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How to play defense with Canadian stocks

In today’s unsteady markets, many traditionally safe stocks ain’t what they used to be, says a fund manager who offers some intriguing picks.

Yes, we have one energy stock for you today. It’s not really the focus of our story, but it seems appropriate to mention it in light of this morning’s headlines. Since it appears we may to have to take out loans to fill our gas tanks for the summer vacation, the least we can do is extract some investment dollars from the oil industry in the meantime.

The real theme of our story today is how to build an investment portfolio in the midst of a market that has fed on instability for more than six months.

As our guide to this process, we have a seasoned portfolio manager. Mr. David Graham, CFA, writes regularly on his approach to the market for The MoneyLetter. In the latest issue, he talks about where to look for good defensive investments.

One thing he makes clear is that some of the usual havens recommended for safety in times like these aren’t quite as inviting as they have been in the past. So he also tells us where not to go.

Relief and nervousness

For years, Mr. Graham was solicited by this advisory for his expertise on small cap investing as the manager of the Renaissance Small Cap Fund. Now he has switched horses: he is co-manager of the CIBC Monthly Income Fund.

Thus he has moved from regions of higher risk to much more conservative terrain. The very nature of his new assignment makes his observations on portfolio management particularly apt in today’s turbulent markets.

Scanning the rugged landscape of the markets since the American housing crisis began to take effect in the fall of 2007, Mr. Graham has this observation: “We think the rally that began in January is an expression of relief that the Fed appears to be actively seeking to ameliorate the effects of an economic downturn in the U.S. In our view, however, market nervousness could return if we see increasing evidence of a slowdown despite the Fed’s efforts.”

Since that was written, of course, the markets have been very nervous again, and the U.S. Federal Reserve Board has jumped in with another multi-billion-dollar offer of relief for the financial system.

In short, whether they rise or fall, the markets don’t appear ready to settle down. It remains to be seen, adds the fund manager, whether the second half of 2008 will bring a full-blown recession south of the border (defined as two consecutive quarters of negative growth).

In any event, you should be prepared for volatility. Here’s how.

Three simple principles

Mr. Graham outlines three simple principles investors should follow in times of volatility. The first two may seem self-evident, but if more people adhered to them, the market would be a much happier place. The third gives directions on where you may not necessarily want to go.

• Stay conservative and stick with high-quality companies.

• Be rigorous and disciplined in your buy and sell targets.

• Remember that the sectors investors have typically looked to for safety — financial services, telecommunications and consumer staples — each have their own problems in this cycle and may not necessarily provide the defensive shield that they have in past cycles.

Looking at the fixed-income side of the equation, Mr. Graham believes bonds are fairly priced and could do well if the economy slows and interest rates rise.

But when the economy returns to health, investors are bound to start worrying about rising interest rates. Thus the manager is holding bonds more for downside protection and capital preservation than for capital gains. 60 per cent of his portfolio is in equities.

Let’s see how it shapes up.

Where commodity prices go

The biggest risk for the S&P/TSX Composite Index, says Mr. Graham, is for a downward revision in earnings. Right now, consensus is for 13 per cent growth in 2008 and 9 per cent in 2009.

If those growth projections are to be sustained, the energy and materials sectors will have to do well. Which means that once again the prospects for the Canadian equity market depend on — surprise! — where commodity prices go.

With this in mind, Mr. Graham and his co-manager, Mr. Stephen Gerring, favour three big utilities. Two are pipelines: TransCanada Corp. (TSX-TRP) and Enbridge Inc. (TSX-ENB). The other is a major supplier of electricity, Canadian Utlities Ltd. (TSX-CU).

Utilities, of course, are traditional defensive stocks. In this sense, they may have to stand in for those other three defensive sectors that look a little shaky just now. In the manager’s view, utilities combine the best of both worlds today: their wealth is based on commodities, and their steady earnings are less vulnerable to fluctuations in the economy.

Now we come to energy.

More energy than the TSX

Mr. Graham’s portfolio actually has an energy weighting larger than the TSX at the moment. “We are positive about oil, but we are also worried that with a surplus of production and concerns about an economic slowdown, the price could drop from its peak of around $100 a barrel.” Well, not yet.

