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Sometimes it pays to bet on laggards

Look for good stocks that have had a rough patch; history shows 'they can become tomorrow's stars'

FUNDS REPORTER

When it comes to matching or beating the S&P/TSX composite index, most giant Canadian stock funds have struggled over the past year.

But analysts suggest that investors should not be too harsh on fund managers in this tough environment in which few stocks drive the benchmark. And dumping all laggard funds to chase better returns elsewhere is not always the best move, they say.

The stock market today is somewhat similar to 1999, when it was being driven by hot technology stocks like Nortel Networks Corp. while many other names stayed on the sidelines. "We are basically seeing the same thing, except that materials and energy are the places to be" as well as in Research In Motion Ltd., Morningstar Canada analyst Jordan Benincasa said.

"If a manager is not holding RIM, Agrium or Potash Corp., they are immediately behind the eight ball."

For the 12 months ended May 30, the S&P/TSX composite index gained 7.4 per cent, including reinvested dividends. And the iShares Canadian Large-Cap 60 exchange-traded fund climbed 11.4 per cent.

There are two categories of Canadian stock funds: Canadian equity funds must invest at least 90 per cent of their assets in domestic stocks, while Canadian focused equity funds can invest up to 50 per cent in foreign securities.

It may not be fair to compare Canadian focused equity funds with the S&P/TSX benchmark because of the former's potentially high foreign-content exposure, and returns that can be affected by currency conversions if there is no hedging, Mr. Benincasa said.

For instance, the CI Harbour Fund run by Gerry Coleman, and the CI Signature Select Canadian Fund run by Eric Bushell have 34 per cent and nearly 48 per cent, respectively, in foreign stocks. Their benchmark for regulatory filings, however, is still the S&P/TSX.

Many laggards tend to be value-oriented funds whose managers look for cheap stocks compared with their intrinsic value and may avoid resource stocks, but the problem is that some holdings "just keep getting cheaper," said Dan Hallett, a Windsor, Ont.-based independent analyst.

Some investors "jumped on the value bandwagon when they saw how smoothly value funds sailed through the bear market of 2000 to 2002," he said. "But value funds don't always hold up well in weak or volatile markets, although most of the time they do."

While it might be more tempting to switch to better-performing growth or momentum funds now, Mr. Hallett suggested adding more money to "skilled managers that have fallen on hard times."

One prospect is the Mackenzie Cundill Security Fund run by Wade Burton, which is down 16 per cent over one year.

If there is a lot of value in a company, "it's eventually going to be realized," Mr. Hallett said. Investors should not be plowing more money into a fund that has had a good three- or four-year run but rather when they have had a rough patch, because history has shown that today's laggards can become tomorrow's stars, he said.

Peter Loach, who heads fund research at BMO Nesbitt Burns Inc., agrees. "The financial services industry is one of the few sectors where consumers shy away from bargains."

Mackenzie Cundill Security Fund underperformed the index by a wide margin in 1999 and 2000, he recalled. But the fund was up 2.9 per cent when the index lost 12.6 per cent in 2001, and up 4.1 per cent when the benchmark tumbled 12.5 per cent in 2002.

Among the 30 largest Canadian equity and Canadian focused equity funds, Dynamic Canadian Growth, run by Rohit Sehgal, and TD Canadian Equity, helmed by John Smolinski, outperformed both the index and the iShares 60 ETF during the past 12 months.

While investors may be tempted to switch into Dynamic Canadian Growth, they should understand it is a "turbo-charged growth fund" and there is a "lot of trading going on," Mr. Benincasa said. "It's quite aggressive.

"There is nothing wrong with it - that's the strategy. But investors should be aware of the downside risks of that strategy," adding he wouldn't be surprised to see the fund experience heavy losses in a down market.

Mr. Sehgal's momentum fund should be viewed as a "complement to one's portfolio" as opposed to a key holding, while the TD Canadian Equity could be considered a core fund, he said.

The TD fund, which focuses on buying growth stocks at reasonable prices, is "firing on all cylinders" he said. "The fund's outperformance is mainly attributable to the fund's overweight in energy - about 39 per cent versus 32 per cent for the S&P/TSX.

"It has a much lower exposure to the struggling financial services sector - about 13 per cent, compared with the 27 per cent for the TSX."

Investors with a heavy weighting in value-oriented funds with little or no commodity exposure might consider adding a resource fund to their portfolio, Mr. Benincasa said. "Mackenzie Universal World Resource is one of our favourites."

While the iShares Canadian Large-Cap 60 ETF might hold appeal, investors should realize that the top 15 names represent nearly 60 per cent of its portfolio, he said. "It will do well on the upside, but it can also do as bad on the downside, especially, if those top names start to flounder in the future."

© 2007 The Globe and Mail. All rights reserved.

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