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Mawer manager warns of too much faith in commodities

The Canadian stock market, which has been powered by a commodity boom over most of the past decade, is "fraught with risk" that investors tend to underestimate, warns one of Canada's more successful money managers.

"We in Canada right now have an overheightened sense of confidence in the strength of commodities" because the sector recovered so quickly from its selloff in the 2008 financial crisis, said Jim Hall, who oversees $2.6-billion in large-cap Canadian mutual fund and institutional assets at Calgary-based Mawer Investment Management Ltd.

While half of the Canadian market has direct exposure to commodities through materials and energy stocks, the problem is that "60 per cent of the remaining half in our estimation is exposed to commodities indirectly," said Mr. Hall, who was named Morningstar Equity Manager of the Year in 2010.

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"A large part of revenue of banks is generated from relationships with commodity-producing companies through underwriting, lending, and day-to-day payrolls. If [resource companies]get into trouble, it is potentially harmful for the banks."

Investors have seen what resource-led volatility can mean over the past week and a half, as falling commodity prices have weighed on stocks of resource producers and dragged the TSX down close to 4 per cent.

This correction has been driven by concerns about slowing global growth, as developing countries such as China and India start raising interest rates, Mr. Hall said.

'Interest Rate Shock'

"We will probably get another interest rate shock in the next six to nine months" after the U.S. Federal Reserve Board ends its second-round of quantitative easing, he said. "There could be a possible 5- to 15-per-cent correction."

But pullbacks are "buying opportunities rather than the beginning of the end for the economy to go into a double-dip recession over the next year or so," he said. "We are going to continue with attractive economic growth."

A major risk is a situation in which the United States faces a debt crisis. "Symptoms of that debt crisis would be higher interest rates and a falling dollar at the same time," Mr. Hall said. "The market would produce those higher rates just like with Greece … That would be an extremely bad scenario. The probability attached to that is less than 10 per cent, but it is not zero."

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Resource Weighting: 22 Percent

Mr. Hall, who oversees Mawer Canadian Equity Fund and Manulife Canadian Investment Class , said his resource weighting is 22 per cent, against 50 per cent for the TSX index. "With base metals and gold, we have zero exposure," while the rest is energy stocks and Potash Corp. of Saskatchewan Inc., he said.

While he prefers oil companies because of stronger prices for that commodity, he does owns natural gas plays such as Encana Corp. and Peyto Exploration & Development Corp. "Over a 10-year period, there is a reasonable case to be made for natural gas demand," but there is now a glut of the fuel, he said. "It is one of the most hated areas of the market."

Mr. Hall, who tries to find companies that can be resilient in any economic scenario, looks for attractively priced stocks of firms with attractive business models and strong management teams. His Mawer Canadian Equity, which he has run since 1999, has posted an annualized a 9.4-per-cent return over the 10 years ended March 31, compared with 8.9 per cent for the S&P/TSX Total Return Index.

Mr. Hall has a disciplined, long-term approach to investment management, and has built a "strong track record" with less risk or volatility than most of his peers, said Morningstar analyst Al Kellett. "He tends not to be in markets that are very hot right now, like materials … The losses his fund suffered during the 2008 crisis were not as severe as many of its peers."

The Mawer Canadian equity funds are now overweight the financial sector, with stocks in that area making up 36 per cent of the funds compared with about 28 per cent for the TSX index. In addition to banks, the manager owns insurers such as Industrial Alliance Insurance and Financial Services Inc., Manulife Financial Corp. and Power Corp., He also holds one asset manager, CI Financial Corp.

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Stock of grocers are also attractive because they will benefit from inflationary pressures as they invariably "pass on price increases" to consumers, said Mr. Hall, who owns shares of Loblaw Cos. Ltd. and bought Metro Inc. for his fund this past month. "If they benefit from rising prices, we are happy with that … But that's the icing on the cake."

Jim Hall's stock picks

First Capital Realty Inc.

The real estate developer and operator of neighbourhood malls is focused on buying property in areas where population and income levels are rising, Mr. Hall said. "By doing that, they are able to charge higher rents and increase rents over time." First Capital attracts stable tenants like Shoppers Drug Mart and banks.

Constellation Software Inc.

Constellation has been acquiring software companies that target niche markets with products critical to running a client's business, Mr. Hall said. Among other products, the firm sells software to run bus networks and book tee times at golf courses. "It has a high percentage of recurring revenue because of long contracts and very little competitive pressure," he said.

Brookfield Asset Management

The company, which is focused on property, power and other infrastructure, is attractive because it generates "a stable, growing stream of cash flow over time," Mr. Hall said. "They have grade-A assets and grade-A management running them … They are a global infrastructure company so they can benefit from economic growth worldwide." Brookfield also manages money for sovereign wealth and pension funds, enabling it to earn performance fees also.

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