Energy threatens to dominate the headlines again in 2006, and investors are best to diversify globally. And, in my opinion, risks remain for income trusts.

THE ENERGY BULLS

The Canadian equity market is being taken over by energy stocks, and the market’s performance in 2006 will hinge on the oilpatch. When the most volatile sector is one of the most dominant, it is also the odds-on favourite to affect performance in any one year.

China and India are no longer marginal players in commodity markets, and the effects have been profound. China is now the second-largest importer of oil after the United States.

“The penny dropped for me in the recession of 2002 in the United States when oil prices never went below US$30 per barrel,” says James Cole, manager of AIC Canadian Focused Fund, who is a “believer in the peak oil theory.” Cole expects the price of oil will average US$55 per barrel.

Rohit Sehgal, manager of Dynamic Power Canadian Growth Fund earned a roughly 25% per year return over the past three years for his heavy bet on oil.

Bob Lyon, manager of CI Signature Canadian Resource Corporate Class, says commodity markets that are “largely outside the realm of speculators,” such as uranium and coal, are spiking, thus corroborating the high price of oil. And the oil-supply response remains muted: “Even the super majors who are ultra-conservative are only now investing in projects that look like they require US$30 or US$30-plus prices of oil.”

THE ENERGY BEARS

It is actually a disingenuous comment to call Geoff MacDonald, manager of Trimark Canadian Endeavour Fund, an “energy bear” because he does not own any oil stocks.

“Is it a good business,” asks MacDonald, “if it is a capital-intensive business with depleting assets, while selling a product that is undifferentiated from any one of my competitors, and anyone who has money can enter into the business and sell exactly same product as me tomorrow?” No matter the motivation, the fund earned a modest 5.6% over the past year as a result.

George Morgan, manager of the $5-billion Templeton Growth Fund, follows a strict value-investing style that counsels caution with oil prices at dizzying heights.

“We don’t spend a lot of time trying to guess where the price of oil is going. There is an army of people who get that wrong every day,” says Morgan, who has little interest in oil stocks at current prices. “We bought Shell a couple of years ago when it got into lot of trouble because of reserve problems that we thought the market did not understand.”

OIL STOCKS DOMINATING THE INDEX

Oil stocks are clouding the waters for Canadian investors because they are so predominant in the index and because the sector is so risky. Investors are selling funds for not keeping pace with the index, but index performance is likely the wrong yardstick for measuring fund performance because oil stocks are so highly volatile and therefore exceed an advisable asset allocation for most investors’ portfolios.

Investors who may have been selling funds because of index performance should not be displeased with the managers who have been sticking to their knitting and avoiding resource stocks.

THE GLOBAL CONCERN

Perhaps investors would be wise to act in a contrarian fashion and diversify their assets abroad. The strong Canadian dollar was the biggest factor affecting U.S. and global equity fund performance over the past few years, and investors should arguably invest overseas when the Canadian dollar is at its strongest.

Richard Jenkins, manager of Trimark Select Growth Fund, cautions that investors “are paying a premium to be in Canadian stocks, and are limiting themselves to very narrow sectors of the global economy.”

Growth stocks, less the domain of Canada than the U.S., are cheap according to growth managers including Noah Blackstein, manager of Dynamic Power American Growth Fund. Price to free cash flow is almost identical for growth and value stocks, according to Blackstein, who earned significant returns in the U.S. in 2005 without the benefit of oil stocks or a U.S. dollar hedge.

Perhaps the most interesting mature global market in 2005 was Japan’s. Veteran fund manager Peter Cundill reaped significant rewards in Japan as lead manager of the Mackenzie Cundill Value Fund.

His focus is surplus cash on companies’ balance sheets. After years of economic stagnation, the Keiretsu cross-shareholding corporate structure has been largely dismantled. Cundill is unlocking that idle cash, since companies are starting to pay dividends and buy back stock to appease shareholders and to play down their attractiveness as takeover targets.

Mackenzie Cundill Value Fund earned a 16.7% three-year annualized return, second only to Mackenzie Cundill Recovery Fund.

Eric Bushell, chief investment officer of Signature Group of Funds at CI Investments, says the Canadian stock market is rapidly shrinking. “In Canada, in the last four months or so, we’ve seen 10 multibillion-dollar-market-cap companies be bought out.” The result is that a narrow stock market is getting even narrower. “I honestly think that ‘05 is the year we’re going to look back on and say that was the year when the Canadian market changed for good, and really became a much narrower market place where the benchmark lost its relevancy.”

THOSE UNTRUSTWORTHY TRUSTS

The future of the income-trust sector remains uncertain. The Department of Finance appears to have backed down from its hawkish stance on income trusts and the associated tax leakage when it opted to address the problem this fall by cutting the effective tax rate on dividends.

But the issue remains: income trusts continue to hold a favourable tax status over corporations for RRSP, pension and foreign investors. Managers James Cole of AIC Funds and Eric Bushell of CI Investments expect the other shoe to drop for income trusts should the Liberals gain a majority government in January.

“The government has twice indicated quite clearly that they would prefer to discriminate against trusts rather than cut taxes,” says Cole. If the Liberals win a majority he expects Ottawa to finish the job it set out to achieve.

In the fall, John Priestman, manager of Guardian Monthly High Income Fund, expected the imposition of ownership limits by the Department of Finance as a first measure against trusts. His best guess was limits on RRSPs (25%), pension funds (5%) and foreign investors (50%) to constrain corporate conversions and tax leakage. Perhaps this change will still come to pass.

Doug Warwick, manager of TD Monthly Income Fund, characterized the sector as “a bit of a minefield” with the quality of recent offerings as “dubious -- not as high as the earlier years.”

Stephen Gerring, manager of CIBC Monthly Income Fund, said: “To me, they are just small-cap stocks where the owner wanted out of the business and no one else would pay him anywhere near what he could get in the income-trust market. So the retail investor, if you will, is the high bidder.”

Take heed and diversify your portfolio appropriately.