Special Free Report From The Motley Fool

Special Report

It’s no secret that we Canadians are heavily influenced by our neighbours to the south. Whether through pop culture, sports, politics, or consumption habits, what goes on in the U.S. generally has an impact north of the 49th parallel.

There is little doubt that Canadian investors are also subject to this American influence. The problem is, what works in the U.S. capital markets doesn’t always translate to Canada, and vice versa. We’ve identified one of these fallacies, and we want to be sure that Canadian investors like you know about it.

In the beginning …

Individual investors consistently hear that if they don’t have the time or desire—or both—to take an active role in managing their investments, they should simply buy a passive, low-cost index fund or exchange-traded fund (ETF) for their equity exposure. Even Warren Buffett, the gold standard in investment-advice-giving, trumpets this strategy every chance he gets. For that matter, The Motley Fool in the U.S. also strongly advocates using this technique to grow your savings.

The index fund was an American invention. John Bogle founded Vanguard, which has grown to become one of the largest asset management firms in the world. Bogle is credited with creating the first index fund for individuals in 1975.

For his undergraduate thesis at Princeton in 1949, Bogle developed several recommendations for the then-fledgling mutual fund industry. Some of his ideas included that low fees should be charged, explicit objectives should be set, and fundholder expectations should be appropriately managed.

As mutual funds evolved, it became clear to Bogle that the industry was not adhering to these suggestions. So he did something about it: He created the low-fee, passively managed index fund. The rest, as they say, is history.

The Canadian angle

The issue for Canadians is not the theory behind investing in “the index”. For us, the issue is with the actual index itself. You see, when Warren Buffett or Fool co-founder and CEO Tom Gardner stand in front of an audience and espouse the virtues of index investing, they are referring to investing in the S&P 500, a widely diversified (across sectors) index that is home to some of the largest, most well-respected corporations in the world.

But when we Canadians are advised to simply invest in “the index”, it can oftentimes mean the S&P/TSX Composite, our True North proxy for the Canadian stock market. The difference between investing in the S&P 500 and the S&P/TSX Composite, however, is like night and day.

The problem

The most significant difference between the two indices is diversification. Indexing supposedly benefits investors because it reduces risk by automatically diversifying across a broad range of sectors and companies. The same 10 sectors help to group the companies that comprise both the S&P/TSX Composite and the S&P 500. But the similarities end there.

The performance of the Canadian market is almost entirely dictated by just three of these 10 sectors:

• Financials (banks and insurance companies) make up 36.1% of the index
• Energy-related companies tied to the oil and natural gas markets account for 21.5%
• Materials companies, which are largely exposed to gold and base metal prices (copper, zinc, nickel, etc.), total 10.6%

Combined, the companies within these three sectors make up 68.2% of the total market capitalization of the Canadian index.

Not for Warren

Such concentration means that the performance of the Canadian market is largely derived from a very narrow slice of companies, heavily influenced by the price moves of oil, gas, gold, and base metals. I don’t think Warren Buffett would be overly intrigued by the idea of having his equity exposure so impacted by these rather volatile commodities.

In addition, the two sectors that will continue to undergo secular growth over the coming decades, Technology and Healthcare, carry weights of just 2.2% and 3.6%, respectively, in the Canadian market. They might as well not exist.

The bottom line is that by investing in the Canadian index, not only will your performance be dictated by three of the market’s more volatile sectors, but you’re also gaining hardly any exposure to two of the global economy’s most important sectors, IT and Healthcare.

More like it

Conversely, the top three sectors in the S&P 500 only account for 52% of the index’s total market capitalization. And, these three sectors are not nearly (if at all) related to the volatile world of commodities. Information Technology leads the way, accounting for 20% of the S&P 500, with Financials (17%) and Healthcare (15%) rounding out the top three.

The big issue here is that because of its theoretically diversified nature, the index approach to investing is meant to be relatively peaceful compared to the world of active portfolio management. After all, it’s known as the “passive” approach to investing. However, the Canadian market’s lack of diversification defies one of indexing’s primary principles. Because of this lack of diversification, many Canadian index investors are taking on more risk than they realize.

We Fools feel that there is a better approach for those who want to sleep a little more soundly, knowing their nest egg is protected by a well-diversified portfolio.

The answer(s)

If this has been a grave wake up call for you, fear not. You have several ways to fix this issue. One very simplistic solution to improve your portfolio’s diversification is to cash in your Canadian index ETF product and purchase an S&P 500-tracking ETF.

However, if you purchase a straight-up S&P 500 ETF, you take on needless currency risk, which will hardly help you sleep more soundly. Instead, purchase a currency-hedged S&P 500 ETF like the one offered by iShares (iShares S&P 500 C$-Hedged (TSE:XSP)), and avoid the issue altogether.

Another solution involves a bit more effort, but could be more rewarding.

To be clear, we’re not ragging on the Canadian market or the Canadian economy. We’ve got a lot of good things going on in this country, thanks in large part to our natural resources. Investing in Canadian companies makes a lot of sense. But given the construction of our index, you’ll need to play a more active role than you might think to ensure you don’t get blindsided.

If you want to remain invested in Canada—which we Fools wholeheartedly recommend!—take one step beyond being a totally passive investor and simply owning the index. Buy a well-diversified collection of Canadian stocks. We can help you with this!

