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High prices, strong flows cause dilution
Money managers searching for investment ideas in Canada's equity markets repeatedly tell me that good values among mid-to-large cap stocks are tough to find. Given that value funds have done well over the past four years (though they generally trailed a bit last year), strong flows of new money have continued into many of the bigger funds. The combination of generally high valuations, maximized foreign content, strong inflows of new cash, and a small market have caused many Canadian equity value-oriented managers to hold relatively small amounts of Canadian stocks.
More than fifty investment funds tracked by Morningstar Canada categorized as Canadian equity mid- large- and small- cap funds (excluding 'pure' funds) report a Canadian equity weighting of less than sixty percent. Here are some of the larger and most notable examples.
Mackenzie Cundill Canadian Security
Over the past two years, this fund has ballooned in size from less than $250 million to nearly $1.2 billion. In the summer 2001, then lead manager Alan Pasnik cited the fund's modest asset base as an advantage since it did not restrict him by market capitalization. At the time, it had a large cap bias and held only 55 percent in Canadian stocks back then. However, its strong performance has drawn lots of new cash, which has effectively precluded it from shopping among smaller companies. Now, its Canadian equity weighting stands at just over one-third of assets. In fact, at 35 percent of assets, it holds nearly as much cash as it does domestic equities.
Co-manager Wade Burton (who stepped in last summer) says he's working hard to find new investment ideas. While he admits that it's tougher today, he maintains that he's still finding new stocks to buy - but apparently not as quickly as cash is piling up.
Mackenzie Ivy Canadian
At 57 percent, this $5.4 billion fund is a poor proxy for the Canadian equity asset class. The Ivy team prides itself on the selection of a concentrated list of names that exhibit the attractive combination of low valuations and above-average growth prospects. However, more than four years ago, when this fund was just a bit smaller, Javasky admitted to having to stick to strictly large cap stocks based both on assets and portfolio concentration.
Javasky's penchant for building up cash (which currently sits at a historically low 14 percent) results from a limited universe of potential investment candidates and generally elevated valuation levels. Credit this team for sticking to their knitting in the face of significant constraints. However, investors desiring pure Canadian stock exposure should probably look elsewhere.
CI Harbour Fund
Like his former Ivy teammate, lead manager Gerry Coleman held 56 percent in Canadian stocks and 20 percent in cash as of the end of March. A recent commentary by the Harbour team highlights the significant contribution that small-to-mid cap stocks have had on longer-term returns. However, with more than $2 billion in this fund - and another $1 billion in other incarnations of the same - Coleman and his team will be more restricted from significant participation in smaller firms. Hence, Coleman's selectivity, big asset base, policy of maximizing foreign content, and high current valuations add up to a portfolio that doesn't come close to offering full exposure to domestic equities.
Other examples
Universal Canadian Growth is a lower profile Mackenzie offering in this space that suffers from the same issue. While it's not as flush with cash as some others - at 13 percent - it is a bit high. However, its foreign content, at 32 percent of market value, leaves just over half for domestic stock exposure. Further, industry competition means most funds maximize foreign content, which leaves relatively few funds that offer pure exposure to Canadian stocks.
AIC Canadian Focussed actually holds more in foreign stocks - 46 percent - than it does in Canadian equities. At 15 percent, its cash holdings have been sharply diminished but only recently after a long period of holding more than three times that level. The result is a Canadian equity weighting of less than 40 percent in this concentrated portfolio.
Chou RRSP, while a solid long-term performer, is the worst offender when it comes to not-so-Canadian equity funds. It holds less than a one-third of its assets in domestic stocks due in large part to a recent cash infusion from Fairfax Financial (the manager's employer). However, high stock valuations made this a bad time to get an influx of new cash since there are relatively few good opportunities in which to deploy the cash.
The managers of the Cundill, Universal, and Harbour funds noted above are on my recommended list. However, a fast-growing asset base and very low Canadian equity content make all of these funds questionable holdings if pure exposure is the goal. This is particularly true of those aiming to maximize foreign content - which most do.
Some will prefer the chosen manager to deploy the cash where they see fit - or sit on it in the absence of suitable opportunities. Others rather prefer a fund that offers a higher and more consistent exposure. Whatever your preference, it is most important to know what you are buying since such drastic changes in asset mix can play havoc with clients' investment strategies.