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earlier discussion

Gavin Graham, Director of Investments, BMO Asset ManagementKevin Van Paassen

As you prepare your portfolio for the end of summer and the end of the recession, where should you be investing to profit from economic recovery?

Certainly in the Canadian stock market, says Gavin Graham, director of investments at BMO Asset Management. He believes the commodity-based Canadian economy will benefit from rising standards of living for the Asian middle class, particularly in China and India. He's also a great fan of Canada's financial system, which has successfully weathered the financial crisis.

Mr. Graham will be answering our readers' investing strategy questions online at noon (ET) on Monday, August 24th. You can get a jump on the queue by submitting your question here.

Mr. Graham joined Guardian Group of Funds as chief investment officer in 1999, and the company became a subsidiary of BMO in 2001. Prior to that, he managed investments in San Francisco and Hong Kong, and served as chief investment officer for Citibank Global Asset Management (Asia). He began his career in Britain in 1979 with Baring Brothers Ltd.

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Sonali Verma, Globe Investor: Hello, everyone, and thanks for joining us again this Monday. We've got a pile of questions waiting for Gavin Graham, so let's get started.

Jim Coldwell writes from Winnipeg: Mr. Graham, there are still many highly respected punduts who feel there's still significant potential for huge negative surprises for Canadian bank stocks. Could you please comment on this? Thanks.

Gavin Graham: Jim, I should begin the session by stating that the individual stocks I mention here and elsewhere are held in the BMOGuardian funds (or not where indicated) and are selected by the fund managers who run the funds.

With that proviso, I would reply that Canadian bank stocks were reflecting the potential for enormous negative surprises earlier this year in February and March, none of which have materialized in the results announced since then, and, as a result, their prices have rebounded sharply.

As I have noted on previous occasions, Canadian banks were simply much more conservative in their lending practices than U.S. or European banks, partially because they keep 70% of all mortgages on their own balance sheets and partially because the Canadian housing market was only down 9% from its peak of December 2007 at the beginning of this year and has since started to see price increases again. While credit losses will rise through the cycle, as they always do, they are a lagging indicator and bank prices have risen while bad debts have been increasing over the last few cycles.

Paul Cohen writes: Thanks for doing this, Gavin. I agree we should benefit from the rising living standards in Asia, particularly as it drives commodity demand. While we have seen a pretty good bump in prices already, I think demand may level out as inventories get replenished. Then I see much slower growth, especially considering the real numbers are likely less than the government's GDP growth "forecasts".

Do you agree with that, and what would you say in terms of time frame to recover to commodity stock price levels of early 2008?? Excluding oil, of course. Thanks very much.

Gavin Graham: Thank you for your detailed question. While one should always regard government economic figures with healthy scepticism, including those produced by developed countries ( John Williams' Shadow Government Statistics website is eye-opening on the quality of U.S. stats), and undoubtedly there has been a lot of "making the numbers" in China, especially, where such relatively trustworthy numbers as electric power output indicate growth is not as strong as the official figures.

Nonetheless the Asian countries are growing by at least mid single digits and using commodities while doing so. It makes sense for them to stockpile when the prices are much lower, as they have been doing to some extent, but their growth has led to Germany, Japan and France emerging from recession in Q2 this year, as their capital exports are mostly driven by Chinese and Asian demand, and thus industrial commodities (and agricultural as well, there's drought and a bad monsoon in China and India this season) have rebounded sharply.

It will take a while to get back to early 2008 levels though, as the deep recession in the developed world will restrain demand to some extent. Perhaps 2011 as a guess?

Chris Curran writes from Toronto: Typically the stocks which lead us into recession, do not lead us out. Which sector will lead the next rally and us out of a recession?

Gavin Graham: While it's true that, after a bear market, the new bull market is usually led by different sectors than the previous one, investors tend to have pre-learned reflexes, and usually buy the same sectors that led the previous bull market initially, even if they eventually recognize the world has changed.

They also buy economically sensitive sectors (financials, technology, materials and consumer discretionary stocks) coming out of a recession, thus in 2003, technology was one of the leaders until investors realized the extent of the overbuilding of capacity during the tech bubble, and the same playbook is being used again in 2009. One has to believe that financials outside of Canada will not be outperformers over the next few years, and that with the consumer starting to save and not spend that retailers and other consumer stocks also won't be favoured. Defensive stocks such as consumer staples (food, beverages) drugs and utilities, which have good balance sheets, don't need to borrow and can pass on inflationary pressures would seem likely to do well.

Richard Gerson writes: The introduction to this session referenced the rising middle class in India and China. What are your thoughts on direct investments (ADR) in Indian companies such as ICICI or Tata or ETFs that represent these economies or their stock exchanges?

China does not have a solid national foundation including the elements of independent judiciary/legal framework, human/minority group and property rights or health and social safety structures. Its growth has been based on massive expansion in exports. Is this an inherently stable situation in the longer term? India lacks many physical infrastructure elements yet has solid and widely supported societal supports .

