From the April 2008 issue of Investment Advisor • Subscribe!

Northern Exposure

With an eye on global economics, Fidelity Canada's Max Lemieux focuses on fundamentals at home to find growth and value

Advisors have long known about globalization and how much faster many other countries--especially emerging markets like China, India, Russia, and Brazil--have been growing than the United States. A consequence of this growth is the build-out of infrastructure: roads, railroads, ports, schools, housing, all of which is necessary to keep these markets' manufacturing and service company expansions on track, and to keep up with workers who are migrating from agricultural areas to urban areas.

While those investing in these emerging markets have been rewarded with some very good returns, there are risks inherent in emerging markets. One way to reap the potentialbenefits of investing in emerging markets, which are expected to continue to grow at higher rates than the domestic economy, is to have exposure to established market countries that stand to benefit from the emerging market infrastructure build-out but perhaps with a bit less risk. The $4.3 billion, no-load Fidelity Canada fund is one fund that has accomplished that. "If you believe in the long-term globalization," says the fund's Boston-based portfolio manager, Maxime Lemieux, "...in the long term Canada can be a safer way to play this globalization in the sense that it's more plausibly stable."

The fund has received Standard & Poor's five-star ranking overall, as well as for the 10-, three-, and one-year periods; and four stars for five-years. The fund posted an annual average return of 15.25%, compared with 9.84% for its S&P peer group of Equity Developed Single Country funds, for the 10 years ended January 31; 27.82 % versus 24.01% for five years; 23.55% compared with 16.17% for three years; and 24.67% versus 2.28% for the one-year period.

Your fund has been doing well for a long time; do you expect it to continue?

In absolute terms, part of the returns were betting [on] a strong Canadian dollar; probably this contributed quite nicely to the overall performance. This was the most drastic move in the Canadian dollar in history, maybe over a two- or three-year period, so these kinds of moves are hard to duplicate year after year. It's a difficult call because we're talking about macro, and I'm not here to make calls on currencies and the economy in general, but in my humble opinion--as you know there's no consensus view here at Fidelity in regard to the economy and currencies--I find it difficult to feel that there's another 20% move this year in the Canadian dollar, and actually, one of the risks, also, is if the global economy were to slow down somewhat, it's usually not positive on the margin for commodities; usually people make strong associations between the Canadian dollar and commodities.

The correlation to watch for is really oil--the Canadian dollar tends to run with oil. I think [with] the Canadian dollar, my best guess is that we're going to be in a trading range. The Canadian dollar will not basically contribute to the returns moving forward, unless we're starting a brand new cycle and oil goes above $100--and then it's quite possible that the Canadian dollar starts running again. I think we'll have to expect more modest returns, and I'll try to do my best to continue to manage the fund the same way I've done it the past five years, which is to try to protect investors on the downside; most of the time I have cash anywhere from 2% to 10%; and try to run a very diversified fund, not being afraid to take on bets in different stocks and industries--I'm not here to copy the index.

For instance, natural resources in Canada represent 50% of the index, and if you look over the past few years, I've been underweight resources most of the time. Even if they've done well, I've tried to choose, maybe, the best stocks among resources, but to me conceptually it's hard to put more than 20% of a given sector in the fund. So if energy represents 35% of the index, conceptually I cannot put more than 20%, 25% in the fund because of business risk. You never know what will happen and none of us is smart enough to have a crystal ball and see clearly what's going to happen. I try to manage the risk; that's one of the variables that I try to control. I like to do well on the upside, but when the market goes down I'd like to protect the shareholders as much as I can, and if you look at the returns in the past they've been good, but also I'm very proud of the volatility of the fund--it's been quite low as opposed to other funds out there. I think it's a measure of stability.

What's your investment process?

The process has always been very much the Fidelity way of investing; stock picking is the norm; a bottom-up approach; looking at fundamentals. I like to buy stocks that have a particular story--companies that could continue to grow no matter what happens in the economy. I look at all kinds of variables but I would qualify myself a bit more as a growth investor as opposed to a value investor, but [with] Canada being a more narrow market it's very hard to establish a dichotomy between the two; it's a little bit of both depending on what kind of market we're in. Between choosing a turnaround and a company that can achieve growth in revenue and improving margins and exponential growth of the EPS, I'll choose the latter. That's my style.

We meet a lot of managements, [and] companies, [by] attending conferences, trade shows, and trying to find the leaders in different industries or trying to find the next or future leader. We don't necessarily buy the number one, but buy a new entrant in a field, so I pay a lot of attention also to the competitive landscape and what's going on on that front in many industries. Obviously, Canada's a bit of back-door play for emerging markets and the globalization--being very much driven by natural resources--I pay attention to the whole economy, so I have to watch a lot of macro variables. Even though I choose a bottom-up approach it's [important] to understand the big picture of what's going on.

