Canadian equities roared ahead in 2005, profiting from gains in the energy and materials sectors that were fuelled by Asia’s growth. Most fund managers are bullish for 2006, but admit that returns may not be as robust as last year and will probably revert to historical averages. Indeed, some suggest, the markets are getting frothy.

“You can’t help but notice that the world is focused on the Canadian market, with the number of takeovers we have seen,” says David Taylor, lead manager of Dynamic Value Fund of Canada and Dynamic Canadian Value Class and vice president of Toronto-based Goodman & Co. Investment Counsel Ltd. “When the Canadian dollar was at US63¢, nobody wanted us. At US86¢, they can’t get enough of us.

“Whether it is Dofasco Inc. or Hudson’s Bay Co. or Sears Canada, it seems that a lot of Canadian firms are up for sale,” he says. “They are small players, if measured on a global scale, but they are an easy way for the bigger companies to boost production.”

The spending spree suggests, however, that the markets could be peaking. “Massive merger and acquisition activity tends to happen at the end of a cycle,” says Taylor. “We’ve had three incredible years.”

Taylor’s own funds have generated strong double-digit returns, which, he admits, were way above the norm: “I said at the start of 2005 that if we could get about 10% I’d be ecstatic. I’ll say the same thing about 2006: if we could return between 5% and 10%, after fees, it would be a great year.”

A bottom-up value investor, Taylor looks for stocks that may be neglected or may have fallen on hard times, but have solid corporate fundamentals and significant free cash flow. He shuns indices and focuses strictly on the cheapest names. The fund has a 13.4% position in energy, underweighted relative to the S&P/TSX composite’s 26% weighting; a neutral 15.9% in materials; and 11.7% in industrials, vs 5.7% in the index.

Among the top holdings in the 35-name portfolio are Talisman Energy Inc. and Petro-Canada. “We don’t identify a sector that looks ‘attractive.’ It so happens that these two stocks were bought because they were cheap relative to their historical valuations and compared with other oil and gas stocks,” says Taylor. The stocks were purchased in mid-2003. “The market had focused on smaller players with high growth rates and ignored established companies with diversified production bases.”

Taylor reduced some core holdings over the summer, and sold the oil-services stocks. But he added to the former when the market corrected in October, and also invested in Total Energy Service Inc. Total, which has converted to an income trust, provides drilling, renting and compression services in Western Canada. He bought the stock in 2003 at $5.50 a share and watched it move to $15 on conversion to an income trust. When it dropped to $11.50 in October, he built up the holding. The trust recently traded around $17.50 a share.

Taylor is also looking abroad, as about 32% of Dynamic Value Fund is invested in foreign stocks, while the “class” or corporate version has about 28% in foreign stocks. A recent large acquisition is Citigroup Inc., the New York-based global financial services conglomerate. “The market was concerned about the flattening yield curve in the U.S. and Citigroup’s ability to make money in that environment,” he says. As a result, the stock was trading at a 12% discount to its break-up valuation. “It was the widest discount we’d seen in years.”

He bought at US$44 a share; it recently traded around $48.60 a share. It pays a 3.5% dividend.

Equally optimistic but just as cautious is John Smolinksi, lead manager of TD Canadian Equity Fund and managing director at Toronto-based TD Asset Management Inc. “The past three years have been exceptional, but we are going back to normalized returns,” he says. “Long-term earnings growth for large-cap firms is in the 6%-8% range, plus about 2% in dividends. So, going forward, we see about 8%-10% long-term returns.”

To be fair, Smolinski cites rising interest rates and high energy prices as concerns for 2006. He anticipates some “softening” in the U.S. economy in the latter part of 2006, but Canada’s outlook remains positive, bolstered by strong growth in China and India. “The Asian economies are becoming a bigger and bigger part of the global economy,” he says, “so we are still seeing strong global growth, which is very good for Canada.”

@page_break@But he is keeping an eye on the U.S. housing market, which is vulnerable to softening demand. “All things considered, the outlook is pretty good,” he says.

Using a blend of top-down and bottom-up investment styles, Smolinski seeks firms that provide above-average growth over the long term. He runs a fairly concentrated fund, in which the top 10 names account for almost 60% of the portfolio. He basically breaks the portfolio into three “buckets” — dividend-paying stocks, high-quality commodity plays and well-managed growth companies.