Gavin Graham: Richard -- You are quite correct to note the difference between the intellectual infrastructure possessed by India (rule of law, democracy, freedom of information) compared to China, and it is also much more domestically oriented, so that buying ADRs or GDRs (Global Depositary Receipts listed in London or Luxemburg) of Indian companies is a sensible route to get exposure.

An ETF or closed end country fund selling at a discount to its NAV is also a good approach as you remove the risk in buying individual stocks (Satyam for example).

China is attempting to redirect its economy to grow its domestic demand to offset its reliance on exports, and, given the success of the Chinese government over the last 25 years and their control of many parts of the economy such as bank lending, tax and property rights, they should succeed, but it will take a long time and the outcome is by no mean certain. Buying stocks in China that have exposure to the domestic consumer is a lower risk way to access China, such as telecoms, consumer products and non govt. owned finance stocks.

Mike writes from Red Deer, AB: Mr. Graham, I have a net worth well in excess of $1 million. My general investment strategy is to focus on Canadian blue chips with the following structure:

  • 30% Canadian banks
  • 30% Canadian utilities
  • 30% Energy companies
  • 10% Other including international, mainly index ETFs

I am in my mid-40s, and have an investment time horizon in excess of 10 years. I certainly respect your opinion, and would appreciate feedback. Thank you.

Gavin Graham: Mike, it's not appropriate for me to comment on individual situations. However, as the introduction to this session makes clear, our managers feel Canada is an attractive market to be invested in, especially for Canadian investors, and if one included telecom and cable cos. amongst utilities, then your suggested portfolio would resemble numerous Canadian dividend funds, which have proven to be capable of delivering performance in line with or ahead of the index with less volatility.

It might be advisable to increase the non Canadian portion, as there are some sectors such as drugs, consumer staples and technology where Canada does not have much if any representation and having some Asian exposure, given their demand for commodities will help drive Canada's growth over the next decade or two, would not be a bad idea either.

Sonali Verma, Globe Investor: We have a couple of questions on picking stable stocks:

Humayun Rashid writes: I would like to develop a portfolio of Candian stocks with a 10 year horizion....solid companies with stable growth and moderate risk. Can you give me your best dozen stock picks(or more)?

Marie writes: I'm an old fan of yours, please recommend 2/3 great Canadian Stocks for my retirement portfolio. Thanks.

Gavin Graham: Marie and Humayun -- If you selected a couple of banks, a life insurer, a pipeline, a utility, a cable/telecom co., a railroad and a couple of consumer staples such as drug stores or supermarkets, making sure they had paid a dividend for the last few years, raised it once or twice and had a decent balance sheet (you can check their debt to capital at Globe Investor), then you won't go far wrong. You can fill in the individual names depending on your own preferences as to the management, approach etc.





Richard Koprowski writes: Would it be wise for me to to pull out of the China and global markets right now and increase my Canadian holdings? I'm 66 years old and don't have the time for these markets to recover. One half of my loss in the five portfolios I'm in at the present time came from investing in the global markets.

Gavin Graham: Given that we hope you'll be with for at least the next 15 years, it would be sensible to keep some global exposure, as long as it's in the type of good balance sheet, dividend paying and defensive sectors I've mentioned.

To get some benefit from the declines, take losses in the ones that have the biggest exposure to non-Canadian financials and the western consumer, and use that to offset the gains your other Canadian and defensive global investments will give you this year.

You should have some non-Canadian exposure if only for reduction of volatility, because of Canada's commodity exposure. Make sure that the managers are hedging their non-Canadian currency exposure; ask your advisor to find out for you.

Eunice de Gruchy writes: Hello Mr. Graham. Where do you see the strongest dividend growth in Canada over the next five years, and what is your outlook for inflation in this period? Thank you.

Gavin Graham: Eunice, we believe that inflation is going to increase, due to the enormous quantity of dollars, pounds, euros and yen being printed by central banks. Canada will do better than most countries as the loonie will strengthen back through parity on the back of higher commodity prices over the next few years driven by Asian demand from the emerging middle classes, but the depth of the present recession will keep inflation under control for the next 18 months- 2 years.

The strongest dividend growth in Canada will likely come from the energy and materials sectors (i.e. resources) and the businesses associated with them such as railroads, equipment providers, real estate and consumer stocks. Financials will likely increase their dividends a lot more slowly than over the last decade as they become more conservative in their approach, witness Manulife's dividend cut.

Graeme Foster writes: If one subscribes to the peak oil theory, then investing in oil and oil related companies in the coming years will be the place to be - therefore if you had to pick one Canadian oil company and/or a small basket of companies, who would they be?

Gavin Graham: Picking one stock in a sector is a higher risk approach; we agree that oil will trade at higher levels than earlier this decade, although not necessarily at the $147 (U.S.) per barrel level it reached last year anytime soon.

