Time to diversify beyond Canada’s resources

The past few trading sessions have demonstrated the dangers of being too concentrated in the commodity-heavy TSX. While global growth is expected to continue, demand for metals and energy has a tendency to fall off when there’s a whiff of inflation.

The commodity play has been extremely lucrative for Canadian investors for the better part of the past decade, as developing economies compete with the industrial world for resources. And with the Canadian dollar rising with oil, investing overseas has been less profitable.

But all that may be changing.

“The best time to diversify out of your home bias is when your currency is strongest,” said Terry O’Sullivan, executive vice-president, national sales, Mackenzie Investments. He was speaking at the firm’s annual Mackenzie University symposium.

Having made tidy profits off the resource industry, he suggested that it may be time to invest in the companies—and countries—that actually buy those resources, adding value and producing fatter profit margins.

Only 11 of the global Fortune 500 companies are located in Canada. Of those 11, all but three are in the financial and resource sectors, making the list fairly representative of the TSX’s heavy overweight in those two sectors.

Now is the time to lock in the earnings made in Canadian resources, and diversify the portfolio abroad, said Ian Ainsworth, manager of the Universal North American Growth Fund. “You don’t make any money until you sell,” he reminded the audience.

Earning returns in the commodities sectors will become increasingly difficult, according to Benoit Gervais, manager of Mackenzie’s Universal Canadian Resource Fund. As the price of oil hits $120, it will face demand destruction, limiting its upside. The same can be expected for other industrial inputs, including copper.

Leveraging the rising commodity prices will no longer work as an investment strategy, Gervais said, and Canadians should be focusing now on which companies can deliver the greatest sustainable volume of a given commodity.

In fact, energy costs will probably start to decline in North America, as massive shale gas discoveries come into production. While there is some opposition to development of these deposits, he said energy regulators will increasingly favour natural gas as a fuel over coal or uranium.

Even before new technologies—horizontal drilling and fracking—made these deposits feasible, gas was the laggard of the energy industry. The price will remain depressed as these deposits are brought online, and that too represents an opportunity.

“We have a drop in energy costs that will be sustained for years to come, and will improve the U.S.’s competitiveness for many years,” Gervais said. “That’s a volume story, not a price story.”

America is once more focusing on secure sources of energy and the country has incredible untapped reserves of shale gas. Construction of gas-powered electrical plants is only one small part of the opportunity, though; Gervais predicts the cost of electricity will fall.

Cheap energy, combined with a flagging American dollar will make the U.S. economy competitive once again, he said.

Phil Taller, manager of the Universal American Growth Fund, agrees with his colleague that the weak U.S. dollar is doing wonders for the American economy. The greenback is not likely to bounce back any time soon either. Policymakers have clearly decided the best way to combat the soaring national debt is through currency devaluation.

The debasement of the U.S. dollar will make its exports far more attractive to the rest of the world, and Taller said a renaissance underway in the American in manufacturing and technology sectors.

Despite hard-luck headlines on consumer confidence or housing prices, the markets are driven by corporate profits.

“If you look at the fourth quarter of 2010, U.S. profits have risen 70% in the last two years,” said Taller. “For all the talk of what shape the recovery was going to have, what we ended up with was the fastest V-shaped recovery in corporate profits in recorded history.”

Paul Musson, manager of the Mackenzie Ivy Foreign Equity Fund, pointed out that the best companies in the world are American-based, and that U.S. managers have a keen focus on return on capital.

Canada has benefited over the past several years from cheap capital, but interest rates will eventually rise, he said. When they do, Canadian companies will lag their American counterparts once again.