Balanced funds in 2005 thrived as Canadian equities produced impressive returns and bond markets posted gains. As interest rates start to climb, however, making bonds less attractive, fund managers are divided on whether to tilt their portfolios toward equities, which appear more attractive, or maintain an even-handed approach to both asset classes.

The equity-oriented camp includes Irwin Michael, manager of ABC Fully Managed Fund and president of Toronto-based I.A. Michael Investment Counsel Ltd. “We find the bond market relatively expensive, and we can buy common stocks that yield at the same rate, if not higher. And they have the potential for capital gains,” says Michael. “We’re also buying deep-value income trusts. If we can get a good yield, with some capital gain potential, we’ll take it. The risk/

reward is tilted to equities.”

In the long run, Michael notes, his fund tends to have a 50/50 fixed-income/equity split. The current situation, he argues, is different from the norm: “This is an excellent opportunity to get into equities that yield more than bonds.” Bonds now account for about 10% of the fund, with about 10% in cash and the balance in equities and income trusts.

A deep-value investor with a contrarian bias, Michael runs a concentrated portfolio of 34 names. This past September, for instance, he bought Legacy Hotels Real Estate Investment Trust at $7.12 an unit, although he estimates its net asset value is $10. It yields 4.5%. “We suspect that over time the trust will reflect its goodness,” Michael says. U.S. financier Carl Icahn is taking a run at Fairmont Hotels & Resorts Inc., which owns 24% of Legacy; the bid may act as a catalyst to raise the unit price from its recent $8 level.

Intriguingly, 12 names, or 24% of the fund, are American. “For every Canadian name, we are finding three or four cheap U.S. stocks,” Michael says. The currency exposure is unhedged.

For instance, about 18 months ago, Michael acquired American National Insurance Co., one of the largest life insurers in the U.S. He paid US$82.68 a share, for which the dividend yield was about 3.6% at the time. Since then, the stock has climbed to US$115.25 a share. Michael estimates its book value per share is US$127. He says the stock is followed by few analysts and is controlled by the Galveston-based Moody family. The firm could go private or merge with another. The family has not divulged its long-term plans, Michael adds.

Other U.S. holdings include Phoenix Cos. Inc., a life insurance and wealth-management services firm, and Bassett Furniture Industries Inc., a furnituremaker.

On the Canadian side, Michael has acquired so-called “broken-down” income trusts. Besides Legacy, other favourites include Royal Host REIT and Avenir Diversified Income Trust. The former operates mid-market hotels in Western Canada but hasn’t recovered from the post-9/11 travel industry malaise. Michael paid about $5 a share for the REIT about a year ago, or half its IPO price in 1998. It recently traded at $5.90 and yields 7%. “It is fundamentally cheap, with hidden assets — land and real estate,” he says.

He calculates the NAV is about $7 a share and expects it will be achieved if the firm is reorganized by entrepreneur George Armoyan, who has taken a 19% stake. “It could be something like the Legacy-Fairmont story,” Michael says.



Although neutral on markets, Richard Nield, a portfolio manager at Houston-based AIM Capital Management who is part of the team that oversees AIM Canadian Balanced Fund, is optimistic about future returns.

“Canada is likely to raise rates by another 50 to 75 basis points, which will help the loonie against the U.S. dollar,” he says. “Usually, higher rates would be a concern to equities and bonds, but the rate increases will be slow and steady; nothing dramatic to shock the markets.”

Regardless of market direction, Nield and his co-managers, Jan Friedli, Jason Holzer and Scot Johnson, maintain a 60/40 split between equities and fixed-income. The latter includes about 7% cash and short-term instruments.

“We don’t make market calls, and [we] keep the asset mix consistent. We are purely bottom-up,” he says. The team focuses on names that are growing faster than the market.

Nield expects Canadian markets to generate high single-digit returns in 2006. Valuations, he adds, are “still good, but not as attractive as a few years ago. Multiples are still less expensive than in the U.S., but that gap has narrowed somewhat.” Canadian stocks are trading at around 15 times earnings, he notes, vs 17 times south of the border.

@page_break@On the fixed-income side, the portfolio has about 70 securities that are roughly divided between federal, provincial and investment-grade corporate bonds. The duration is about six years, or neutral, vs the benchmark Scotia Capital universe bond index. “We don’t take much duration risk and have solid credit quality,” he says.

