Rich in natural resources, Canada's economy is booming. Here's how to profit. By David Landis, Contributing Editor March 31, 2006 Canada is the second-largest country in the world in terms of area. It has enormous energy reserves and is the U.S.'s largest trading partner. Yet Canadian stocks are prone to fall through the cracks of most U.S. investors' portfolios. While it may have been easy to overlook Canadian stocks in the past, it is no longer wise to do so. They have been on a tear over the past three years, delivering a 24% annualized return in U.S.-dollar terms compared with a mere 16% for Standard Poor's 500-stock index. The insatiable appetite of developing nations, particularly China, for Canada's huge stores of oil and minerals is a major reason for the recent boom. Canada is the world's second-largest source of proven oil reserves (behind Saudi Arabia) and a leading producer of nickel, zinc, aluminum and copper. The strength of its natural-resources sector has had substantial spillover effects, helping to create jobs and government budget surpluses and, in general, invigorate the economy. Although demand from China will ebb and flow, it is not a passing phenomenon. "There will be corrections, but the long-term outlook for Canada is decent," says Maxime Lemieux, manager of the Fidelity Canada fund. Canada accounts for a little less than 2% of the world's economic output, so don't go overboard -- Canada shouldn't account for more than a few percentage points of your stock holdings. In addition, the U.S. and Canadian economies are tightly linked. "Jumping across the border to Canada doesn't give your portfolio much diversity," says Kate Warne, Canadian market strategist for broker Edward Jones. One way to get exposure to a large number of Canadian stocks is through iShares MSCI Canada, an exchange-traded fund that tracks a 95-stock index. It returned an annualized 36% over the past three years to February 1. However, like Canada's stock market, the fund (symbol EWC) is concentrated in just a few industries. More than 75% of its holdings are in energy, materials and financial-services stocks. Advertisement Fidelity Canada, a traditional mutual fund, provides a bit more diversity plus the stock-picking skills of manager Lemieux. Energy, materials and financials make up 62% of the fund's $2.1 billion in assets, but it also has a sizable, 14% allocation to technology and telecommunications stocks. The fund (FICDX; 800-544-8544) returned an annualized 36% over three years. U.S.-traded Canadian stocks Buying Canadian stocks directly on Toronto's TSX and other exchanges is problematic for U.S. investors because of tax, foreign-exchange and other issues. Fortunately, about 150 Canadian stocks trade in the U.S. The four described below should fit comfortably in any U.S. investor's portfolio: Petro-Canada has a major interest in Alberta's oil sands -- a vast reserve of crude trapped in a mixture of sand, water and clay. Rising prices have made extracting this oil profitable, and potential profits are huge: The sands could contain up to 2.5 trillion barrels. Edward Jones' Warne likes Petro-Canada (PCZ) because its diverse operations also include Rocky Mountain natural-gas production, oil-and-gas exploration in the North Sea and the Middle East, and refining and marketing operations throughout Canada. At $46 in mid February, Petro-Canada's shares trade at 10 times the average of analysts' 2006 earnings estimates (according to Thomson First Call) of $4.42 per share. Inco is the world's second-largest miner of nickel, a key ingredient in stainless steel and products ranging from rechargeable batteries to jet engines. Its proposed acquisition of another Canadian miner, Falconbridge, will make it the world's largest nickel producer and could double its copper production and significantly lower its overall production costs. Nickel prices have weakened recently, but Chinese demand for stainless steel has been rising by more than 20% annually. At $48, the stock (N) trades for 14 times this year's expected earnings of $3.50 per share. Advertisement North American railroads are at full throttle (see "Railroads Reborn as a Growth Industry," Dec.). That's true as well of Canadian National Railway (CNI), the nation's largest railroad and one of the industry's most efficient operators. Growth in grains, metals, minerals and forest products will boost revenues 8% this year, and industry-best operating margins (operating profits divided by sales) could hit 36%, says Standard Poor's analyst Andrew West. He says the shares, recently $90, could hit $99 in a year. It should be no surprise that Canada's economic good fortune is good news for its financial-services firms. But Canada accounts for less than one-fourth of Manulife Financial's global profits. The world's fifth-largest life insurer has had a strong presence in Asia for more than a century. "There is a large emerging middle class in those countries, and they're going to want to insure their homes and lives," says Marc Johnson, editor of the Toronto-based newsletter Investment Reporter. He recommends the shares (MFC), which recently traded at $63. The integration of U.S.-based John Hancock Financial, purchased in 2004, could gradually boost Manulife's profits, expected to hit $4.20 per share this year.