Last year was a chilly one for the Canadian stock market but three funds that follow a momentum style of investing chalked up some of the hottest returns.
The $23.2-million Synergy Canadian Momentum Class surged 20.2 per cent in 1998, putting it at the top of the Canadian equity fund heap.
The $52.6-million Aim Canadian PremierFund climbed a robust 11.4 per cent while its sister $792.1-million Aim GT Canada Growth Class rose 5.2 per cent.
Compare those numbers with a dismal 2.9-per-cent loss for the average large-capitalization Canadian stock fund, and a 1.6-per-cent loss for the Toronto Stock Exchange 300 composite index.
The common thread among the trio of funds is that they all use an "earnings momentum" investment strategy. Relatively new to Canadian investors, it's much more common in the United States.
While the funds vary slightly on how they pick their stocks, they all focus on the earnings records of companies. Generally, they look for firms with strong earnings growth, and positive earnings revisions and surprises. And they don't hesitate to dump those stocks whose earnings disappoint.
So why did these funds shine last year? The fund managers point out that the earnings growth of many companies has been slowing down in North America, largely because of the Asian financial crisis which, among other things, has put a damper on commodity prices.
That means investors are piling into those few companies that momentum funds have their eye on: firms with fast earnings growth and positive earnings surprises. "In a market where one cannot find good earnings growth, money is focusing on those places [companies] where they are and thus their valuations are rising more dramatically," says Derek Webb, manager of the Aim GT Canada Growth Class.
David Picton, manager of Synergy Canadian Momentum Class, says he expects the momentum style to do well again this year because "we are in a period where earnings growth is becoming harder and harder to find."
Like managers of traditional growth funds, Mr. Picton looks at a stock's growth potential rather than its current price. But the big difference is his shorter time horizon.
"A good growth manager will buy a company that they can put away for four or five years -- just a consistent strong earnings growth company," says Mr. Picton, 33, who has been running Synergy Canadian Momentum Class since its inception in December, 1997.
He, on the other hand, is not necessarily looking for the five-year hold. "I have a shorter time horizon -- say nine months to one year."
But he insists that "it is not a high-flier strategy. I just don't buy the hot stocks -- like the Internet stocks -- because they are going up. There has to be some fundamental positive improvement in the companies before I buy it."
Mr. Picton, based in Toronto, has about 35 stocks in his portfolio. Some of last year's best performers included TLC Laser Center Inc., JDS Fitel Inc., ATI Technologies Inc., Canadian Tire Corp. Ltd., Loblaw Cos. Ltd., Teleglobe Inc. and National Bank of Canada. He sold stocks like Air Canada and Mitel Corp. after they came in with negative earnings surprises.
"I had a big underweight in resource stocks because there was not a lot of positive change occurring there," he said.
Some of the momentum picks that helped Mr. Picton's return last year also came from foreign stocks as the manager capitalized on his 20-per-cent foreign content allowance. While the Canadian market was in the doldrums last year, U.S. and European stock markets were on a roll.
The San Francisco-based Mr. Webb, who has managed the AIM GT Canadian Growth Class since its December, 1994, inception, says his research shows that momentum investing beats the market consistently.
"From 1990 to 1998, it [momentum investing] did 20 per cent per annum compounded versus the TSE, which did 11 per cent per annum," says Mr. Webb, 39. "More importantly, over that 18-year period, it beat the market 17 out of those 18 years.
"We found that companies that have strong earnings revisions, earnings surprises and earnings growth -- where the earnings are always going higher -- is the best way period to outperform the market."
He says 80 per cent of his fund is composed of about 30 or 40 stocks. His foreign-content stocks accounted for about 2 per cent of last year's return.
The top-performing stocks in his fund last year included Teleglobe, Imasco Ltd., Canadian Tire, ATI Technologies, JDS Fitel, Celestica Inc., C-Mac Industries Inc., Rogers Communications Inc., Shaw Communications Inc., and Groupe Vidéotron Ltée.
"We owned no natural resource stocks or manufacturing companies because the earnings are going down there and not going up," he says.
Paul Rogge, 32, who has been the lead manager of Aim Canadian Premier Growth since October, 1997, changed the fund's style to become a momentum player.
Mr. Rogge, based in Houston, Tex., says it has been easier to apply momentum-style investing in Canada in recent years because of the abundance of fast-growing technology companies that have sprung up. He names companies like JDS Fitel and ATI Technologies.
"Ten or 15 years ago, I don't think we would have been as nearly as successful because . . . there weren't the companies for us either," he says.
Mr. Rogge has about 65 stocks in his portfolio. Last year, he concentrated on a lot of small- to- mid-capitalization technology names. The top performers included Teleglobe, Geac Computer Corp. Ltd., ATI Technologies and JDS Fitel. One big disappointment was Newbridge Networks Corp., which he sold.
The manager has boosted his foreign stock holdings recently to make up 18 per cent of the fund and take advantage of markets with a bullish outlook. Most of those stocks are now in the European market, he says.
Mr. Rogge appears to take a more cautionary stance than his rivals about how his earnings momentum strategy will fare this year. Because growth expectations are so low, he worries that some companies -- which he doesn't own in his portfolio -- might come in with earnings surprises.
The fund is underweight in commodity stocks and if there is a rally in that sector, the portfolio would underperform in the short term, he says.
Whatever happens, fund industry watchers say that momentum-style funds have a place in portfolios for diversification, along with the more traditional value- and growth-style funds.
"Ultimately, you want to diversify by style and sector," says Peter Loach, an investment analyst at TAL Fund Management.
He notes that such funds are well-suited to an RRSP because they tend to trade stocks more actively -- and generate higher-than-average taxable distributions.
But both he and Dan Hallett, an analyst at Windsor, Ont.-based Fundmonitor.com Corp., say these funds should be additions to existing core holdings because they tend to be more aggressive. That means making them no more than a third of the average Canadian equity portfolio, Mr. Hallett says.
One big reason: momentum investing, like other strategies, will have times when it goes out of style, he says. "It's in volatile markets and segmented markets where generally more aggressive styles will shine."