We will work it out, fund managers say

“Recently, we’ve seen a stabilization of growth in China – or, at least, a perception of stabilization,” says Brandon Snow, a principal with Cambridge Advisors, a unit of Toronto-based CI Financial Corp., and co-manager of CI Cambridge Canadian Equity Corporate Class Fund. “On the European side, we’ve seen continued impact from the stronger euro, which has slowed parts of the economy. But with the commitment made by the European Central Bank through the bond-buying program, we’re getting some clarity.

“Meanwhile, growth has been slow in the U.S., but the quality of the growth has been improving over the past 12 months,” says Snow, adding that the U.S. housing and energy sectors are showing definite signs of renewed strength.

But China remains the biggest concern for Snow: “The market has reflected a slowdown in [gross domestic product (GDP)] growth, from around 10% to a 7% range. If there was a more serious hiccup, however, and it caused the Chinese currency to depreciate, that would be a shock to global growth.” Although Snow adds that the odds of the latter scenario coming to fruition are slim, “the chances are not insignificant.”

As for Canada’s prospects, Snow argues our economy will slow. “It will be led by the consumer and housing side,” says Snow, adding that last summer’s new mortgage-financing rules will affect the housing sector. “Overall, it probably won’t be as bad as it could be. But there is always this ‘it depends.’ A question mark hovers over China, and how it may impact our own economy.”

A value-oriented investor, Snow shares portfolio management duties with Alan Radlo, Cambridge’s chief investment officer, and Bob Swanson, a principal with Cambridge. About 62% of the CI fund’s assets under management (AUM) are in Canadian stocks, plus about 25% in the U.S., 6% in international equities, and 7% in cash. From a sectoral standpoint, energy accounts for the largest component, at 18% of AUM, followed by: consumer staples, at 16%; financials, at 15%; industrials, at 11%; and smaller weightings in sectors such as information technology.

One top holding in the 50-name CI fund is Alimentation Couche-Tard Inc., a leading operator of convenience stores in Canada and U.S. that has expanded into Scandinavia and the Baltic states after last year’s acquisition of Norway’s Statoil Fuel & Retail AS. Alimentation Couche-Tard stock trades at roughly $46.50 a share, or about 12 times forward earnings. Snow has no stated target.

There are too many vested interests for the U.S. fiscal cliff to go unresolved, says Stuart Kedwell, vice president and senior portfolio manager with Toronto-based RBC Global Asset Management Inc. (RBC GAM)and co-manager of RBC North American Value Fund. “If they let the [tax and program] cuts expire, it could be a hit to GDP of 3%-4% and erase growth,” says Kedwell, who shares portfolio-management duties with Doug Raymond, senior vice president at RBC GAM. “It’s potentially very serious.”

Kedwell and Raymond also believe there is too much at stake in Europe for its debt crisis to remain unsolved. Says Kedwell: “The countries that have the money understand the cost of a ‘bad’ outcome is greater than a ‘good’ one. At the end of the day, there will be a solution – the least bad choice. The resolve is high enough to keep the euro together.”

Similarly, Kedwell believes that China’s economic deceleration is starting to ebb. “The maximum point of deceleration has passed,” he argues, adding that economic indicators point to a moderation in China’s slowdown.

“None of these issues are clear sailing,” says Kedwell. “But at the same time, there is evidence that each has passed the point of maximum pain.”

On a positive note, Kedwell adds that the U.S. housing sector has turned around, which should boost consumer confidence and counteract some of the impact of the fiscal cliff.

Adds Raymond: “We are more than compensated by the unpriced upside that exists.”

Meanwhile, the portfolio managers argue, stocks are more attractive than they have been for a while. “Even if total earnings for the S&P 500 composite index fall to US$90 and compound at 5%,” says Kedwell, “in 10 years’ time, you’d still a get a 5.5% total return, including the current dividend. That’s three times the return on a 10-year government bond.”

Kedwell and Raymond are value-oriented investors running a portfolio that has about 10% of AUM in cash and the balance split 45%/45% between Canadian and U.S. companies. The high U.S. weighting is attributable to the fact that proportionately more U.S. companies have high returns on invested capital compared with their Canadian peers. One of the top holdings in the 120-name RBC fund is Berkshire Hathaway Inc., the conglomerate headed by investment guru Warren Buffett.

“Buffett is doing his job: Berkshire’s book value has compounded 7%-10% over many years. And if it trades beneath 1.1 times book value, he says he will buy back unlimited stock,” says Kedwell, noting that Berkshire stock is trading at around 1.16 times book value. “But should we decide to wait a year and book value continues to grow, we’ll be in the money.” Berkshire Hathaway stock trades at about US$88 a share. There is no stated target.

Another favourite is Canadian Natural Resources Ltd., a senior oil producer that has had production problems at its Horizon oilsands operation. It is trading at about $27 a share, although Kedwell and Raymond believe the net asset value is $40 a share. Says Raymond: “It’s a classic value idea.”

It’s difficult to predict how the three challenges may unfold, says Daniel Dupont, a portfolio manager in Montreal with Toronto-based Fidelity Investments Canada ULC who oversees Fidelity Canadian Large Cap Fund. “They seem intractable. But, eventually, and slowly, we will work them out,” says Dupont, adding that the issues may remain in the background and then come to the fore periodically.

At the same time, Dupont observes, there’s been a significant change in the Canadian equities market that has pushed up valuations of some sectors to unsustainable levels: investors who are frightened by the uncertainty have been flocking to stocks that are perceived to be less volatile and generate some kind of yield.

“We should be very careful what we invest in,” cautions Dupont, noting that the gap between the stocks with the lowest price/book ratios and those with the highest ratios is approaching levels last seen during the 2001 high-tech/telecom bubble.

“These stocks have bond-like characteristics,” he says. “I’m referring to the real estate investment trusts, pipelines and utilities, which are clearly over-valued. Some investors may not have pushed the analysis far enough, and that puts them at risk in a scenario in which interest rates go up.”

Dupont, a value investor who believes strongly in downside protection, focuses on less expensive companies. Yet he thinks one of the key risks on the horizon is the inevitable rise in interest rates, which, he contends, many investors are ignoring: “I am forced to invest in companies that seem risky but have become so cheap because of the market’s fixation with return and low volatility. These companies may be interesting at this point in the cycle.”

The Fidelity fund is fully invested, with about 19% of AUM in each of consumer discretionary and consumer staples, 16% in information technology, 11% in industrials and smaller amounts in sectors such as financials and energy.

One of the top holdings in the 35-name Fidelity fund is Loblaw Cos. Ltd., a leading supermarket chain. Loblaw has suffered from weak earnings, but has hired a new chief financial officer, Richard Dufresne, who used to work for Quebec-based merchandiser Metro Inc. Says Dupont: “Dufresne understands how to create high returns. Over time, his philosophy and Loblaw will go in the same direction, where maximizing returns on assets invested will become more important.”

Loblaw stock trades at about $33 a share, or 1.5 times book value. There is no stated target.

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