Investing 2005

Where to put your money this year. Our panel of experts delivers a mixed outlook for stocks, but offers advice to help you outperform.

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It was a whiz-bang year for savvy investors in 2004, but will the good times continue in 2005? Is this the year income trusts lose some of their lustre? How do interest rates and the value of the Canadian dollar factor into the investing equation? For answers to these and other questions, Canadian Business put together a panel of five investing experts: Michael Butler, president, Northwest Mutual Funds Inc. in Toronto; Leslie Lundquist, Calgary-based portfolio manager of Bissett Income Fund; Geoff MacDonald, Toronto-based vice-president at AIM Trimark Investments Inc.; Greg Peterson, senior portfolio manager at Mawer Investment Management Ltd. in Calgary; and value manager Irwin Michael of I. A. Michael Investment Counsel Ltd. in Toronto. Their tips could help keep the sizzle in your portfolio during the coming year.

Canadian Business: What can we expect of the markets in 2005?

Butler: Globally, I think 2005 will be positive and should provide decent results for investors who are prudent and thoroughly research the stocks they wish to own. I believe a value manager will outperform in 2005.

Peterson: We expect modest returns from both equity and bond markets with somewhat higher volatility. The strong close to 2004 has resulted in higher stock valuations in the face of rising interest rates and slower earnings growth. The bond market is also entering a lower return environment.

Lundquist: Double-digit gains will be harder to come by [in the income trust sector]. We expect a portfolio of well-chosen trusts to generate returns of about 8% from income.

MacDonald: Given generally high valuations, lack of great opportunities [and] disregard for risk in the marketplace, I don't expect much. Having said that, this year will present opportunities to buy a few great companies at very attractive prices. The key will be to capitalize on those opportunities.

Michael: On the macro side, we look positively at the Canadian government surplus and the fact that the Canadian economy is still reasonably firm, subject to a strong dollar. Canada is probably a hidden jewel in the world.

Canadian Business: What should investors consider when it comes to where they put their investments in the coming year?

Michael: I think you have to look at companies that can be profitable either by having a competitive cost advantage, or that can weather the storm of a strong Canadian dollar. I think that with the strong dollar, certain companies will look to make acquisitions, mainly in the United States, because it is now less costly to do so. I also look for opportunities in the commodities sector.

Lundquist: The market will continue to fret over when interest rates might rise and by how much, and we also expect to see continued keen interest in the value of the Canadian dollar. These factors are particularly acute for income trusts, as interest rates are relevant in valuing a trust's income streams and currency changes can produce noticeable variations in the amount of Canadian cash available to be distributed.

Canadian Business: Which asset classes do you think have the most upside potential?

Butler: I believe that we should see strong equity markets and I would be more weighted to equities than bonds. I believe that the bond markets will be trending upward for 2005 and investors will have to be careful. Obviously, the longer the bond, the greater the volatility. We are still in a very low interest rate environment, and even with rates going up, I feel that interest rates will be at the low end of the scale.

Peterson: We continue to see good upside potential in Canadian equity and international stocks. Canadian corporate profits will be pressured by the rising Canadian dollar, but we believe companies will adjust relatively quickly to the higher dollar, provided it stabilizes in 2005. The strong dollar will assist this process by lowering the cost of imported machinery and equipment needed to improve productivity and by helping to keep interest rates low. Indexers will have a harder time in 2005, as the market will be more discriminating–value and opportunity will be uncovered stock by stock.

Lundquist: We expect income trusts to outperform bonds in 2005, but whether they also outperform stocks is anyone's guess.

Canadian Business: What are some downside risks?

Peterson: Two major risks are a spike in interest rates and a rapid decline in the value of the U.S. dollar. An interest rate spike would cause prices of bonds to fall and stocks would become too expensive, causing stock markets to decline. Higher interest rates would put the brakes on the economy as financing expansion would become more expensive. Consumers may also rein in spending. A sharp fall in the U.S. dollar would put the stability of the global economy at risk [and] lead to a large imbalance of trade and investment as well as a loss of confidence in the world's largest economy.

Lundquist: For income trusts, the potential for interest rate increases is probably the biggest single risk. This can be mitigated by choosing trusts that can grow their distributions along with the economy–generally, the business trusts. Also, in the past, trust investors have worried about the potential for unlimited liability, but in 2004 those fears were largely put to rest as Alberta and Ontario both passed legislation limiting liability for trust investors.

Butler: I am quite concerned about the flood of income trusts and other structured products that have been sold to investors. Some of these products are offering yields that are not sustainable, and investors could see their yields being cut.

MacDonald: A slowdown in China is a risk and a real probability. China has just gone through a capital boom unlike many others. Capital booms, by their nature, bust. This would be painful for resource companies.

Canadian Business: Are there particular hurdles investors should consider in making investments in 2005?

Butler: We could see interest rates moving up and this will have an impact [on] long bond investors. The growth [in 2004] was driven by a red-hot resource sector and key financial services sector, and I think that some of these sectors are overvalued and cannot repeat their performance of last year.

Peterson: As I see it, there are no particular hurdles that investors should wait for. A couple of major hurdles are now behind us, such as the U.S. presidential election and the easing of energy prices. Equity valuations will take time to moderate, and investors will have to guide their expectations lower.

