetting of about two million subprime mortgages, thus helping to stabilize the housing market. And the Fed has made three interest rate cuts since September, although the global financial system continues to grapple with an array of credit issues, all of which could take time to be resolved.

Meanwhile, the markets continue to deal with the U.S. economic slowdown. “Will it be a soft landing, or a recession?” asks Smolinski. “And what are the implications for the global economy?”

In his view, if the U.S. slips into a recession, it will be short and relatively modest: “The U.S. might just skate through.” The global economy may slow, too, he adds, but the U.S. slowdown should not materially affect the record global GDP growth of the past five years.

Smolinski’s response to a slowing U.S. economy is to minimize exposure to Canadian industrial firms reliant on revenue from the U.S. Conversely, he is also increasing the exposure to commodity-oriented plays that are benefiting from global growth, particularly in Asia.

Slightly more than half of the TD fund is invested in resources stocks, with 31.5% in energy stocks and 20.2% in base metals and minerals. At the same time, exposure to the banks has been reduced and holdings such as Bank of Montreal have been sold because the sector has been tarnished by the U.S. banking sector, which has been caught in the liquidity crisis. The financials weighting is 19%, down from 29% several months ago. The remainder of the fund is spread across industrials (7%), telecommunications (6%), consumer discretionary (6%), technology (6%) and cash (4.7%).

Using a blend of top-down and bottom-up stock-picking, Smolinski has split the 60-name TD portfolio into three so-called “buckets”: dividend-paying stocks, high-quality commodity plays and well-managed growth companies. Holdings in the first bucket include Royal Bank of Canada and TD Bank Financial Group.

A top holding in the second bucket is U.S.-based Freeport-McMoRan Copper & Gold Inc. (part of the 10% foreign content, which is hedged back into Canadian dollars). A global leader in base metals, Freeport acquired competitor Phelps Dodge Inc. this past year and has used its strong cash flow to reduce debt rapidly. Freeport recently boosted its quarterly dividend to US43.75¢ from US31.25¢. “We’re now seeing more cash being returned to shareholders,” says Smolinski.

Acquired last fall, the stock recently traded at US$108 a share. Smolinski has a US$130 a share target within 12 months as he expects strong production growth.

In the third bucket, names include Research in Motion Ltd., a core holding for two years to which Smolinski has recently added. “The beauty of RIM is that it has global relationships with hundreds of carriers,” he says. “And the ‘smartphone’ market, or data-enabled phones, is rapidly expanding.”

RIM, with 11.5-million BlackBerry subscribers globally, is growing at about 15% a quarter. The stock recently traded at $106 a share; Smolinski anticipates another 30% upside in the next 12 months.



There has been a significant rise in market volatility, which is likely to persist, argues Dan Bain, manager of Thornmark Enhanced Equity Fund and president and chief investment officer at Toronto-based Thornmark Asset Management Inc.

One of the causes is the asset-backed commercial paper market, he says, “which has completely seized up. Until it’s resolved, it’s going to create an actual risk that was not identified in the marketplace until the past few months.”

@page_break@Sixty organizations and institutions in Canada have significant ABCP exposure. “We still don’t know the outcome of that exposure,” he adds. Indeed, the ABCP market could have an impact beyond North America because many organizations shifted some of their risk to other regions.

From a macroeconomic perspective, however, Bain is a little more upbeat. He points to continuing double-digit GDP growth in China, for instance, and solid growth in Europe. But North America’s GDP growth will decelerate to around 2%. At the same time, year-over-year corporate earnings growth is expected to slip to 2% in the U.S. and to 5% in Canada in 2008. Bain expects that markets will provide positive returns in 2008, but says it’s also a time to be more conservative.

Because of the risk of a North American recession, Bain is looking for areas in the equity markets that already discount the probability of a recession. He points to two risks on the horizon: one is a rapid unwinding of global fiscal balances (more than US$1 trillion in U.S. Treasury bonds are owned by China, for instance) and the other is that the U.S. consumer-led economy slows more than expected. But Bain does not expect these two risks to materialize; China is in no hurry to dump its U.S. bonds and U.S. employment and income growth remain high.

