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portfolio diversification

Any investor who has bet big on the Canadian stock market has something to cheer about these days. From energy stocks and gold miners, to fertilizer producers and financials, the S&P/TSX composite index has been firing on all cylinders, walloping the U.S. benchmark index over the past 10 years.

But is it time to diversify across the border? Jim O'Shaughnessy, chairman and chief executive officer of O'Shaughnessy Asset Management, based in Stamford, Conn., believes it is.

"Canada had one of those rare occurrences where everything was working at the same time," he said. "But when things work perfectly over a long period, you should thank your lucky stars and at least consider that that might not reoccur over the next 10 years."

It is an interesting point, given that Canadians on average have about 70 per cent of their equity portfolios exposed to Canadian stocks, even though the country's stock market represents just 4 per cent of the global equity universe.

As a quantitative money manager, Mr. O'Shaughnessy often delves into historical patterns to find today's opportunities. He wrote the bestselling book What Works On Wall Street. Two of his mutual funds - the RBC O'Shaughnessy U.S. Growth Fund II and the RBC O'Shaughnessy All-Canadian Equity Fund - received Lipper awards this month for their performance in 2010.

While Mr. O'Shaughnessy doesn't see problems ahead for Canada, or for resource-based stocks in particular, he believes there might be better opportunities in other markets - particularly in the United States.

While U.S. unemployment is stuck at its highest level in a generation and the housing market remains weak, Mr. O'Shaughnessy believes the market's upside potential outweighs these issues. His research concludes that the third year following a stock market calamity is always rewarding for investors - and with the third year of the current recovery just one month away, this one is unlikely to be an exception given the current pace of earnings growth.

"Corporate profits in the United States are actually quite good, but they're priced differently," he said.

In 2006, the first time the Dow Jones industrial average rose above 12,000, it traded at about 23 times earnings. Now, after moving above 12,000 again, it trades at just 14 to 15 times earnings. This suggests that the market is cautious about profit growth, and that stocks are relatively cheap.

While smaller-capitalization, higher-risk stocks outperformed in the first two years of the stock market's recovery, Mr. O'Shaughnessy believes this year will be rewarding for so-called market leaders - stocks that have larger-than-average market caps, sales that are 50 per cent greater than average, and higher-than-average cash flows. To find the best deals, he hones in on stocks with the highest shareholder yield, which is a combination of dividend yield and share buybacks.

He declines to mention names, but among the top holdings of his O'Shaughnessy All Cap Core fund are Verizon Communications Inc., Travelers Cos. Inc., Intel Corp., McDonald's Corp. and AT&T Inc. - which have dividend yields ranging between 2.5 and 6.2 per cent.

Mr. O'Shaughnessy argues that the market isn't paying enough attention to the enormous amount of cash that companies are sitting on. This cash could give stock prices an additional boost.

"Going forward, something has to give," he said. "Companies either have to spend that cash by buying other companies. Or, they have to return it to shareholders in the form of higher dividends or buying back their own shares."

He expects companies will move this cash into all three areas over the next 12 to 24 months, creating a domino effect of wider corporate spending. His quantitative models suggest that technology companies could be well-poised to benefit from this trend - but he remains diversified among U.S. stocks.

"The United States has been a dirty word for investors up here for the last little while," he said. "Given the carnage, the reversion to the mean is going to be very nice for the U.S."







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