The canadian equity market has had a phenomenal run over the past three years, growing at an annual average rate of more than 21%. However, investors betting on a repeat performance in 2006 could be out of luck.

Mutual fund managers who follow growth, “growth at a reasonable price” and value investing styles have different views on where the broad Canadian market is going — ranging from a high single-digit rate of return to a potential loss. And given their styles, they also have different views on what sectors and companies could prove lucrative for investors.

“The past three years was an aberration,” says Fred Pynn, president and chief investment officer of Calgary-based Bissett Investment Management, a division of Franklin Templeton Investments Corp. , and portfolio manager of Bissett Canadian Equity Fund. Pynn, a GARP manager, expects the market to slow down this year and post a more modest return of 7%-9%.

He says the resources and energy sectors will lose some momentum, causing a pullback in performance. The Toronto Stock Exchange is rather narrowly focused on these sectors. The S&P/TSX composite index is dominated by oil & gas, mining and financial services stocks. Together, they account for more than 75% of total market capitalization.

On the other hand, Eric Sprott, chairman, CEO and portfolio manager of Toronto-based Sprott Asset Management Inc. , is a growth manager who takes a top-down/bottom-up approach to investing. He sees the potential for the market to “break even” or decline by about 5%. He does not believe that the Canadian market should be viewed in isolation from the U.S. market, which, in his opinion, is very weak.

Sprott would not be surprised if the U.S. market fell by about 10%-20% this year, dragging the Canadian market down but not to the same extent. He looks at developments in the U.S. as a precursor to what will happen in Canada. “Typically, what happens in the U.S. eventually happens here,” he says.

Irwin Michael, president and portfolio manager of Toronto-based I.A. Michael Investment Counsel Inc. , a deep-value manager, foresees a return of about 10% for the S&P/TSX index.

He argues that there has been “excessive exuberance in mining and energy stocks” and that “investors drove stock prices too high.” Nonetheless, he is optimistic about what will be “a stock-picker’s market over the next 12 months, with plenty of mergers, acquisitions, takeovers and privatizations.”

Michael says that the Canadian and U.S. economies should continue to advance at a 3%-3.5% growth rate for at least the next 12 months and that he expects “their stock markets to track this steady economic growth to appreciate meaningfully in 2006.”

Although some sectors — in particular, energy, precious metals and financial services — are expected to continue performing well in 2006, albeit to a lesser extent than in recent years, investment managers are focusing more and more on individual stocks rather than on sectors as a whole.

In areas in which the relatively narrow Canadian market does not offer good prospects, they are increasingly seeking opportunities overseas. For example, ABC Fully Managed Fund (a diversified Canadian balanced fund) and ABC Fundamental Value Fund (a Canadian equity fund) each has 20% exposure to U.S. stocks. Michael, who manages the funds, sees selective opportunities in small- and micro-cap companies in the U.S.

In comparison, Bissett Canadian Equity Fund has less than 10% exposure outside of Canada.

Bissett’s Pynn currently favours financial services, energy and consumer staples. He believes that although valuations of banks and insurance stocks have increased, there is scope for growth in earnings and dividends in the range of 8%-12%, making them attractive.

Two smaller companies he likes in this area are Mississauga, Ont.-based Kingsway Financial Services Inc. , a specialty insurance company that has earnings per share of $2.26 and a price/earnings ratio of 10.35; and Toronto-based Home Capital Group Inc. , a mortgage and credit company that has EPS of $1.60 and a P/E ratio of 26.19.

Sprott does not see opportunities in financial services, largely because of potential weaknesses in the U.S. that could negatively impact the sector in Canada. He refers to the bursting of the housing bubble, accompanied by potential problems in the mortgage business, and the evolution of an inverted yield curve — all of which could hurt the sector.

@page_break@Michael does not hold shares in any big banks but has exposure to Laurentian Bank of Canada and in smaller companies such as Mississauga-based Clearlink Capital Corp., a recovery situation that provides customized technology and equipment financing and leasing, and in Toronto-based E-L Financial Corp. Ltd. , which provides a range of insurance services.

In the energy sector, Bissett Canadian Equity Fund holds larger names such as Petro-Canada, Nexen Inc. and Canadian Natural Resources as part of its top 10 holdings. In Pynn’s opinion: “Resources could last a little bit longer. But if prices remain high, demand will decline and new sources of supply will emerge.”

When looking at energy, Sprott goes on “elephant hunts” to find companies with huge potential opportunity. He owns shares in companies such as Delta Petroleum Ltd, a Denver-based gas exploration and production company with large proven gas reserves in the Louisiana and South Texas basins, and in Halifax-based Corridor Resources Inc., a natural gas exploration company with large proven reserves in New Brunswick. Delta currently has EPS of 1¢ and a P/E ratio of 2031, while Corridor has EPS of 20¢ and a P/E ratio of 225.

Michael, who owns selective names in energy such as Calgary-based Saxon Energy Services Inc., Caribou Resources Corp. and Endev Energy Inc., believes that it has “become cheaper to drill on Bay Street than in the ground.”

Pynn likes consumer products, including grocery stores such as Loblaw Cos. Ltd. and Sobeys Inc., which are attractively priced. He believes that this sector will gain momentum, while sectors such as energy lose momentum. In addition, he believes that “any threat from Wal-Mart Corp. is already discounted.”

Sprott suggests that the precious metals sector will continue to outperform in 2006. Sprott Canadian Equity Fund has direct exposure to gold and silver bullion in its top 10 holdings. Sprott likes silver, in particular, because of an imbalance in supply and demand. “There are very few above-ground silver mines,” he says. Plus, “silver gets consumed.”

In this area, he likes Palmerejo Gold Corp. a Longueuil, Que.-based gold and silver mining company with operations in Mexico; Silvercorp Metals Inc., a young Vancouver-based company with mineral properties in China; and Vancouver-based Western Silver Corp., which has interests in Canada and Mexico.

Pynn believes that the real estate market “is still firm in Canada,” although he expects a slowdown in the housing market in the U.S. This slowdown would not affect the Canadian market as much because “the Canadian market did not have the same boom as the U.S. [and] Canadians have less debt, with their debt-service ratio half of that of the U.S.”

Michael sees value in selected real estate plays such as Legacy Hotels REIT, Morguard Corp., and Royal Host REIT.

Sprott, on the other hand, believes that housing prices will come down, driven by a fallout in the U.S.

The major risks that are likely to impact the Canadian markets are linked to higher interest rates, the strength of the U.S. dollar and the fallout from the bursting of the housing bubble.

Pynn says that significant appreciation of the Canadian dollar against the U.S. dollar could have a semi-permanent impact on forestry products and manufacturing.

Sprott foresees a decline in housing but believes that a “loss of confidence in the US$” is perhaps the biggest risk. IE