Although Canadian equity and bond markets ended 2007 on a positive note, the outlook is mixed, according to managers of Canadian equity balanced funds. Some managers are being defensive and keeping large cash positions, while others are favouring equities because of their greater upside potential.

In the cautious camp is Eric Bushell, manager of CI Signature Canadian Balanced Fund and chief investment officer at Signature Advisors, a division of Toronto-based CI Investments Inc. The fund has a 17% cash weighting, as well as 30% in bonds and 53% in stocks. His caution goes back to the fall of 2006. “We began to feel, in the midst of the greatest leveraged buyout cycle in history, that the excitement about equities and the global economy was cresting,” he says. “We began to become more defensive.”

That view was further reinforced this past summer, when global credit markets came under severe pressure. One of the warning signs was the inability of New York-based Bear Stearns to find buyers for highly rated fixed-income instruments. “It was an indication,” Bushell adds, “that stresses lay ahead for the financial system.”

But he is not keen on bonds, either. The CI fund’s target weighting is 40%; Bushell has consistently maintained the present holding, comprising 18% government bonds and 12% investment-grade corporate bonds. “We don’t see a lot of value in government bonds,” he says. “Government bond yields, in relation to inflation rates, are a bit too low. There is a safety premium embedded in the market.”

The fund’s fixed-income duration is 6.2 years, or one-third of a year shorter than the 6.5 years for benchmark DEX universe bond index (formerly the Scotia Capital universe bond index).

The fund’s 53% equity weighting is split between 28% Canadian and 25% global stocks. The high foreign content, which is actively managed for currency risk, is a reflection of Bushell’s view that the Canadian stock universe is inadequate. Indeed, he intends to boost the fund’s equity weighting. “We are trying to identify the right entry point, after pulling money out during the summer,” he says. “It’s going to emerge in the first or second quarter [of 2008].” His equity target is slightly more than than 60%.

Running a 95-name equity portfolio — Bushell is supported by eight sector specialists — he favours companies with strong balance sheets and market share and “lots of free cash flow so they can be acquirers.”

One of the fund’s larger Canadian holdings is Finning International Inc., a distributor of Caterpillar equipment in Britain, Western Canada and South America. The latter two markets, says Bushell, are “benefiting from the mining ‘super cycle,’ activity in the energy sector and general construction such as the 2010 Vancouver Olympics.

“The valuation of the stock is fair, and the quality of the organization is high,” he adds. “But there is still room for improvement if it deploys more technology into its operations and solves training problems it has encountered with the rapid pace of growth.” A long-time holding, Finning now trades at $28.80 a share, about 15 times 2008 earnings. Bushell, who anticipates 15% earnings growth, has a target of $34 a share within 12 months.

Another favourite is Smith International Inc. A U.S.-based supplier of specialized drill bits and fluid systems used in the oil and gas industry, Smith is geared toward the deep-water offshore sector. “The offshore market will boom for many years to come because it’s the most difficult geography to explore and the most undeveloped, too,” says Bushell. “The companies that will benefit are those supplying the consumables for the exploration and development of the resources.” Bought in the fall of 2005, when it was US$35 a share, the stock recently traded at US$73.65 a share. Bushell’s 12-month target is US$90 share.



There is a lot of uncertainty weighing on the markets, says Robert Swanson, lead manager of Fidelity Canadian Asset Allocation Fund and vice president with “Team Canada” at Boston-based Fidelity Investments. Swanson expects that the multibillion-dollar write-offs related to the subprime mortgage market taken by large U.S. banks will continue into 2008. “The fear of the unknown is worse than the reality,” he says. “But the markets are getting hit pretty hard.” Commercial paper market has dried up because it is difficult to value the securities. “There has to be housecleaning before we see the bottom of the cycle,” says Swanson, adding that the crisis is similar to the savings and loan debacle in the 1980s.

@page_break@“We haven’t seen the bottom in home prices, and there are a lot of unsold homes,” he says. “Until we work through the inventories, we won’t get to the bottom of the prices. Until the problems are resolved, there will be this cloud hanging over the marketplace.”

Nevertheless, Swanson notes that employment in the U.S. is still OK and employment in Canada is at 30-year highs: “The economic variables are still quite solid.”

Indeed, he expresses some optimism, based on the fact that central banks in several countries have pumped liquidity into the financial markets, and deep-pocketed foreign investors have put money into U.S. investment banks.

“Hopefully, this [crisis] will be contained and it won’t spread to the rest of the economies. In the meantime, we will see continued rate cuts from central banks and this will result in what we call the ‘reflation trade’,” says Swanson. “Global growth will be sustained and the demand for resources and commodities will continue. That’s how we are positioned.”

