Go global, reallocate within Canada

Canadian investors need to trim their domestic holdings and further diversify into foreign markets, according to the top portfolio managers from Franklin Templeton Investments, speaking in Toronto at the annual Outlook and Opportunities Forum.

“One place we are not finding value is in Canada. That’s not to say we’re making any kind of call, we’re not top-down managers,” said George Morgan, outgoing portfolio manager of the Templeton Growth Fund.

Of course, Franklin Templeton has been extolling the virtues of foreign diversification for some time now, which is hardly surprising given its hefty offering of global and international funds.

Backing up the “go global” recommendation, Morgan and his colleagues warned of excessive valuations on Canadian markets, currency and core industries — notably energy and mining.

“Whenever the commodity market turns down, there is roughly a decade of misery and gnashing of teeth,” he said. “It will probably end up the same way again. Who knows where the top is, but after that top it will probably not be terribly pretty.”

Against that backdrop, perhaps the most interesting speaker at the event was Fred Pynn, president and chief investment officer of Bissett Investment Management and co-lead manager of the Bissett Canadian Equity Fund.

What is a Canadian equity manager’s take on the current market environment? “We believe that equity returns will be lower as we go forward,” Pynn said. “The Canadian stock market has produced returns in excess of 20% annualized over the last several years. This is well above the historical long-term average, which would be more in the 10% range.”

He admits that the burgeoning resource sector is responsible for much of the returns on the TSX and also for the overall profitability of corporate Canada, with other sectors benefiting from the low interest-rate environment as well.

Pynn points out that both inflation and short-term interest rates have been creeping higher over the past few years, curtailing some of the “very robust economic growth.”

“Currency strength has had a huge impact on Canadian equity returns when we look globally,” Pynn said. “We see that as being more of a headwind going forward, with Canadian businesses having a harder time trying to compete.”

He also suggests that the current commodity price boom could soon be finding its peak. Investors would be wise to take their profits off the table and retreat to more stable, less cyclical industries.

“Historically, as earnings growth has slowed in the Canadian equity market, more stable sectors of the market have outperformed — healthcare, the consumer groups, and financial services have all done very well,” he said.

“Small caps have outperformed — they look expensive — and we see better value in the larger cap sector of the Canadian market,” Pynn said. “In an environment of lower overall equity returns, we think the power of dividend paying and dividend growing will come to the forefront.”

One trap clients may need to have pointed out is comparing dividend yield rates to risk-free returns from fixed income vehicles. Pynn reminded the audience that the favourable tax-treatment given to a 3.5% dividend yield makes it more comparable to a 4.7% bond yield on a pre-tax basis, for investors in the highest tax bracket.

In fact, large-cap, dividend-paying stocks may be considered the overarching theme of the Franklin Templeton outlook, both within Canada and abroad.

“We think it’s maybe something as simple as the ‘law of big numbers’,” said Lisa Myers, vice-president of Templeton Global Advisors and Morgan’s successor at the helm of Templeton Growth. “Over the past couple of years, investors have been focused on small companies, which are using a very accommodative interest rate environment to grow their sales and earnings at a very fast pace.”

She suggests that many investors see global large caps as sluggish next to these rapid growth stories, because they are starting from such a massive base.

“While they’ve been growing sales and earnings and having great profit margin expansion, and buying back shares and paying dividends, just that simple percentage growth rate has been considerably less impressive than what smaller companies have been able to deliver over the past few years,” she said.

Filed by Steven Lamb, Advisor.ca, steven.lamb@advisor.rogers.com

(07/27/06)

Steven Lamb