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What do you make of what's going on in the markets now?

It really depends on the day, (laughing) but (and this is my personal opinion) the bubble we've seen in the U.S. is quite scary in the sense that since 2001-2002, about a third of all U.S. growth was driven by real estate. So it is a lot; it's obviously the result of very low interest rates set by Mr. Greenspan in '02, '03. Now we're going through a cleaning process, and I'm one of those that think that you don't clean everything in six months--I would think it's going to be a little bit longer. The question here is: is it going to be deeper or are we just going to go sideways for a longer period of time? Unfortunately I don't have the answer for you. I think that these problems are not only related to housing but also to private equity and LBO firms that took on a lot of leverage; now we're seeing a lot of banks trying to get out of a lot of these potentially bad situations because the [securities'] covenants were almost nonexistent. We've reached new crazy points in history over the past six months.

In terms of what do you do in these times, I have a bit more cash in the fund. If you're facing negative real rates, where inflation is basically higher than interest rates, that's good for gold stocks; they've done quite nicely since August last year, so this is a sector of interest. You've got to be careful with stocks that are very highly valued or companies or stocks that are more aggressive by nature, so you may want to be a bit more defensive, so it's a balancing act--there's no rocket science here.

How closely correlated are Canadian companies to American companies?

There is a correlation because 80% of the exports from Canada go to the U.S. However, all of the natural resources stories are levered to the globalization, not only the U.S.

So it's growth in infrastructure and all that?

Yes. You could have a situation where, let's say the U.S. slows down, the rest of the world doesn't slow down as much, and maybe commodities don't go down as much, so that's good for Canada as a whole. But if the U.S. doesn't buy goods as much as last year, it's not good, let's say, for eastern Canada's more manufacturing base. It's a mixed bag.

You've had a pretty big commitment to financials in Canada, any rough spots ahead for those?

The housing market in Canada's quite different: they've never had these exotic products, mortgages where you don't have to pay the interest, so it's much more conservative, but let's face it, if Canada were to slow down, obviously there'll be some credit defaults, and things won't be as good, but it's nothing close to the magnitude that we saw in the U.S. Actually, so far the Canadian banks that have suffered a little bit, these stocks are down 15% or 20% since their peak. It's probably because they were involved in some of these U.S. markets, these asset-backed securities, credit swaps, so they were involved somewhat in U.S. markets but not to the tune that we've seen at any U.S. banks. Some of the Canadian banks had to take write-downs; it may not be over--we have to monitor what's going to happen in the U.S. As of December 31, I was still quite underweight the banks in Canada. This contributed to the performance last year.

Is there anything that's performed better than expected?

We can talk about last year. The gold sector started to move; infrastructure stocks like engineering firms have done well; the agriculture theme has played out quite nicely--that's mostly through chemical companies like Potash [POT], which is the largest potash producer in the world. Last year was very much also a year of stock picking, so tech companies like Research in Motion [RIMM] worked out well, and even if I was underweight natural resources, I had some takeovers in that complex such as Alcan and IPSCO, which is a steel company. When I look at the top contributors last year it was very well diversified. Rogers Cable [RCI] is a cable company, but most of their profits come from their GSM franchise [mobile telephone standard]--they're the only GSM operator in Canada, so it's been broad-based.

Any sectors that did not work out as well as you anticipated?

We could talk about oil and gas--not that I was very bullish on that, but the oil stocks in Canada have not followed through last year...the price of oil has gone up a lot in the last year, I think it was almost 50% in U.S. dollars, but the oil stocks in Canada have not really worked out--they went up a little bit, but most of them have got issues with cost. The cost of labor is going up tremendously in Alberta, and also overruns in cost on the engineering side, so the design of these big projects and cost of equipment is going up fast. Lastly, back, I think, in October, the provincial government decided to raise, somewhat, the royalty on oil and gas there.

What's your sell discipline?

I need to see changes in fundamentals, so it's not because the stock is a little bit expensive that I'm going to sell right away. If it's tremendously expensive, yes, I'll probably take some profits, but I like to sell when I see something is coming that will change the perception of the investors. It could be a new competitor, pricing power declining, something internally in the company--they won't have the same margins. You also need to factor in some macro-economic factors and sometimes put valuations into the center of your thesis. Usually I need to see a change in fundamentals to get out of a story.


Senior Editor Kathleen M. McBride writes regularly about mutual funds. She can be reached at kmcbride@investmentadvisor.com.

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