Erring on the side of caution, the Thornmark fund has raised its cash holdings to 22% from 6% a few months ago. Bain has sold some of the materials and energy names in the fund (which now account for 17% and 24%, respectively), and is looking to add to the 10% weighting in consumer staples, 13% in financials and 3% in utilities.

A value-oriented investor who is opportunistic (he will adopt a growth bias when growth is in favour), Bain uses a “barbell” approach to sector allocation — the 30-name portfolio is split between cyclically sensitive resources stocks and less sensitive consumer staples, financials and utilities.

Among the larger holdings in the latter camp is Liquor Stores Income Fund. It’s the largest private liquor retailer in Canada, with a 19% market share in Alberta and 16% share in British Columbia. The income trust is expected to add 30 more units to its present 190 stores. The income trust yields 6.6%. “It has a good history of growing its distributions,” says Bain, “and we expect further increases in 2008.”

Bought about a year ago, the firm recently traded at $24.40 a share. Bain’s 12-month target is $26. The total return should be 13%, including the 6.6% distribution.

In the cyclical group, names include Altius Minerals Corp., which has stakes in various base-metals projects but is best known for its 37% interest in Newfoundland and Labrador Refining Corp. NLRC is building a refinery near Placentia Bay, Nfld., that will process 300,000 barrels of crude oil a day starting in 2011. Acquired last fall, Altius shares were recently trading at $27.80. Bain’s 12-month target is $40, based on a combination of cash, the market value of existing investments, its interest in NLRC and royalty payments.

“It’s one of the most exciting names in the portfolio,” says Bain, “and it’s not economically sensitive, for the most part.”

But some managers argue that the best course is to remain invested; timing the market is too risky. “We stay fully invested and never make tactical asset-allocation decisions,” says Jason Hornett, a portfolio manager at Calgary-based Bissett & Associates Investment Management Ltd. and co-lead manager of Bissett All Canadian Focus Fund.

“For this fund, it’s a case of sticking to your best ideas,” he says.

Although macroeconomic considerations come into play, Hornett and co-manager Garey Aitken, vice president of Bissett, are largely bottom-up investors who rely on a quantitative screen to select growth stocks. “If a sector is strong, it comes through in the individual securities,” says Hornett. “We don’t set any targets for sector weights. If we are already overweighted in a particular sector and a highly rated security comes up, it doesn’t matter — we will add it to the portfolio.”

Currently, there is an overweighted 32% in materials (vs 18% in the S&P/TSX composite index). There is also an overweighted 10% in consumer staples and 10% in industrials: “They have very strong levels of profitability, relative to the rest of the market, and have very attractive valuations.” The fund also has an underweighted 22% in energy, 7% in financials and 3% in infotech.

A large holding in the 40-name Bissett fund is Potash Corp. of Saskatchewan Inc. A leader in the fertilizer and chemical industry, it supplies nitrogen, phosphate and potash to a world that has a growing need for those products. Acquired in August at about $85 a share, the price was recently $133. “It’s not a cheap stock,” says Hornett. “But we look at it in terms of profitability, its rapidly growing earnings and its 21% return of equity.” He has no stated price target.

Another favourite is Montreal-based Saputo Inc., a provider of milk products and cheeses. “We like the fact it has low earnings volatility, which means you can see quarterly earnings on a more predictable basis,” he says. “Its Canadian operations are a cash cow as it benefits from a heavily regulated industry, and it has a large market share,” he says. Saputo has a 17% ROE.

Its California operations have been more challenging because of high milk prices in that state, but that situation should turn around due to recent regulatory changes.

Bought in March 2007 at $21 a share on a split-adjusted basis, Saputo’s stock was recently trading at $31.70 a share. IE