Investing in Canada's Bifurcated Economy

In this hostile financial climate, long-term investors must now give more thought than ever to capital preservation and sustainable growth. It is not a profound observation that growth is not sustainable if it is driven by debt-fueled consumption. Sound fundamentals for growth include:

• Favorable demographics;
• Low national debt levels;
• High savings rates; and
• Persistent trade surpluses.

Many emerging economies have all of these characteristics, while the so-called 'developed' economies have virtually none of them. Take Canada as an example. It can be argued that Canada suffers from many of the problems of the typical developed nation, though to a lesser degree than its G8 brethren. Canada is the best of the worst, so to speak. Still, it has familiar developed-economy problems, including:

• Aging population, with unfunded liabilities for social benefits;
• High debt-to-GDP levels;
• Low savings rates;
• Increasing government regulation and intervention in the economy;
• Large fiscal deficits; and
• An overly accommodative monetary authority.

This raises the question: why should investors emphasize investments in developed economies such as Canada over emerging economies? The fact is that direct investments in emerging economies often come with higher levels of political risk - see Russia's expropriation of oil assets, or Argentina's punitive export tariffs on agricultural commodities during its 2008 food crisis. The challenge becomes how to obtain emerging economy growth with developed economy risk.

That is the investment draw of Canada. Even though it faces many of the issues of the rest of the developed world, there is an opportunity to capture emerging market returns in Canada due to its uniquely bifurcated economy.

Eastern Canada, represented by Ontario and Quebec, is heavily exposed to deteriorating US demand through its automotive and aerospace industries. To put it simply, Eastern Canada imports what the emerging economies need and exports what they make, putting it under pressure on both the cost and revenue side of the equation.

Meanwhile Western Canada, represented by British Columbia, Alberta, Saskatchewan and Manitoba, is in the enviable position of exporting what the emerging economies need and importing what they make. What do I mean by this? It's a well-understood process that energy and food consumption undergo rapid growth as a developing economy makes the transition to a middle class standard of living. Energy and agriculture are Western Canada's dominant industries - and this region, with only 10 million inhabitants, is one of the world's largest net exporters of both energy and agricultural commodities. Here's an approximate breakdown:

Energy -
• Oil (13% of world reserves; 4% of world production)
• Uranium (8% of world reserves; 20% of world production)

Agriculture -
• Potash (60% of world reserves; 30% of world production)
• Wheat, coarse grains, oilseeds (21% of the world export market for wheat; 10% for oilseeds)
• Farmland (80% of Canadian total)

Therefore, investing in Western Canada provides exposure to emerging market growth in energy and agriculture within one of the world's most politically stable markets. In addition, investors who have a 'value' orientation have been provided what I believe are attractive entry points into the Western Canadian market by some recent events.

In the energy sector, the credit crisis has caused financing to become scarce for junior oil & gas companies while low natural gas prices are reducing their profitability. They are being forced to sell assets to stay in business. This has created a buyers' market for the acquisition of smaller oil production assets - assets that are highly cash-flow positive at current oil prices.

In the agriculture sector, the regulatory barriers that made it difficult to invest in Saskatchewan farmland have recently been liberalized, allowing capital to move in and acquire the cheapest farmland (on a productivity basis) in Canada and perhaps the world.

Its reasonable to expect China to overtake the US as the world's leading economy, and, as part of this process, I think Canada's fortunes will surprise many. Indeed, Canada's uniquely bifurcated economy may serve as a bridge from the developed to the developing world.

Stephen Johnston - Partner - Agcapita Partners LP