Canadian equity fund managers are tilting their portfolios heavily toward cyclical stocks, betting on economic improvement and crossing their fingers in hopes of an upside surprise.

The consensus economic prediction for 2011 won’t surprise anyone: sluggish growth with a vigilant watch on a few fronts. For instance, fund managers are aware of the risk that China’s government will tighten monetary policy to ensure that inflation is under control. A downward shift in the world’s second-largest economy would definitely be felt in Canada, as our raw commodities are in high demand there.

In addition, a continued threat to eurozone sovereign debt could drive more investors away from the euro and toward the U.S. dollar, which has a negative correlation to resources prices.

On the upside, seven of 13 global fund managers surveyed by Investment Executive expect the U.S. economy to be surprisingly strong, which will certainly benefit Canadian firms that export.

Here’s a look at the Canadian companies in the non-financial services and non-resources sectors that fund managers favour — as well as their recommendations on the sectors’ weightings in client portfolios.

> Consumer Staples (neutral to overweighted). Investors punished Shoppers Drug Mart Corp.’s stock in 2010 when the Ontario government reduced the profits that pharmacies could make on generic drugs. But many fund managers believe cosmetics and other front-of-store sales can provide some offset — and Shoppers has a number of other initiatives that should increase the company’s earnings.

Fund managers are split on Métro Inc. and Loblaw Cos. Ltd. as top picks. Metro’s current revenue projections are stronger, but some prefer Loblaw because of its new technology to improve its supply chain and other management systems. Kate Warne, Canadian market strategist with St. Louis-based Edward Jones, says Loblaw’s cost structure is already coming down and there’s more to come when Loblaw starts introducing new product mixes.

Warne also likes Canadian Tire Corp., because it has mostly stopped store expansion. She notes that once you stop adding stores, same-store sales improve as management focuses on organizing stores and selecting merchandise.

> Consumer Discretionary (overweighted). Fund managers generally favour Astral Media Inc. because it’s well managed and offers great upside when advertising revenue picks up.

“It seems companies are [already] stepping up their advertising budgets,” says Charles Jenkins, senior vice president of Canadian equities with Standard Life Investments Inc. in Montreal, “because, ultimately, you need to do so in order to bring consumers into your stores.”

Magna International Inc., the auto-parts maker, is favoured as the auto sector improves and accelerates globally — especially in China, Russia and India. Magna’s margins have improved because of a better business focus, says Stephen Carlin, senior vice president and head of equities with Toronto-based AEGON Capital Management Inc., a subsidiary of the Netherlands-based AEGON NV.

Fund managers are also keen on information provider Thomson Reuters Corp., but they want to see the fruits of the big Thompson Corp./Reuters Group PLC merger soon — as well as further momentum derived from improvement of the financial services sector. Says Jenkins: “[Thomson Reuters] should start to generate a lot of free cash flow and continue the dividend growth.”

> Industrials (overweighted).Fund managers consistently favour the railway operators, but they’re split on which company they prefer. Canadian National Railway Co. comes with a longer track record of efficient operations, but also a higher valuation. Canadian Pacific Railway Ltd. is tightening up its operations on the cost side — offering potential upside.

However, says Jenkins, both firms will see earnings boosts when the U.S. economy picks up.@page_break@SNC-Lavalin Group Inc., the Montreal-based mining engineering company, is a top choice mainly because of governments’ infrastructure spending. Portfolio managers like the large backlog of orders from around the globe in a variety of sectors and the possibility for a boost when the economy turns around. “There’s lots of visibility in earnings for the next couple of years,” says Carlin, pointing to SNC-Lavalin’s contracts in the U.S., Brazil and Saudi Arabia as well as in Canada.

Bombardier Inc. would be more interesting, Carlin notes, if the economy surprised on the upside and the firm’s aerospace unit saw more orders.

But Martin Hubbes, executive vice president and chief investment officer with Toronto-based AGF Management Ltd. and manager of AGF Canadian Stock Fund, says Bombardier’s railway infrastructure business is low-margin and capital-intensive, so he considers the firm high risk until there’s big expansion in that subsector.

> Technology (overweighted). Fund managers like Research In Motion Ltd., especially as it trades at eight to 10 times forward earnings, and the consensus is for top-line growth of 20% for the next two years.

Although Hubbes currently prefers RIM, he says it needs to work on its operating system and the availability of applications.

Warne is an outlier, preferring to look outside Canada for exposure to this sector. (That’s also her take on health care.)

> Health Care (neutral to overweighted). There’s not a lot on offer in this sector domestically, but a name worth watching is SXC Health Solutions Corp. Its stock is growing “like a weed,” says Hubbes. SXC expects 30% growth for the next two years.

> Telecommunications (neutral to overweighted). Rogers Communications Inc. is still favoured because its cash flow and dividend payouts keep growing.

On the other hand, Telus Corp. might have more upside potential, says Carlin, who has been shifting to Telus from Rogers.

Fund managers are interested in BCE Inc. for the yield. Warne says she would buy BCE based on its dividend growth policy and for the potential that new management will rein in costs and make the company more nimble.

> Utilities (underweighted). Al-most unanimously, fund managers are steering clear of this sector because valuations are too high.

Warne is the exception. She likes Fortis Inc., the largest regulated utility in Canada, noting that the company may be expensive, but it has raised its dividend for 37 consecutive years.

> Small-Capitalization stocks (neutral to slightly overweighted). This could be a year of convergence in large- and small-cap company performance — with maybe a slight edge to large-caps. But that doesn’t mean there aren’t good opportunities in the small-cap sector.

Martin Ferguson, director and small-cap portfolio manager with Mawer Investment Management Ltd. in Calgary, says his biggest overweightings are in financials, industrials and technology. He likes Canadian Western Bank and alternative-credit provider Home Capital Group Inc. He also says Stantec Inc. and New Flyer Inc. remain attractively valued in the industrials sector, while Constellation Software Inc. stands out in the technology sector. Ferguson adds that he’s tilted away from resources; he doesn’t own gold and feels other resources are risky to own right now.

Similarly, Ralph Lindenblatt, portfolio manager with Calgary-based Bissett Investment Management Ltd. , is underweighted in materials — although he does see some value in certain energy stocks.

His largest overweighted stocks are in the consumer sectors: In-digo Books & Music Inc. and Cor-by Distilleries Ltd., the latter the maker of Wiser’s whisky and Polar Ice vodka as well as the distributor for Pernod Ricard SA, which owns more than 45% of Corby. IE