The Fidelity fund has a 72% equity weighting, as well as about 20% in bonds and 8% in cash (vs the long-term mix of 65% equities, 30% bonds and 5% cash). The allocation is based on the relative attractiveness of stocks. “It’s clear that stocks are as cheap as they have been historically,” Swanson says. “They’re almost back to the level of mid-2006, when stocks were pretty cheap. That was the most attractive level we’d seen in about eight to 10 years.”

There currently is a 4% differential between the 4% bond yield and the 8% earnings yield on stocks.

On the fixed-income side, the allocation is divided between 37% federal bonds, 12% provincials, 32% corporate bonds, 11% commercial mortgage-backed securities and 7% asset-backed securities. The duration for the bond portfolio, which includes more than 300 securities, is 6.1 years. Swanson and his team (which includes David Prothro, a fixed-income manager) have been bearish on bonds for about two years.

“We felt that inflation was more of a problem than anyone recognized — it wasn’t reflected in the slope of the yield curve,” Swanson says. “And corporate spreads over treasuries were at the tightest levels we’ve seen historically. There could be an event to cause credit spreads to widen. We’ve been right on both fronts.”

On the 250-name equity side, Swanson boosted the fund’s precious metals’ exposure this past summer and fall and added to holdings in Yamana Gold Inc., Goldcorp Inc., and Barrick Gold Corp. “Increasing liquidity, coupled with lower interest rates on a global basis, will be inflationary,” he says. “Also, bullion had moved up a lot, but gold stocks had not. When the shares began to catch up to the gold price, we started to add to the shares.”

Yamana, says Swanson, has the greatest potential in the sector: “Since its merger with Meridian Gold, it has a broader resources base to develop. It has been a laggard. But we expect, based on its production profile, it could be a dark horse winner in the gold sector.” Its stock price was recently $12.80 a share. Swanson has no target.

Another favourite is Potash Corp. of Saskatchewan Inc., one of the largest fertilizer producers in the world. “There is global population growth, increasing wealth and a greater desire for protein in diets. Add to that the growing need for biofuel,” says Swanson. PCS is benefiting from global supply shortages and rising prices, he says: “We expect to see that story continue.” The stock, which doubled in price in 2007, was recently trading at $142.80 a share.



Although cash levels have risen moderately since this past summer, Michael Lough, co-manager of TD Dividend Income Fund and vice president with Toronto-based TD Asset Management Inc. , remains upbeat about equities. “We’ve been more cautious since June and raised cash levels to around 7% from 1% early in the year. But we don’t see this as a start of a prolonged bear market,” says Lough, who works closely with co-manager Doug Warwick, managing director with TDAM. “We’re still quite comfortable being invested in the market,” adds Lough, “and using our usual strategy of owning dividend-paying stocks.”

The TD fund is concentrated, with 35 common stocks accounting for 60% of the portfolio, which includes large holdings in Royal Bank of Canada, CIBC, Bank of Nova Scotia, TD Bank Financial Group and Brookfield Asset Management Inc. There are also 20 income trusts that represent 10% of the fund by weighting, plus 17.6% in bonds, 5% in preferred shares and 7% in cash.

Although some Canadian banks made headlines for their losses in the U.S. subprime market, Lough ar-gues that the sector’s overall exposure was relatively small. “There will be more uncertainty,” he says. “It’s not that we think this is the absolute low. It’s very hard to judge that. But now is a good time to buy if you have a two-year time frame. As cash comes into the fund, we’re maintaining the same weights.”

CIBC is one example. Lough argues that the bank has been able to grow its earnings and revenue over the past two years — until it hit a $3-billion speed bump when investments linked to the subprime market turned sour. “It’s difficult to know the actual losses,” says Lough. Analysts have revised their expectations for potential losses resulting from falling house prices and higher default rates. “Either way,” he says, “CIBC has sufficient capital in the business that these losses won’t impair its long-term strategy. Once this is behind it, CIBC should do well.”

A long-term holding, CIBC stock recently traded at $70.50 a share. Lough has no stated target, although he notes the stock is trading at eight times 2008 earnings, versus 11 to 12 times for its peers: “There is a lot of room to rebound when the uncertainty is removed.”

Another favourite is Canadian Oil Sands Trust. “The biggest plus is the long-term nature of its reserves,” Lough says.

The firm has a 30- to 40-year reserve life. “Some of the other royalty trusts have much shorter reserve lives of their assets and have to keep spending larger portions of their cash flow to replace their reserves, which is proving to be quite expensive,” he says. “And we are quite comfortable that [Canadian Oil Sands] will benefit from high long-term oil prices, which we believe are here to stay.” A long-term holding, the income trust was recently trading at $39.30 a unit. IE