Strategically, the managers have made some small changes on the 80-name equity side and taken profits in the energy sector, which they reinvested mainly in European equities, raising the foreign content to 20% from 18%.

Nield expects that 20% to rise a few more percentage points. As a rule, he adds, the firm does not hedge the currency exposure because, over the long run, currency issues wash out.

Energy stocks are still favoured, and about 27% of the equity side is in senior oil and gas stocks. A top holding is Canadian Natural Resources Ltd. “It has excellent management, a great track record and a good long-term growth profile with its oilsands projects,” says Nield, adding that the firm will transform itself into an oilsands producer in five to 10 years. In valuation terms, it is trading at 4.5 times debt-adjusted cash flow, vs 5.5 times for its peers. Acquired several years ago at an average cost of $11 a share, it recently traded at $58.65. His 12-month target is $70 a share.

In a similar vein, he likes EnCana Inc. “It has one of the best production profiles among the majors,” says Nield, adding that the average cost for the long-time holding is $23.87 a share. The stock recently traded at about $53.66. If commodity prices stay the same, Nield says, the 12-month target is about $65.

He also favours Manulife Financial Corp. , as well as Power Financial Corp. and Kingsway Financial Inc. , because of the likelihood they will not be as affected by further rate hikes as the banks: “Insurers will do better; they can reinvest their premiums at higher rates.” Manulife, he says, also has a strong growth profile.

On the foreign equity side, this past fall the AIM fund acquired shares of InBev SA, one of the world’s largest brewers (the result of last spring’s merger of Brazil’s AmBev SA and Belgium’s InterBrew SA). “The deal has brought in better management,” says Nield, noting that AmBev’s management is expected to introduce cost-cutting measures and boost earnings. The stock is trading at a P/E ratio of 11 to 12 times. Bought at 31.74 euros, it is now trading at 36.75. Nield’s target is the low 40s within 12 months.



James Cole also favours equities over bonds, but the lead manager of AIC Canadian Balanced Fund admits attractive stocks are hard to find. As a result, about 15% of the fund is in cash, says Cole, senior vice president at Burlington, Ont.-based AIC Investment Services Inc. There is also 24% in bonds and 61% in stocks. “Over the long term, returns on carefully chosen equities should outperform the total return from fixed-income,” he says. “That view has been validated in our returns, and we’ll keep doing what we’re doing.”

The fixed-income portion, managed by Randy LeClair, vice president at AIC, is dominated by federal and provincial bonds but also includes some high-quality corporate credits. The average duration is five years, which reflects the managers’ defensive stance on bonds and concerns about increasing rates.

“There could be a little more to go in the bond market correction,” Cole says, referring to a trend in rising yields in long-term bonds.

About 30% of the fund is in equities, comprising 10 names, which indicates Cole’s willingness to take larger, concentrated bets. In a similar vein, he owns only four income trusts: CML Healthcare Income Fund, RioCan REIT, Canadian Oil Sands Trust and Yellow Pages Income Fund, which together account for 13% of the fund. Referring to CML, Cole notes the firm has a 30% market share for lab testing in Ontario, and is a national leader in medical imaging.

“Health-care spending will increase faster than the overall economy,” says Cole. “Private-sector involvement will also continue to increase. CML is the best private-sector provider; therefore, it should continue to grow at above-average rates.”

Acquired in 2001, at an average cost of $4 a share, the firm was converted to an income trust in 2004. It recently traded at $14.60, and yields about 6.4%. A long-term investor, Cole expects increases in distributions, although that will depend on negotiations with the Ontario government and potential acquisitions.

Cole is also keen on Wal-Mart Stores Inc., the fund’s largest holding. “It was absurdly undervalued in September, when I made a significant investment,” he says. He paid US$43 a share, when the stock was under pressure because of the rebalancing of the S&P 500 composite index (which was reorganized based on public float, and excluded control blocks; the Walton family owns 40% of the firm). Wal-Mart shares recently traded at US$46.50 .

“At the acquisition price, it had both substantial appreciation potential and limited downside risk.” Cole says. He expects Wal-Mart to achieve earnings growth in the low teens, while paying a 1.5% dividend yield, and to hold its P/E ratio where it is. “If this proves to be correct, total return should be in the 12%-14% range,” he says. IE