To get you started, below we’ve profiled five companies that we think will serve you very well over the long term. And if you combine these five names with the simplistic solution of parking a chunk of cash in the iShares S&P 500 C$-Hedged (TSE:XSP) ETF as mentioned above, you’ll be able to once again rest easy and get back to doing the things you’d rather be doing.

Five Canadian companies worth buying

Before we go any further, we ought to warn you that there’s nothing sexy about any of these stock ideas. You are unlikely to impress anyone down at the local curling rink with these picks. They are boring. The companies are well-known, and none of them can be described as necessarily “cheap.”

However, these companies have all made investors money over long periods. If you keep buying these five stocks in increments over time, just as you might do with an ETF, you can be confident your net worth will go up, with risks minimized, over the long term.

In no specific order, the five stocks:

Company #1 is Power Corp. of Canada (TSX:POW). Power Corp. has been around since 1925 and describes itself as a diversified international management and holding company. Controlled by one of Canada’s elite business families, the Desmarais,  POW provides you with an ownership stake in life insurance company Great-West Lifeco (TSX:GWO) and IGM Financial (TSX:IGM), which houses the well-known brokerage firm Investor’s Group and asset manager Mackenzie Financial.

Remember that issue with diversification? Power Corp. is here to help.

In addition, if there is a member of this group of five that might be considered reasonably valued, POW is probably it. The stock sports a yield of around 3.8% and trades at 1.3x its book value  — both attractive levels relative to historic readings.

Next on our list is Enbridge (TSX:ENB). Enbridge owns energy-related infrastructure that moves oil and natural gas around North America. The company is relatively unaffected by swings in the prices of the commodities that it moves, because it operates under a toll-road-like model. Traffic (meaning the volume of oil or natural gas) is the key for Enbridge, and given the rapidly growing supply of shale oil and natural gas in North America, Enbridge is having trouble keeping up with all of the opportunities it has to invest in new projects.

With Enbridge, you get a play on energy, without taking on the commodity price risk that owning an energy-producing company entails. The stock carries a yield of around 3.4% , but it has a dynamite history of dividend growth. And even though it trades with a lofty earnings multiple , it is the kind of stock that just seems to perpetually creep higher. Given the company’s track record of creating value for shareholders, ignore the earnings multiple and build a position in this premiere Canadian firm.

Canadian National Railway (TSX:CNR) checks in as the third idea. This company likely needs little introduction — CN is one of North America’s premier railroad operators. Like Enbridge, CN moves things that make the North American economy function, a service unlikely to change in the lifetime of anyone currently able to read this. CN’s stock has been on a near-constant rise for more than a decade, and there is little reason to believe that the next decade(s) won’t have a similar fate in store for those who stick with it over the long term.

Seeking out a bit of international flavour, we now turn our gaze upon company #4, Brookfield Asset Management (TSX:BAM.A). Institutions such as pension funds or life insurance companies give Brookfield portions of their investable assets, and in exchange for a fee, Brookfield invests these assets and tries to make them grow. Investments include real estate, renewable power, and infrastructure assets  that span the globe.   An investment in Brookfield, like Power Corp., offers instant diversification. In addition, you are purchasing a well-run entity that is levered to global growth.

On to #5 — and if you’re waiting for a Canadian bank to appear, sorry to disappoint. There is no arguing with the success of the Canadian banks and the wealth they have generated for shareholders over the years. However, we can’t trust our housing market to keep growing as it has in recent years. Therefore, you’ll likely have a better time to buy the Canadian banks in the future.

Instead, we’ll round out our top five with another provider of critical services. You’ve received this message thanks to your ability to connect to the internet. And for many in this country, the provider of that internet service is Rogers Communications (TSX:RCI.B).

Whether it’s through a wired or wireless connection, Rogers’ telecommunications infrastructure provides the company with an irreplaceable asset. An asset that will continue to generate sizeable returns for the company, and its shareholders, for years to come. In addition to this crown jewel of a network, Rogers has also compiled a stable of media and sports related assets that help to ensure that its pipeline is full of content that people desire – thus helping to make that pipeline even more valuable.

Five names that provide instant diversification and a long-term risk/reward profile that will ensure even the lightest of sleepers will rest easy. Combine these ideas with a low-cost index ETF, the kind that Buffet talks about that is, and the makings of a long term winning portfolio that beats the pants off the S&P/TSX Composite, at least in risk adjusted terms, are in place. Enjoy your sleep!

Looking for more investing ideas?

We hope you’ve enjoyed this special report as much as we enjoyed preparing it for you. It’s been our passion at The Motley Fool to help individual investors build lasting wealth with the very best investments.

My name is Iain Butler, and I’m the Chief Investment Advisor of Stock Advisor Canada, our members-only investment service tailored for Canadian investors just like you!

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This report has been written and updated by Iain Butler. At the time of writing, Iain Butler owned shares of Rogers Communications. Stock Advisor Canada recommends shares of CN Rail and Rogers Communications. David Gardner owns shares of CN Rail. The Motley Fool owns shares of CN Rail. All figures as of December 18, 2014. All figures in Canadian dollars.

This report is: (a) for general information purposes only and not intended as investing advice; and (b) not to be used or construed as an offer to sell, a solicitation of an offer to buy, or an endorsement, recommendation, or sponsorship of any entity or security by The Motley Fool Canada, ULC, its employees and affiliates (collectively, “TMF”). This report represents the opinion of the individual author and does not attempt to give you professional financial advice or advice that relates to your personal circumstances.

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