Slightly more than a third of the portfolio is in the first bucket, which generates growing dividends. Dominant names include Royal Bank of Canada, Bank of Nova Scotia and TD Bank Financial Group.

“We like the banks because retail banking in Canada is very profitable,” Smolinski says. “Returns on equity are in excess of 20%. There has been double-digit earnings growth for the past few years and they pay good dividends.”

Scotiabank’s dividends, for instance, have more than tripled since 1998. A core holding, the stock recently traded at $45.75 a share, or 12 times 2007 earnings (as Smolinski is looking more than a year ahead), and pays a 3% dividend. His 12-month target is $53.

The second bucket includes materials (19% of the fund) and energy stocks (28%), and is generally leveraged to growth in the Far East.

Smolinski notes that about 15 million people in China move each year from rural communities to cities. “It’s a very infrastructure-rich [play] and requires a lot of metals,” he says. “That’s where Canada has a lot to offer.”

Leading names in the materials area are Inco Ltd., Falconbridge Ltd. and Phelps Dodge Corp. Inco will continue to benefit from low global nickel inventories, he says: “We see higher nickel prices for a long time.” With nickel prices at US$5 a pound, and possibly rising, “Inco should make very good profits.” While Inco recently traded at about $52.20 a share, or nine times 2006 earnings, he expects the multiple to expand and the share price to rise about 20% over the next 12 to 18 months.

The last bucket is composed of stocks such as Shoppers Drug Mart and Canadian National Railway. The latter, he notes, has benefited from the growth in global trade and the proliferation of containers. “The barriers to entry are very high and, after many years, the rail industry is starting to gain market share from the trucking industry,” he says, noting that CN could see 15% annual earnings growth in the next few years. CN recently traded around %90 a share, but, Smolinski says, it has about 15% upside over the next 12 to 18 months.

Warner Sulz, manager of RBC Canadian Growth Fund and senior vice president of Canadian equities at Toronto-based RBC Asset Management Inc. , still feels good about the markets.

“I’m concentrating on Canada,” he says. “There are a lot of good things happening here in energy, materials and financials.” Recent tax changes have made dividends more attractive and leveled the playing field with income trusts.

Energy prices are a concern. But, Sulz argues, prices have to remain high to finance new sources, noting that North America gas reserves are not growing fast enough to replace falling reserves. He believes he can capitalize on the growth of the sector with a 28% weighting, vs 26% in the index. In a similar vein – and focusing on strong global growth – he has allocated about 18% of the fund to materials, vs a 5.4% index weighting. Other sector weightings are 7% industrial products (vs 5.7% in the index), 5.7% consumer discretionary (5.2%) and 4.3% health care (1.3%).

Blending value and growth styles, Sulz has also allocated about 27.5% to financial service stocks (including Manulife Financial Corp. and Bank of Montreal), vs 32.4% in the index. The underweighting, he adds, is not a matter of caution but a byproduct of his decision to favour energy and materials as they seem to offer the best upside.

Sulz owns about 100 – primarily large-cap – names, with the top 25 accounting for 60% of the portfolio. About 11% of the fund is in the mid- and small-cap arenas.

Among the leading energy names are EnCana Corp., Talisman Energy and Husky Energy Inc. The latter, he says, is “a compelling growth story with the White Rose oil project that will start producing off the coast of Newfoundland.” He bought Husky at an average cost of $33 a share in early 2005. It recently traded around $60 and, Sulz says, it has a further 10% upside within 12 months.

Another favorite is HudBay Minerals Inc., a zinc-and-copper producer spun off by global mining giant Anglo American Corp. Bought in early 2005 at an average price of $2.25 a share, it recently traded at $4.60. Sulz says it could be $6 within a year, if zinc prices rise to US80¢ a pound.

He also favours less popular names, such as Extendicare Inc., which has three businesses but primarily operates nursing homes and assisted-living facilities in the U.S. Acquired in mid-2001 at about $8 a share, it recently traded around $17.90. Sulz says the company can leverage off its assisted-living business and the stock could hit $23 within 12 months. IE