Finding an effective way to invest in Canadian stocks while achieving reasonable sector diversification is challenging. The Toronto Stock Exchange is dominated by financial stocks and energy stocks. Mining stocks used to form a significant portion as well, although the weight has come down over the past several years due to the declining price of gold and base metals. As it stands today, more than 1/3 of the S&P/TSX Composite Index is comprised of financial stocks, while more than 1/5 of the Index is in the energy sector:
For this reason, it is very difficult to invest in Canadian stocks using ETFs and achieve proper sector diversification. This recent Seeking Alpha article suggests avoiding Canada altogether in portfolios, in part because of the significant weighting financial stocks have in Canadian ETFs.
A recent article in the Globe and Mail (paywall) by David Berman outlined an interesting idea for Canadian portfolio construction: create a portfolio of equally weighted positions in the largest (or most well known) stock from each GICS sector. Mr. Berman excluded healthcare, because there are so few reasonable options in that sector in Canada (Valeant (VRX) is by far the largest Canadian healthcare stock, and it is rather controversial).
My idea is to expand this slightly to 20 stocks - this improves diversification and produces a portfolio of well-known companies with a solid dividend yield and 1-year track record.
20 Stock Diversified Portfolio - Methodology
This portfolio will consist of 20 names, each with a 5% weighting. It uses the largest two stocks from each GICS sector (based on market capitalization), with the exception of healthcare. Compared to the S&P/TSX Composite Index, defensive sectors such as real estate, telecom and consumer staples are over-weighted, while more cyclical sectors such as financials, energy and materials are under-weighted. The result is a portfolio with MUCH better diversification than the S&P/TSX Composite Index.
If you wanted even further diversification, TD Bank could be switched for an insurance company such as Manulife (NYSE:MFC), but Royal and TD have somewhat different strategies (Royal has more capital markets exposure, while TD has significant retail exposure in the U.S. northeast), so holding two Canadian banks in this portfolio seems reasonable.
These two energy companies have impressive dividend growth track records and are solid complements to one another. Enbridge is one of the largest energy infrastructure companies in the world and Suncor offers both energy production and refining.
Barrick Gold (NYSE:ABX)
I do not particularly like the outlook for either of these companies, but that doesn't matter in this diversified portfolio based solely on sector and market cap. A 5% exposure to precious metals and 5% to agricultural materials makes sense from a diversification perspective. Potash will be renamed Nutrien once its merger with Agrium (AGU) closes later this year.
This is one sector where choosing the top 2 stocks based on market cap does not provide much extra diversification. Both of these railroads have performed well over the last several years, but one could choose Waste Connections (NYSE:WCN) (the third largest company in this sector) instead of CP Rail to obtain added diversification.
A global leader in auto parts (Magna) and the owner of Burger King, Tim Hortons and other well-known fast food restaurants (Restaurant Brands Int'l) - sounds like a solid pair of consumer stocks for this portfolio that both offer global exposure.
Couche-Tard is one of the largest convenience store operators in the world (it also happens to be one of my largest holdings) and Loblaw is the largest grocery store operator in Canada. Again, these two stocks are a nice combination when it comes to diversification.
BCE is a slow growth, dividend machine (nearly a 5% yield), while Rogers offers slightly more growth potential and owns sports teams such as the Toronto Blue Jays, Toronto Maple Leafs and Toronto Raptors (BCE also owns minority stakes in the Leafs and Raptors).
Fortis is a boring, but steady utility with a strong dividend growth track record, while Brookfield Infrastructure offers global exposure and forms a meaningful part of my own portfolio. Seeking Alpha writer Dividend Sensei called BIP the "greatest dividend growth stock in the world" recently.
Two technology stocks with strong track records of making acquisitions. Constellation Software is not a well-known company outside of Canada, but its long-term performance is stellar and worth a look.
Units in Riocan REIT have declined more than 15% over the last 12 months due to its exposure to retail properties. Brookfield Asset Management is by far the largest company in this sector, but you could easily switch it out for Brookfield Property Partners (NYSE:BPY) to increase your yield (5.0%) and get pure real estate exposure.
Combining these 20 companies in equal weights creates a very well-diversified portfolio of Canadian large cap stocks, most of which are dominant players in their respective industries. The yield of this portfolio is 2.55% and its 1-year performance track record is impressive, especially relative to the S&P/TSX Composite Index:
Obviously, this 20-stock portfolio is not as diversified as owning the broader index through an ETF. One could also reasonably argue that selecting 20 stocks based purely on sector and market cap is a type of momentum investing - stocks that have done well over the proceeding weeks and months have a higher chance of being included in stocks that have struggled recently. However, selecting two stocks from each sector means that one will always have exposure to sectors that have been out of favor recently (in this case, energy and materials).
While concerns about the Canadian housing market cause some global investors to stay away from the entire country, Warren Buffett doesn't seem too concerned. Although Canadian stocks have tended to under-perform thus far in 2017, the country is generating impressive economic growth.
My biggest issue with the Canadian stock market as a whole is its lack of reasonable sector diversification. Therefore, the above semi-passive strategy allows investors (from Canada, the United States or any international market) to create a diversified portfolio of high-quality Canadian companies with a history of outperforming the S&P/TSX Composite Index.
6 months from now, I plan to write a follow up article, looking at how this strategy performed over the final half of the year and whether there have been changes in any of the 10 GICS sectors featured in this portfolio.
Disclosure: I am/we are long CNI, GIB, ANCUF, BIP. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.
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