The largest energy stocks by market cap in Canada are Suncor, Encana, Imperial, Canadian Natural Resources and Husky Energy -- all of which BMO Guardian and BMO Funds own. Buying the energy ETF or the oil sands ETF would be a way of gaining exposure to the sector while reducing the individual stock risk.

Roslyn Ritz writes: I feel as if I personally know you.....after all you are a TV personality! I have seen you on Business News at 6:30 P.M. Thank goodness they have bright lights such as yourself or it woud be a dull program otherwise! I stupidly purchased Manulife just before they cut their dividend. (they are a cruddy company) and have a paper loss of $400.00. Should I wait for it to recover or take my loss and invest in something that would pay me a higher dividend.

Gavin Graham: Thanks for your kind words; we own Manulife in the BMO Guardian and BMO Funds, and have kept it after the dividend reduction (I also own it personally).

If you look at what happened with Trans Canada after they cut their dividend 10 years ago, they had increased it sufficiently within five years to get back to the original level, and the stock and the dividend are both now substantially higher than they were before the cut. I would hold on if you have a similar time horizon.





Arthur Yip writes from Vancouver: How should the upcoming dismantling of the income trust structure in Canada affect our investing decisions? Will income trust prices become volatile? Will distributions remain as high once some trusts convert to corporation structures?

Gavin Graham: Arthur, income trusts have been fairly volatile over the last four years since the possibility of first removing their tax exemption was suggested. Most of the trusts are converting to corporations and announcing whether they will cut or maintain their distributions at the same time, while some are giving advance warning that they will cut the payout before they do so with the stock price reflecting this.

One point to consider is that all distributions from trusts will be taxed as dividends, so at a preferential rate equivalent to 2/3rds of your top tax rate, so the net effect of some cuts is to leave taxable investors no worse. Look at the underlying business; if it's a good business then the corporate structure, whether trust, LP or corporation doesn't matter.

Sonali Verma, Globe Investor: We also have a couple of questions generally on the market:

Dave Downie writes from Winnipeg, MB: A lot of comments are being made about the need for a correction in the market because stock prices are ahaed of earnings. Do you think that we will have a correction? My definition of a correction is > 15%.

And a reader identified as Monkie writes: Do you think there is too much speculation in the stock market? Or is the recovery really here? And do you see any chance of a double dip recession?

Gavin Graham: Dave and Monkie, the market has come a long way in 6 months, up almost 50% from its March lows. While it would reasonable to expect some pull back, we actually had a 10% correction in June and July before taking off again, and given the better than expected earnings from many sectors, many investors are making the case that the market was massively oversold in March and all we've done is get back to fair value.

We would suggest looking at the sectors that have underperformed, such as telecoms, (all of which are flat to down for the year) supermarkets and drug stores and utilities and pipelines. That way, if there is a pullback, these sectors should hold up better.

Ed King writes from Hanover, ON: Many investors have lost tremendous amounts of money in canadian stocks. To back this up David Trahair, author of just published No Bull, tells investors to stay out of stocks and into GICS . What advice do you have?

Read more:

Gavin Graham: You're correct to note that many investors have lost lots of money in Canadian stocks, although losses are not actually realized until the stocks are sold. To have all of your wealth in one asset class, whether that's GICs, govt. bonds, stocks or real estate, is to risk having that asset class underperform or lose money while other assets are doing better. When stocks were going down 35% last year, govt bonds, cash and gold were holding their value or increasing.

This year has seen the reverse. If you believe that inflation is likely to increase due to the massive govt. stimulus and the demand for commodities from the Asian markets, then having all your money in cash or fixed income runs the risk of having your purchasing power eroded by inflation as happened in the 1970s when inflation ran at 8% p.a. Having a mixture of assets would seem the best and most prudent policy.

Sonali Verma, Globe Investor: I'm afraid it's time to wrap it up. Gavin, thank you very much for all your time and for taking our questions. And thanks to everyone who participated. Please join us again, on Friday, for a discussion on metals and miners. We'll have David Whetham from Scotia Cassels taking your questions. See you then!

Gavin Graham: To conclude, I'd like to reiterate the three most important points that I hope emerged from today's discussions. Firstly, Canada remains one of the best markets to be invested in today, as its strong financial system and large commodity exposure mean it will benefit from the global recovery in the next 2 years and more specifically, from the strong growth in Asian emerging markets due the emergence of the middle class consumer, demanding goods that use lots of commodities in countries that have decent banking systems and high savings levels.

Secondly, dividend paying stocks with good balance sheets, of which there are a good selection in Canada, will continue to outperform the index with less volatility and should be the core of any investor's portfolio.

Thirdly, the enormous amount of stimulus delivered by the world's central banks will eventually lead to higher inflation, which will benefit Canada, its currency and its commodity oriented economy and enable investors to at least partially protect themselves through rising dividends.

Thanks for setting this up, Sonali. I enjoyed taking part.

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