Stay at home investors risk missing out

(July 21, 2005) Canadian investors may have realized hefty gains over the past three years from their domestic equity holdings, but the complacent investor risks missing out on lucrative opportunities abroad, according to the top managers at Franklin Templeton Investments.

“Resource driven markets, and Canada in particular, have been absolute star performers, and we have more or less been left in the dust,” said George Morgan, manager of the firm’s flagship Templeton Growth Fund, at the annual Outlook and Opportunities Forum on Thursday in Toronto.

But he points out that top performing sectors are now offering much more risk to investors — oil prices appear unsustainably high and the word “bubble” is applied almost daily to the real estate markets.

“There is some very good news at the global level,” he says. “I think we have turned the corner on that dastardly bear market. I would suggest that now is the time to be looking at stocks and notably global stocks.”

Aside from the global demand for Canadian resources, domestic investors have benefited from the related run-up in the Canadian dollar, which essentially wiped out returns from U.S. dollar-denominated investments.

“In two-and-a-half years, the Canadian dollar has regained most of what it lost in the preceding eight or nine years. It’s phenomenal,” he said. “There are a lot of industrial companies that are starting to hurt from this.”

Morgan calls the Canadian equity market “hostage to commodities,” drawing a comparison to the Canadian economy of the 1950s. Add financials to materials and energy, and these three sectors make up over 75% of the overall market. The same three sectors account for only about 40% of the MSCI World index, highlighting the Canadian index’s under-diversification.

“I don’t think I’d be very happy with an index fund or quasi-index fund that had this much of my investment in those few eggs,” he said.

Canadian and American equity markets currently carry the highest valuations on the global scale. The Franklin Templeton team believes some of the best values lie in Japan and Europe.

“Europe has been going through a lot of reform over the last little while, and this reform has moved to stronger corporate earnings,” said Don Reed, president and CEO of Franklin Templeton Investments and lead manager of the Templeton International Stock Fund. “Valuation levels are extremely low. In fact they’re as low as they’ve been in 10 years at 15.5 times earnings. Europe is the cheapest on price to earnings multiple basis and also carries the highest yield.”

Reed cites productivity increases, along with more investment-friendly regulatory reforms in the U.K., as the main factors in closing the gap between Britain and the Eurozone. France, Italy, Germany and Spain are undergoing labour and welfare reform, leading to lower corporate taxes.

At the same time, interest rates remain low in historical terms in virtually every major economy. “These low levels in interest rates, while they will be rising, are still low enough to fuel growth in corporate earnings,” Reed said.

“Forty per cent of companies today in Europe have a dividend yield equivalent to the bond yield,” Morgan said. “This very rarely occurs and speaks to a lot of latent value in the market. Japan similarly has a situation where the dividend yield is presently equal to the bond yield.”

While the global managers insist valuations are preferable overseas, the company’s domestic managers insist this is not a bearish call on the Canadian economy.

“The economy in Canada has performed second best of the G7 countries, after the U.S. and has had very stable growth over the last few years,” says Mike Quinn, president and chief investment officer of Bissett Investment Management and o-lead manager of the Bissett Canadian Balanced Fund.

He points to Canada’s low interest rates, relatively low unemployment, rising dollar and higher corporate profits as the drivers of the economy.

“Not only has the consumer been a big part of the economy in Canada, but also corporate profits have been very strong and that’s led to increased corporate spending,” he said, predicting that sustained low inflation will give the Bank of Canada little reason to tighten credit.

“We’re not that concerned about interest rates over the next little while,” Quinn said. “We think we’ll stay in a relatively narrow range at the low end of historical rates.”

Some have voiced concern over the TSX index’s recent breach of the 10,000 level, suggesting that it was dangerously high and comparing it to the 2000 market. Quinn agrees that there is a massive overweighting in the volatile commodities sectors, but points out that in 2000, Nortel made up 30% of the market.

“The market at 10,000 today is completely different from the market at 10,000 a number of years ago,” he said. “Valuations now on the market are much better than they were before — they’re supported by earnings.”

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

(07/21/05)

Steven Lamb