Given the tumult in equities markets and uncertainty about the macro-economic picture, this is a particularly challenging time for both stocks and fixed-income investments. As a result, managers of Canadian equity balanced funds are defensive and positioning their portfolios for continued economic turbulence.

Christine Hughes, manager of AGF Canadian Balanced Fund and senior vice president of Toronto-based AGF Management Ltd. , was cautious long before the credit crisis hit epic proportions this past fall. “There were risks building, in terms of the amount of debt in the U.S. financial system,” says Hughes. She had expected the crisis in 2002. “Instead of dealing with it then, they pushed it out. And now it’s much worse.”

Hughes had sold off the AGF fund’s Can-adian bank stocks in 2007 and had kept the cash. “They were the most expensive banks in the world, coming into the fall,” she says. “There was no way [their stock prices] were going to hold up.”

Although Canadian banks are not as exposed to the credit crisis as their U.S. counterparts, Hughes believes they will be dragged down by the environment south of the border. “The banks will have a rough ride in the first half of 2009,” she says. “They’ve just embarked on the beginning of what they will be dealing with throughout 2009; what we saw in the third quarter [of 2008] — but more of it.”

In more certain times, Hughes maintains an allocation of 60% of the fund’s assets under management in equities and 40% in fixed-income. In this economic environment, there is 37% in equities, 37% in bonds and 26% in cash. Significantly, 12% of the fund is in gold stocks.

“Gold tends to hold up the best, because people have fears about the banking system collapsing,” says Hughes, noting that the bullion price is at an all-time high of US$868 an ounce.

Hughes believes the US$ will suffer because of the massive bad debts that are being transferred to the U.S. government’s balance sheet. “I have grave reservations about the U.S. dollar. Its slow demise is continuing,” she adds. “The contra play to this is gold. Once we get out of this deleveraging phase, we’ll see the resumption in the downturn of the US$.”

On the fixed-income side, Hughes favours Government of Canada bonds. The AGF fund has only 1.5% of AUM in corporate bonds because they are far riskier than government securities. The portfolio’s duration is 5.2 years, slightly less than the 5.3 years for the benchmark DEX universe bond index. “It’s a very liquid, secure situation,” says Hughes of the AGF fund’s bond holdings. “At some point, this massive policy response will stoke inflation.”

Running a 34-name equities portfolio, Hughes likes Agnico-Eagle Mines Ltd. for its strong growth profile. “It will be doubling gold production, which is extremely difficult to do these days,” says Hughes. A long-time holding, the stock was recently trading at $44 a share. Hughes has no stated target.

Loblaw Cos. Ltd. is a recent acquisition. Its stock has been battered and it may be taken private by George Weston Ltd., following the sale of a U.S. division. “We’re coming into a slowdown,” she says. “People are going to eat [more often] at home. These food stores will be getting traction.”



Equally cautious are Dina DeGeer and Dennis Starritt, co-managers of Toronto-based Mackenzie Financial Corp. ’s Mackenzie Universal Canadian Balanced Fund and partners in Toronto-based Bluewater Investment Management Inc.

“I’ve seen a number of contractions in 30-odd years — such as the one in the early 1980s, when Paul Volcker [former chairman of the U.S. Federal Reserve Board] broke the back of inflation,” says Starritt. “But this one is different.”

First, he argues, the current contraction is more global in extent and driven by liquidity on a massive scale. Second, although past contractions were triggered by the Fed and other central banks trying to slow the economy, this event is “totally out of control,” says Starritt. “It’s not being managed by any central banks. In fact, central bankers around the world are hanging on for dear life and hoping this does not get totally away from them. That is why we had the total credit creation capability of the U.S. Treasury thrown at the crisis — because we were very close to a credit collapse.”

@page_break@Starritt believes the global economy has avoided that event. But, he says, “We [are not] through the credit contraction. It’s very dangerous to be definitive about the duration or magnitude of this event. We are keeping our minds open on that score. It could take much longer than people currently expect.”

