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Take Stock v2. – Together, Let’s Beat the Pros’ System of Expensive Mediocrity

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According to Morningstar, 65% of the average Canadian investors’ equity allocation is tied to the Canadian stock market. (We are nothing if not loyal!) That means approximately $200 billion of our invested savings have been handed over to Canadian equity mutual funds.

This needs to change!

To steal a line from a former employer, the Canadian market is “idiosyncratic.” Largely, this is because our market, as represented by the S&P/TSX Composite Index, is dominated by financial and resource companies. You know who they are — the banks, the life companies, the Barricks, the Suncors, and so on.

Currently, 33.6% of the index is allocated to the Financials sector, 24.7% to Energy, and 14.7% to Materials. On a day-to-day basis, these three sectors account for an astonishing 73% of the market’s behaviour!

Not only do these sectors, and the companies within, dominate our country’s broad stock market index, they dictate how Canadian institutional investors behave. Hence the need for change.

You see, in general, most institutional investors are evaluated (i.e., receive their bonuses/variable compensation) based on their relative performance to a benchmark over a given period. For Canadian mutual fund managers, the benchmark tends to be the S&P/TSX Composite Index.

This leads many of them to a warped pursuit of relative performance, as opposed to actually trying to make money for their clients. Their primary goal is to beat “the market,” while at the same time protecting themselves from losing much ground.

To accomplish this balance, portfolios are managed based on which companies or sectors the manager thinks will relatively outperform — not on their absolute merits as stand-alone, prospective, money-making ideas. This leads to a whole lot of what’s known as “closet indexing.”

Because of our highly concentrated index and the tendency to “closet index,” you can pull up the top 10 holdings of most Canadian large-cap, equity-oriented mutual funds and find plenty of overlap in the names you see. It won’t matter if the fund is classified as “value,” “growth,” or “income.” In our market, all these terms amount to is marketing gibberish. You can bet that any Canadian equity fund benchmarked to the TSX will have a very similar portfolio.

For the individuals who have trusted their collective $200 billion to these managers, it’s highly unlikely that they’ll achieve a return that is materially different, up or down, from the overall Canadian market over the long term. And for these market-hugging, mediocre expectations, an annual fee that oftentimes exceeds 2% is levied!

There’s a better way

Rather than settling for market-like returns that are so heavily influenced by a narrow collection of stocks — in three relatively risky sectors, no less! — many Canadian investors have sought an alternative. And if you’re reading this, it’s very likely that you count yourself as one who has made a stand against this faulty, outdated system of expensive mediocrity, and taken your financial future into your own hands.

We say “BRAVO” to you, and, we’re here to help!

To invest in the Canadian market, you don’t have to mimic the composition of the TSX. Far from it. Beyond the large-cap financial and resource stocks, there is a reasonably vast pool of quality companies that fly below the institutional radar simply because they don’t carry a heavy weight in the “benchmark” and are therefore deemed too risky. We’re going to help you uncover them.

Recently, on Fool.ca we uncovered the list of the 10 best Canadian stocks, in terms of total return, over the past decade. The results are tabled below:

Company (Ticker)

Dividend-Adjusted 10-Year Return

Current Market Cap

Industry

Osisko Mining (TSX: OSK)

10,600%

$1.8 billion

Mining/Materials

Bankers Petroleum (TSX: BNK)

10,570%

$715 million

Oil & Gas   Exploration and Production

Paladin Energy (TSX: PDN)

9,050%

$763 million

Mining/Materials

Pacific Rubiales Energy (TSX: PRE)

8,638%

$6.9 billion

Oil & Gas   Exploration and Production

MTY Food Group (TSX: MTY)

8,322%

$431 million

Restaurants

Brookfield Canada Office Properties (TSX: BOX.UN)

8,016%

$2.7 billion

Real Estate   Investment Trust

Computer Modelling Group (TSX: CMG)

7,563%

$823 million

Software

Rainy River Resources (TSX: RR)

5,980%

$225 million

Mining/Materials

Catamaran (TSX: CCT)

5,295%

$10.5 billion

Health Care

Imperial Metals (TSX: III)

5,012%

$808 million

Mining/Materials

Data from S&P Capital IQ. Market cap in U.S. dollars.

No Royal Bank. No Suncor. There isn’t a household name in the bunch. In fact, I’d be shocked to learn that even one of these names had been bought and held by a Canadian equity mutual fund for the entire 10-year period.

With their minds focused on whether to be over- or under-weight “bank X” or “energy company Y,” most institutional investors have no chance of uncovering a company like MTY Group.

For more than 25 years, MTY Group has been a leading franchisor of a variety of quick-service restaurants. Some of the more well-known names in its stable of franchises include Country Style, Mr. Sub, Thai Express, and Villa Madina.

If you’re at all familiar with this country’s food court scene, you’ve undoubtedly seen many of MTY’s brands in action. And the company’s most recent acquisition of “Extreme Brandz,” which includes Extreme Pita, PurBlendz, and Much Burrito, helps to ensure its strategy is still very much intact.

Common themes

Each of the top performers listed above has taken a different path to where they are today, and while it’s possible that the next decade’s great stocks could be from this list, it will be much harder for these companies to repeat their past success.

Their sheer size now will make it hard for them to replicate the run over the next decade. But still, we can draw out a few common themes from each company’s path to market domination (keep in mind, the TSX increased by about 88% over this same 10-year period) — themes we can apply to our search for tomorrow’s winners:

  1. They’ll be small and overlooked.
  2. They’ll be disrupting their industries.
  3. They’ll be focused on doing one thing      exceptionally well.

You’ll note that one of the themes is not: “Will carry a significant weight in the S&P/TSX Composite.”

While the pros are scouring this country’s large-cap universe trying to figure out whether to allocate 3% or 4% of their portfolio to CIBC’s stock (for instance), we Fools are going to be getting our hands dirty trying to find tomorrow’s true winners. No company is too small, or obtuse. If a valid risk/reward relationship exists, you’re going to hear about it.

Before we go

To be clear, there is a place in every portfolio for stability. Our intent is not to focus exclusively on “zero or hero” type stocks. Your portfolio should never be completely built around stocks holding these characteristics. However, with a well-diversified portfolio, you can afford the risks that come with investing in at least one smaller company before it becomes a thing of legend like those on today’s list.

Recent developments

Because we’re in this Canadian journey together, we want to be sure that you’re kept up to date on all of the latest developments surrounding Fool.ca. Part of each Take Stock will therefore include a portion dedicated to keeping you apprised of what we’re up to.

This week’s development is that we’d like to provide you, dear Fool, with an opportunity to send a question our way that we’ll address in either a subsequent issue of Take Stock or via a dedicated post on Fool.ca. Simply fire us an e-mail at CanadaEditorial@fool.com with any burning questions you might have. Though our resources are still limited, we’ll do our best to respond in a timely manner.

‘Til next time … happy investing and Fool on!

Sincerely,

Iain Butler

Senior Analyst

The Motley Fool Canada

P.S. Attention all investment writers! We’re always looking for new contributors for Fool.ca, so if you’re interested in providing Foolish commentary on Canadian stocks, or if you’ll be in the Toronto area on July 11 and are interested in attending our Blogger Bonanza, send me an email by clicking here. We still have a limited number of seats to fill.

P.S.S. Be sure to follow us on Twitter and Facebook for the latest in Foolish investing.

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