3 Rules for Success in 2007

Here are three key rules you’ll need to follow to invest safely and successfully in 2007.

1. Make sure you have substantial U.S. market exposure — 20% to 30% of your equity investments, if not more.

Some Canadian investors have avoided the U.S. market recently. They worry that Americans are spending too heavily on consumer goods, especially with borrowed money, while neglecting to save. But the low U.S. savings rate is a misconception. That’s because the conventional method of calculating the U.S. savings rate excludes capital gains on stocks and real estate, and the build-up of value in U.S. pension funds. Yet this is where many Americans hold most of their life savings.

It’s true that the U.S. dollar fell from $1.60 Canadian to $1.10 Canadian between late 2002 and mid-2006. During that period, Canada ran budget surpluses and the U.S. had federal budget and trade deficits, but that’s only part of the story. A more crucial reason for the U.S. dollar downturn was the worldwide boom in prices of oil and metals. High prices for oil and other resources are, relatively speaking, a positive for Canada and a negative for the U.S.

The resources boom is now waning, however. That’s part of the reason why the U.S. dollar has risen about 5% against the Canadian dollar since the summer.

U.S. stocks now seem likely to rise this year. If the U.S. dollar’s recovery continues this year as we expect, it will enhance your gains on U.S. investments. But regardless of foreign exchange trends, the historically low level of the U.S. dollar in Canadian terms presents an attractive buying opportunity for Canadian investors. Make sure you take advantage of it.

2. Be wary of high-yielding investments, especially income trusts.

A proven rule for investment success is that “High yields often signal danger rather than a bargain.” Many investors ignored this rule in the past few years and filled their portfolios with high-yielding income trusts. Unfortunately, many income trusts are based on declining businesses. In addition, they benefit from a tax shelter that was bound to close eventually.

That’s what Ottawa did with its October 31 announcement of new taxes that will put income trusts on the same tax footing as corporations.

Under the new rules, the after-tax return on income trusts in taxable accounts of Canadians will be virtually unchanged from current levels (see page 3). The object of the new rules is to let Ottawa extract taxes from trusts that are held in RRSPs and other registered accounts, or owned by foreigners. The income-trust tax advantage is ending, but the average trust still suffers from hidden risk, due to a generally low level of investment quality.

Many of today’s trusts were thrown together to fill investor demand for any high-yielding investment. They offer much higher yields than the average new issue. But, like most new issues, they lack the investment quality that helps well-established companies survive a period of business disruption and thrive all over again when good times return.

Although unit prices on trusts have dropped, we see no great wealth of opportunity in this market segment. We still advise you to confine your trust holdings to issues we recommend, and to limit your trust holdings to 15% or less of your portfolio.

3. Be wary of investments that are in the broker/media limelight, even when they seem to offer a high level of investment quality. These investments may be much riskier than you’d guess. If brokers, the media and investors are focusing on their good qualities, any hint of unexpected bad news can be devastating to their value.

This doesn’t mean you should go to the other extreme and focus on obscure stocks. Instead, aim for balance. If a stock seems to appear on every magazine cover and cable-TV stock market report, maybe it spends too much time promoting itself. That can leave it with too little time to invest in building its business. If so, it’s a poor choice for your portfolio.