His largest oil holding is Canadian Oil Sands Trust (TSX-COS.UN) thanks to its “nice life-long profile with its 37% holding of the giant Syncrude oil sands project in Alberta, an 8% yield and the prospect of further distribution increases.”

The fund manager has already mentioned telecommunications as a defensive sector that’s giving up a lot of shots on goal at the moment. A number of telecom stocks have fallen on worries of slowing subscriber growth and the federal government’s willingness to open the field to greater competition.

Under these circumstances, Mr. Graham’s top telecom pick may be a bit surprising. It’s BCE Inc. (TSX-BCE). If the takeover goes ahead as advertised — and he believes it will — there are some handsome capital gains to be made at the current share price.

His next pick is Rogers Communications Ltd. (TSX-RCI.B) “which seems most capable of competing against any new entrants.”

Not in this portfolio

Financial stocks, of course, are pretty much the main culprits when it comes to defensive stocks that aren’t doing their jobs.

“We don’t have any concerns about the financial viability of the Canadian banks, but we don’t expect any immediate price appreciation in this sector until the credit issues are settled,” Mr. Graham tells his MoneyLetter readers. “We are maintaining our core positions in the banks and balancing them based on our relative valuation for each bank.”

As an aside, we might mention that this makes Mr. Graham somewhat less enthusiastic on the big banks than a number of other commentators who see them as solid undervalued buys.

This fund manager also turns consumer stocks on their head. These are usually divided into two categories: consumer discretionary (stuff you don’t have to buy) and consumer staples (stuff you do have to buy). Naturally, staples are usually the better defensive pick.

Not in this portfolio. Mr. Graham has been tempted to add to positions in three discretionary stores whose share prices have slipped: Canadian Tire Corp. (TSX-CTC.A), RONA Inc. (TSX-RON) and Linamar Corp. (TSX-LNR). Based on their earnings forecasts, all three look like good value. Still, there is no indication how far their profits could fall in a slowdown, so he is proceeding cautiously.

But he has added to his holding of Thomson Corp. (TSX-TOC). It has made itself one of the world’s largest electronic information companies, with over 80 per cent of its revenues coming from recurring subscriptions.

Having cleared all the regulatory hurdles for its acquisition of its famous competitor, Reuters Group, Thomson saw its share price fall. The theory is that all of those financial clients of Reuters will cut back on their information purchases due to their credit problems. But this fund manager holds the company as one of his key positions among consumer stocks.

No food at all

So far this year, those gotta-have-‘em consumer staples have actually been trailing the S&P/TSX Composite Index. As Wal-Mart continues to expand, “there has been pressure on all the domestic food stores,” says Mr. Graham, who is avoiding the sector. So even though people will keep on buying their groceries, there is no food at all in this portfolio.

If there’s a bright spot in this fog of uncertainty, it’s corporate earnings. “Unlike consumers, corporations, with their still-strong balance sheets, have the ability to spend, particularly if the global economy is helping their sales.”

Things being what they are, there is always room for caution, of course. Since consumer spending still accounts for such a larger part of the U.S. economy, few companies could escape disruption if things get worse down south.

Nonetheless, Mr. Graham has some enthusiastic buys.

Railroads and engineers

“We see the railroads, Canadian National Railway (TSX-CNR) and Canadian Pacific Railway (TSX-CP) as beneficiaries of corporate spending and a buoyant global economy,” says the fund manager.

He acts as well on his conviction that the global demand for commodities will remain high. Plus he weighs in on one of today’s favourite investment themes, the crying need for infrastructure around the world.

He has added to positions in engineering firm SNC Lavalin Group (TSX-SNC), metals distributor and processor Russel Metals Inc. (TSX-RUS), mine services company Major Drilling Group International (TSX-MDI) and Caterpillar products distributor Finning International Inc. (TSX-FTT).

“We believe 2008 could be a roller coaster market, because both good and bad headline news might influence investor sentiment,” Mr. Graham advises his readers in The MoneyLetter. “Our short-term strategy is to maintain stringent buy and sell targets for various holdings in the portfolio in case sentiment moves too far in one direction. As we move through the year, we will position the portfolio for a return in investor confidence.”

In the meantime, confidence comes from playing good defense. And while you may not be able to rely on some of the old defensive standbys, the secret of good defense hasn’t changed: keep your head up at all times.