Still, as bottom-up, growth-oriented stock-pickers, Starritt, DeGeer and partner Phil Taller, who is part of the fund management team, are finding some attractive valuations. “Because we don’t know the duration of this crisis,” says DeGeer, “the focus is on companies that have extremely strong balance sheets and cash flows, and have no credit issues.”

The team is shunning the financial services sector and underweighting most resources companies that are likely to be affected by the credit contraction. “It’s always important for us,” she says. “But it’s even more imperative now, as this recession could be longer than most.”

Currently, the Mackenzie fund’s portfolio has about 22% of AUM in bonds (mostly in short-term Canadas), 52% in equities (36.5% Canadian and 15.5% U.S.) and 26% in cash. “We like companies with very strong competitive positions, high barriers to entry and that are able to grow independently of the economic activity,” says Starritt. “We also look for strong free cash flow that can be returned to shareholders through dividends or share buybacks. These kinds of companies will tend to perform very well.”

One top holding is Thomson Reuters Corp. The stock had been in the portfolio for several years but the entire holding was sold in 2007, when the financial information services firm acquired Reuters Group PLC. “As a long-term strategy, it could prove to be very beneficial,” notes Starritt. “But in large acquisitions, even when both sides are full of optimism, 80% of the time it does not work out.”

Then, when the stock hit the low $30s in January 2008, the team decided to reinvest in the firm, he says: “The cheaper a business gets — that is, the lower the stock price and nothing else has changed — the more we will build on that position.” The stock recently traded at $33 a share; the target is $40 a share, although the team will not predict when the shares will hit that price.

Another favourite is Rogers Communications Inc., long known for its aggressive acquisition strategy and highly leveraged balance sheet. “It’s one of the few that can rival Thomson Reuters, in terms of free cash flow,” says DeGeer. “It is very well positioned in a world in which big bandwidth requirements are very important.”

Although competitive pressures and a slower economy will affect the firm’s growth rate, says DeGeer, “The valuation is still very compelling.” The stock recently traded at $35 a share; Starritt believes its fair value is more than $40 a share.



Although central banks have used every tool at their disposal, there is some doubt about the quickness of their response to the credit crisis, says David Graham, manager of CIBC Monthly Income Fund and vice president at CIBC Global Asset Management Inc. of Toronto. “We are going to see an extended recession, because central bankers were late getting started. The question now is: how long and how deep? The recovery could come in late 2009.”

The wild card is consumer spending. Even though mortgage rates have been slashed and consumer loans are cheaper, consumers will be torn between saving and spending. “Will people say, ‘We don’t want so much debt’,” asks Graham. “Or will they say, ‘Let’s spend again.’ If they choose the latter, we’ll have a faster recovery.”

But Graham suspects most people will not return to old spending habits, mainly because their net worth has been eroded. “I can’t see a turnaround until house prices stop dropping. Economists say that might be the middle of 2009,” he adds. “You have to get the consumer to start spending. But every time he picks up the newspaper and reads about layoffs, he’ll say, ‘I better save my money’.”

Graham began to be cautious this past summer, when the global recession started to bite and credit problems accelerated. By then, he had reduced the equities exposure in the CIBC fund to 52% of AUM; last fall’s market meltdown brought that down to 38%. There is also 20% in cash and 42% in bonds — mainly short-term Canada bonds. The duration is 4.8 years.

Graham has been cautious in his stock selection, favouring companies with histories of paying dividends. For example, he likes high-yielding energy firms TransCanada Corp. and Enbridge Inc., and Rogers Communications. Graham also continues to favour financial services firms, even though there are some inherent problems. “Their dividends are fairly safe,” he says.

Among the fund’s top holdings is Royal Bank of Canada. “I like the management,” says Graham. “It has the risk of loan losses starting to creep up. But it has a good track record of managing the assets. And the bank has an 18% return on equity. Among the banks, RBC and Bank of Nova Scotia have weathered the storm better than most.”

Another favourite is Yellow Pages Income Fund. It has taken a beating in the past year because of concerns that it will lose business to Internet search engines. Yet, Graham believes, the business is recession-resistant. The income trust is trading at $6.65 a unit and has a 17.6% distribution yield. IE