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for foreigners to buy, the more loonies they need to purch

in order to own that stuff, and this pressures the loonie higIn addition to higher commodity prices, the surge in hot mflowing into Canadian capital markets helps push the C-dhigher (seeHot Money, Cold Country.)

One of the innocent bystanders amongst all this cheer hasthe Canadian manufacturing sector. Energy inputs are a sicant part of manufacturing costs, biting into their bottom lMore importantly, the resource-inspired rise in the Canaddollar means that the prices of manufactured goods for salCanada tend to become more expensive relative to those sgoods manufactured overseas. Local wages, which must bin Canadian dollars, are slow to adjust downwards and, asresult, manufacturing margins are pummeled. It doesnt helpthat other countries with much cheaper labour are competin the same manufacturing arena and able to offer better p

In chart 2, we show manufacturing returns on capital relato average Canadian returns. In general, manufacturing oupaced most sectors through the 1990s. This was a manufaing golden age characterized by weak resource prices and afalling loonie. Things changed dramatically in the early 2as the resource/c-dollar boom kicked off in earnest. This ision, of course, illustrates the Jekyll and Hyde dilemma faCanadian investors. Prosperity in resources cannibalizes mfacturing.

We have constructed a Canadian manufacturing equity indwhich is comprised of Bombardier, CAE, and twenty othemanufacturers who have been publically traded since 199qualify for inclusion, all companies had to have a significa

Canadian manufacturing vs. Canadian resource companies, and why it might be time to get back into manufacturing

Investing is hard, but to compound the problem, the Canadian

investor faces an extra dilemma: we have a Jekyll and Hyde econ-omy. This stems from the fact that Canada has an outsized re-source sector as well as a large manufacturing sector, combinedwith a floating exchange rate that bobs around with resourceprices. The resulting tendency is for a strong resource sector to be accompanied by a weak manufacturing sector, and a weaken-ing resource sector to go along with a strengthening manufactur-ing sector. There is no universe in which both do remarkablywell. Canadian investors need to be aware of the Canadian econ-omys Jekyll and Hyde nature in determining the makeup of theirinvestment portfolios.

In general, the Canadian economy has outperformed most na-

tional economies over the last decade and, as a result, the averageCanadian household is wealthier on a relative basis than we oncewere. This general outperformance is no doubt due to rising re-source prices, which help not only the oil, gas, and mining sec-tors, but have spill-over effects that permeate the entire Canadiancapital structure. Rich drillers in Fort McMurray and loaded min-ers in Timmins mean prosperous donut shop owners, and pros-perous donut shop owners mean healthy bankers. You get thepoint.

Because we are significant exporters of resources, and the pricesof these tend to be volatile, resource prices have a tremendousinfluence on Canadas terms of trade. This latter refers to theratio of Canadas export prices to import prices. The terms of trade, which have moved dramatically in our favour since 2000,have encouraged the upward movement of the Canadian dollar.(See chart 1) After all, the more expensive that Canadian stuff is

Pollitt & Co. Inc.11 King Street West, Suite 1950, Toronto, ON. Tel: 416.365.3313625 Boulevard Ren Lvesque Ouest, Bureau 930, Montral, QC. Tel: 514.395.8910

Canadas Jekyll and Hyde economy

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number of their facilities in Canada. This index (see chart 3) hasremained mired below 2002 levels. Chart 4 shows the ratio of our manufacturing index to an index of 50 non-manufacturingequities, also publically traded since 1994. In general, investing inmanufacturers outperformed through the 1990s up till around2002. From then onward they were a losing proposition and non-manufacturers, in particular resources, became the game of choice. The ratio bottomed out in 2009, although weakness in2011 among manufacturers leaves one wondering if they haveindeed turned a corner.1

Here is the case for why Canadian manufacturing stocks, havingplayed the dastardly Mr. Hyde for the last decade, might turn back into the more affable Dr Jekyll:

A. The necessity of adapting to a continuously rising Canadiandollar means that Canadian manufacturers have probablynever been as efficient as they are now. This is the oppositeof 2001 or so when, having grown fat and lethargic thanks to

The information contained in this report is believed to be reliable, but its accuracy and/or completeness is not guaranteed. All opinions, estimates and other information included in this report constitute our judgement as of the date thereof and are subject to change without notice. Pollitt & Co. Inc. does not issue ratings or price targets on any securities mentioned within this letter, nor does Pollitt & Co. Inc.maintain and publish current financial estimates and recommendations on securities mentioned in this publication. Pollitt & Co. Inc. discontinues coverage of the stocks highlighted in this letter. For informa-tion on our policies on research dissemination, please see our website, www.pollitt.com. Stock Recommendation System and Terminology: Pollitt does not issue price targets for companies. Pollitt intends tomaintain a Buy List of 10-15 stocks. The listing of a stock on the Buy List should be considered as advice to carry a position in that stock. The removal of a stock from the list should be considered as advice toreduce a position in that stock. Pollitt provides continuous coverage of all stock ideas on its Buy List. Stocks currently on the Buy List are Franco-Nevada, Molson Coors, Pulse Seismic, and Softchoice.

the benefits of a constantly falling loony, inefficient Cdian manufacturers were blindsided by the that currencyreversal.

B. While Chinese manufacturers will continue to take awlow margin business, particularly in non-durables, Cadian manufacturers enjoy an advantage in the realm ocomplex manufacturing processes requiring large invements in human capital like education.

C. With the glut of natural gas coursing through North Aica, and what seems to be a massive oil boom on its w(seeThe Blue Eyed Sheiks are Back), energy prices willprobably not have the same buoyancy they did duringlast decade. As a result our terms of trade should softeensuring the C-dollars buoyancy is pricked. For thosemanufacturers left standing after a ten year manufacturecession, a weaker dollar would be a godsend.

John Paul Koning jpkoning@pollitt.com

Toronto, OntarioFebruary 14, 201

1. For the curious, here is an explanation of how we built our indexes. For themanufacturing index, we used monthly price data for all manufacturing stockstrading on the Toronto Stock Exchange in 1994 and 1995 that currently totrade on the exchange. For our non-manufacturing index, we randomly chose 50TSX listed non-manufacturers in 1994 who continue to trade on the TSX. Re-

gardless of their market capitalizations, we set each stocks initial trading value

equal to $1. The final value of either index is the median price of all componentstocks. Median values rather than averages avoid outliers that skewed the final results.

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