What’s ahead for Canadian stocks

Unemployment will remain steady in both the U.S. and Canada. However, an upswing in U.S. shale natural gas plays could increase the appetite for the services of Canada’s industrial and utilities companies and create more jobs on both sides of the border, says Normand Lamarche, senior portfolio manager with Toronto-based Front Street Capital Inc.

Below is a closer look at what’s ahead in the non-financial and non-resources sectors that fund managers favour, including their recommendations on the sectors’ weightings in client portfolios. (For the outlook for resources and financials, see pages B5 and B6, respectively.)

l consumer staples. Rated “neutral” to “overweight,” consumer staples stocks, such as those of grocers, are a great place to be for those who want stable returns and minimal risk, says Daniel Dupont, portfolio manager of Fidelity Canadian Large-Cap Fund, sponsored by Toronto-based Fidelity Investments Canada ULC. “I prefer to invest in businesses that are predictable,” he says. “And consumer staples, in this respect, have a higher batting average.”

Fehr agrees: “Even when the economy is in the pits, people still need to buy groceries, napkins and paper towels.”

Portfolio managers are particularly bullish on grocers and drugstores, with Metro Inc. and Shoppers Drug Mart Corp. as top choices. Metro is a safer bet than Loblaw Cos. Ltd., says Dupont: “Unbeknownst to most investors, Metro has a significantly better business model than Loblaw, as it doesn’t own its real estate and, therefore, offers a higher return on capital.”

Metro also recently purchased a 55% stake in Epicerie Adonis Inc., a grocery chain specializing in ethnic foods from the Mediterranean and Middle East. It’s a good opportunity, says Charles Jenkins, senior vice president, Canadian equities, with Montreal-based Standard Life Investments Inc.: “[Adonis] has a few locations in Montreal and will build more in Toronto.”

Although Shoppers Drug Market had a tough year in 2010 because of reforms to Ontario’s drug laws, which lowered the cost of generic drugs by up to 50%, the worst is behind the firm, says Jenkins: “For Ontario pharmacists, generic drugs are their bread and butter. However, that hit is now behind [Shoppers Drug Mart] and it is starting to grow again.” The mammoth franchise has focused on consolidating the Ontario market, as well as launching specialized cosmetics boutiques and focusing on economies of scale.

Dollarama Inc. is also among Jenkins’ top picks. It has invested heavily in its payment and inventory systems, which will be rolledout over the next six to 12 months.

> Consumer Discretionary. This sector is rated “overweight” as consumers continue to spend up to 60% of their disposable income on discretionary items, says Fehr, despite research that suggests they are reacting to the drama surrounding Europe and other economies worldwide by cutting back on their spending. Thus, he favours retailer Canadian Tire Corp. Ltd., although he warns that the stock price could bounce around quite a bit in the near term, given the general market volatility.

Fehr points out that Canadian Tire recently acquired Forzani Group Ltd. — which includes stores such as Sport Chek, Sports Mart, Hockey Experts and Nevada Bob’s Golf. This, Fehr says, “adds a whole new demographic to its current segment” because Canadian Tire does not currently offer the wide variety of upscale brands the Forzani boutique stores carry. Over time, this acquisition should increase Canadian Tire’s top-line revenue.

> Telecommunications. This sector is rated “underweight” to “neutral” because competition for both consumer and investor dollars is fierce, says Dupont. As a result, small changes in revenue at Rogers Communications Inc., BCE Inc. and Telus Corp. can make a significant difference to their bottom lines. All three firms had increased their dividends in the past year. In addition, BCE and Telus also have upgraded their network, which, Jenkins says, should provide a boost to their earnings.

Although new entrants, such as Glob-alive Communications Corp.’s WIND Mobile brand and Public Mobile Inc., were thought to be a threat to the sales of the Big Three, the newbies’ networks are still too small, adds Jenkins: “They don’t have deep enough pockets to compete.”

> Information Technology. Although this sector is rated “overweight,” the outlook for Canada’s technology darling, Research In Motion Ltd., is slightly optimistic. Portfolio managers are waiting to see if RIM can turn itself around with its new line of smartphones equipped with the QNX operating system, expected to be released in 2012.

Fehr recently upgraded his recommendations on the firm to “hold” from “sell.”

Jenkins is holding onto the stock, hoping for a turnaround: “If I didn’t already own any, I wouldn’t bet the bank on a turnaround. However, I am willing to sweat it out to see if it turns things around.”

> Health Care. Rated “underweight,” companies in this sector are currently overvalued, says Jenkins, who is waiting for a “better price point” to add to his holdings.

> Utilities. Portfolio managers are negative on this sector, which is rated “underweight.” Dupont points to overleveraging at big names such as TransCanada Corp.

> Industrials. This sector is rated “overweight.” Portfolio managers favour firms that sell equipment to the booming resources sector. Among Fehr’s favourites are Toromont Industries Ltd. and Finning International Inc., both of which distribute mining and construction equipment.

Dupont prefers Magna International Inc. and Bombardier Inc., which have seen increasing demand from emerging markets: “Bombardier has been heading transportation globally for wealthy individuals in China. The only downside is that if China is in trouble, this demand could slow.”

> Small-Capitalization Stocks. These equities are rated “neutral” because small-caps are more susceptible than large-cap stocks to macroeconomic factors such as high unemployment, a rise in interest rates or a slow economy, and they are paying a high price for negative news on those fronts. “A lot of small-caps are being unfairly punished,” says Richard Fortin, portfolio manager of Bissett Small-Cap Fund and Bissett Microcap Fund, and vice president of Bissett Investment Management Ltd. in Calgary, a subsidiary of Toronto-based Franklin Templeton Investments Corp.

Low valuations make small-caps attractive as takeover targets. In 2011, eight of the 55 small-cap firms that Martin Ferguson, director and portfolio manager with Mawer Investment Management Ltd. in Calgary, covers were bought by larger competitors. “Many of these companies are not getting much in the way of revenue growth,” he says, “yet still have a lot of cash flow.”

Among the companies that could be taken over is Rona Inc., says Fortin. Retailers in other lines of business have seen their earnings recover since the 2008 recession but home-renovation stores have not.

One reason is that consumers are cautious in how they are spending their dollars. Says Ferguson: “At some point, the sales will turn around, as people will need to repaint their homes or fix their windows.”

Outside of acquisition targets, Ferguson’s top holding is Constellation Software Inc., which sells to 40 industries. “Many businesses can’t turn on their lights without Constellation’s software,” he says, making it a good defensive stock.

Paladin Labs Inc. is another small-cap in the health-care sector to keep an eye on, says Ferguson: “It has large cash-flow generation and a strong niche market.”

Fortin’s top small-cap holdings are in the consumer discretionary sector. He favours Corby Distilleries Ltd., a Canadian spirit manufacturer, for the steadiness of its cash flow and dividend payouts. Corby has about 25% of the market for spirits in Canada, second to Edinburgh-based Diageo PLC.

“Unlike other businesses that are volatile, there is a reasonable degree of confidence,” Fortin says, “that demand for Corby’s products will be the same five and 10 years from now.” IE