Lundquist: Investors in trusts should consider two things. First, the trust market has been very strong for a very long time, and at some point there will be a pause or a pullback. If it is a strong, sudden pullback, we could see a great deal of hot money suddenly want out of the trust market, and this could amplify the weakness. [At the same time] investor interest in income trusts remains huge, and early indications suggest we will see more and more new investors enter this market. This could produce even higher prices than we have today, and it could also be a destabilizing force as new trust supply [via IPOs or conversions] is rushed to market to meet demand. Long-term trust investors should try to ignore the noise and volatility that 2005 may bring, and focus instead on holding strong businesses that can produce stable to growing cash distributions regardless of what is going on in the market.

Michael: I think the main tool to overcome any investment challenge in 2005 is patience. You're going to have to do a lot of analysis, go through a company's fundamentals and hunt for opportunity. It just comes down to pure grunt work.

Canadian Business: What impact will a higher Canadian currency have?

Peterson: Going forward, the higher Canadian currency will put a dent in corporate profits for companies who export their goods. That will slow Canadian GDP and will restrain stock prices in 2005. Looking longer term, the value of a currency is often viewed as a gauge of economic health, which would indicate that Canada remains a strong and growing economy. Canadians will be better able to invest in machinery and equipment to make them more competitive.

Butler: Currency management is as difficult as stock or bond selection. We are of the opinion that the U.S. dollar should strengthen for 2005. Consequently, we are not going to hedge the currency for 2005 and would expect better returns from our U.S.-denominated holdings.

Michael: Once our dollar goes through 83¢ to 84¢ barrier, it starts impacting the Canadian economy. It prices Canada outside the market, especially in manufacturing, and we start running the risk of going from being a net exporter to becoming a net importer, because our goods and services are no longer as competitive as before. So I think the Bank of Canada is going to have to walk a fine line when it comes to interest rates. If it raises rates, it will force the dollar upward. But if interest rates increase in the U.S. over the next year or so, and if our rates stay constant, the Canadian dollar will decline. This will probably give a shot in the arm to Canadian manufacturing and exports.

Lundquist: The strength of the Canadian dollar has reduced Canadian-denominated returns from the U.S. and overseas markets, and this could prompt Canadian investors to stick close to home and invest more domestically. However, it is important to remember that Canada does not have the variety of businesses and industries that other countries have.

MacDonald: The question seems to imply a further appreciation of the Canadian dollar. The negative impact to our economy of a higher dollar, and thus the sustainability of the higher dollar, causes me to want to challenge your thesis.

Canadian Business: What is your outlook for corporate earnings?

Butler: The Canadian economy is improving, and corporate earnings should be very positive for 2005.

Peterson: Corporate earnings will continue to be strong; however, the pace of growth will slow. The past 12 months have been very good, with strong double-digit growth in earnings. The next 12 months will see a more modest pace.

Michael: It depends upon the industry and it depends upon our dollar call. If the dollar remains very firm, it is going to impact on Canadian business profits, depending upon the industry. But if the Canadian dollar weakens–let's say it drifts to 75¢–Canadian companies will start to benefit again.

Lundquist: We expect most of the larger, more established REITs and business trusts to continue to produce modestly higher distributable cash levels. These gains are likely to be in the single digits. The oil and resource trusts are less predictable; distributable cash will be largely dictated by changes in the selling price of the underlying commodity.

Canadian Business: Are there specific Canadian stocks you can mention that reflect your investment strategy?

Peterson: We have been adding to Loblaws and George Weston, as they are well-managed, with a track record of steady growth. Valuations have been contained in the past few months due to weak food prices and the impact of the low-carb craze on bakeries. On the energy side, we find some of the service companies particularly appealing, such as Ensign Resource Service Group and CHC Helicopter. For financial stocks, there are more opportunities for insurance companies to add value than for the large banks. Manulife generates shareholder value with its good track record of growing through acquisitions, and they are in a good position to benefit from their international exposure.

Butler: Here are three examples that reflect our forward-looking value management style of investing. The first is Kingsway Financial Services. Its primary business is specialty insurance, such as insuring automobiles for drivers that do not meet the criteria for coverage by standard automobile insurers. We have owned the stock since 2000. The firm has grown rapidly and now has 80% of its business in the U.S. Another example is Reitmans. It's a specialty fashion retailer with over 800 stores in Canada. The company has a very clean balance sheet, lots of cash and virtually no debt. Finally, there's CP Ships, one of the pre-eminent container shipping companies. [They] announced in 2004 that they would have to restate their earnings from 2001 to 2003. This resulted in a 40% drop in the share price, and we started to accumulate the stock. International trade is growing at twice the rate of growth as the economy, and shipyards are at capacity. We are confident the stock will regain some of its lustre.

Lundquist: Superior Plus Income Fund has been a large position [in our portfolio] for many years. We expect another good year as it continues to add value through both acquisition and cost-cutting. We also hold large positions in Davis + Henderson Income Fund and CML Healthcare Income Fund, both of which offer stable businesses with no material foreign currency exposure. Our top oil royalty trust is ARC Energy Trust, which is conservatively managed and financed. Our top REIT is RioCan, which offers strong cash flows, plus some growth potential from joint ventures and other initiatives.

Michael: If I had to give you any picks, they would be companies based in the U.S., because that's where we're finding the best value lately. For instance, we like a company out of Dublin, Ohio, called Dominion Homes. It builds lower-priced homes. The stock is down from US$40 to about US$20, but it's growing at a rate of about 20%. People are worried about a housing bust, but we think there is still more juice in the housing market. Another example would be Bon-Ton Department Stores. A lot of analysts are maybe a little too hard on retailers. We tend not to be so negative. Bon-Ton, which is usually the main department store in smaller U.S. markets, last year merged with another company. We expect to see economies of scale result from this merger. It's trading around book value. Bon-Ton is not followed by analysts, but it's a value story.

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