Managing Director and Head of Dynamic Funds
Vice President and Portfolio Manager
Mark Brisley: You are tuning in to On the Money with Dynamic Funds, a podcast series that delivers access to some of the industry's most experienced active managers and thought leaders. We're sitting down to ask them the pertinent questions, to find out their insights on the market environment, and navigating the investment landscape.
Mark Brisley: Welcome to another edition of On the Money. I'm your host Mark Brisley. As we emerged through the tunnel of this global pandemic and see the light that no longer appears to be a train, the long-term effects of an event of this magnitude have, and will continue to have, an impact on the way we live, work, and play. It has also had a massive effect on how we look after ourselves, our access to healthcare, and how we will govern ourselves going forward to protect against future risks.
While the development of the vaccines late last year has hopefully put the worst of this pandemic behind us, the surge in the Delta variant has us take stock of where we are exactly in the virus's trajectory and makes this an opportune time to review and discuss the remaining risks as we move forward. It's also an opportune time to look beyond COVID optimistically and dig a little deeper in on the healthcare sector as a continued investment opportunity.
For my two guests today, the healthcare sector has been a top weighting in their global portfolios, specifically to highlight the innovative product development that is taking place in this space as the result of a global healthcare event. I'm pleased to be joined by Vice President Portfolio Manager Eric Benner, and portfolio manager and healthcare investing specialist, Ryan Nicholl, both global managers with a focus on identifying and describing the opportunities that are available within the sector.
Eric and Ryan combined have over 33 years of industry experience, are members of Dynamic's Equity Income team that uses a disciplined process known as QUARP or investing in quality at a reasonable price while focusing on dividend-paying stocks. Gentlemen, thanks so much for joining us today. Eric, I'm going to start with you because healthcare, as I mentioned, has been the largest allocation in your global funds for some time now. Can you describe the role that these investments currently play in your portfolios?
Eric Benner: On the Equity Income team, our investment philosophy is quality at a reasonable price. That means that we focus on identifying high-quality businesses, and then we aim to invest in those businesses at attractive prices. The other core pillar of our investment philosophy is protecting capital. Lastly, we have a focus on dividend-paying stocks. The healthcare sector plays a key role in our portfolios because it checks so many of these boxes for us.
In terms of quality, healthcare businesses tend to be high-profit margin, cash flow generative, and high return on invested capital businesses. These high margins and high returns are typically protected from competition by competitive advantages, or what Warren Buffett refers to as “economic moats”. For example, pharmaceutical businesses invest billions of dollars into research and development, but then the innovative drugs that emerge from that process are protected by patents for many years.
Medical technology businesses also have a patent protection component to their competitive advantage, but they also enjoy the benefit that comes with high switching costs. Once a hospital starts using a certain device or tool in their procedures, it's not straightforward to switch to something else to save a few pennies. Finally, US health insurers enjoy purchasing power advantages that come from their large pools of customers and are also investing heavily in data as well to optimize delivery of healthcare and also preventative care across their platforms. That's quality.
The other leg of our quality at a reasonable price school is, of course, reasonable price. We're focused on investing in businesses that offer attractive valuations relative to their fundamentals and we like to buy shares that offer strong free cash flow yields today, as well as strong free cash flow growth tomorrow and upside to our measure of intrinsic value, or what we think a business is worth. Lots of high-quality companies in the healthcare sector today offer very attractive free cash flow yields and growth, and the sector in general arguably trades at a less demanding valuation than the broader equity market.
When it comes to protecting capital, the other core pillar of our approach, healthcare stocks come in handy because they tend to be naturally defensive. The reason for this is simple, healthcare spending is not so much a function of economic growth of the business cycle, instead, it's a function of the aggregate healthcare needs of individuals in our society. Healthcare sector free cash flow growth tends to be driven more by innovation and demographics over time, both of which are relatively favorable for the sector.
Lastly, when it comes to dividends, there are plenty of dividend payers in the healthcare sector, and many of those offer yields that are relatively attractive today, sustainable, and with strong growth prospects. Putting it all together, healthcare investments are a great fit for the equity income team's approach and so our core holdings in our global funds.
Mark Brisley: All right, that's a great stage set for how things are playing out in portfolios and portfolio allocations as well as what some of the investment opportunities are going to be. I think all of our listeners are going to be interested and are going to want to hear, from an investment manager's perspective, where are we with the global COVID situation so, Ryan, how worried do we need to be about this Delta variant at this time?
Ryan Nicholl: It's a very topical question, the world does seem to be going through a Delta-driven wave at this point. Our thinking on this issue has changed over the past few months. If we were to go back in time to the spring, we would have looked at the scenario that we had where the original coronavirus, and even the initial variants, the spread rate, what we call the R0, how many people you're likely to spread the virus to absent any social distancing measures, we thought that spread rate was in the 2.5 to 3 range.
When you look at the initial success of the vaccines, they were showing efficacy in the 95% range, the US had pretty quickly gone into about half their population being vaccinated. When you combine that with about 20% of the population having a prior infection, that meant that about 70% or so, 65%, 70% had a reasonable amount of immunity protection from the virus. Given that additional 2.5 to 3 spread ratio, that was enough for the US to just be at herd immunity.
Canada was a bit further behind in our vaccine rollout due to lack of supply, but the demand was clearly there and the intention to get vaccinated was clearly there. We were confident that Canada, as we got supplies, would pretty quickly get to herd immunity.
What's changed in the interim period has been the Delta variant. Of all the variants we've seen so far, Delta looks the most transmissible. It doesn't necessarily look the most deadly; if anything, it's probably a little bit less deadly, although we're not certain on that yet. The issue is that the transmission is much, much higher, the R0 that we're seeing on Delta is probably at least 4 and there's a potential that it's higher than that. That changes the math on what reaching herd immunity means. Now you need something more like 75% to 80% of the population to have broader immunity. That is just very, very difficult.
If you take the US as an example, their vaccination numbers are more in the mid-50s to high 50s range, and then you layer on prior infections, that doesn't get you there. On top of that, there's another issue is that the vaccines themselves do seem a little bit less effective against Delta. The original vaccine efficacy against infection was about 95%. Early data we're seeing on Delta shows that being more like 85%.
There's another issue on top of that is that the efficacy does seem to wane over time. If you think of how a vaccine works, it creates an initial antibody response that provides some protection, and then, over time, that antibody response fades and you're left with memory T cells. Essentially, memory in your cells of how to fight the virus if it comes back around again.
We're seeing early data coming out of Israel. If you recall, Israel was the first to really do a large-scale vaccination campaign back in the January-February timeframe. They are starting to see the efficacy of the vaccines fade. The most recent data they put out was something like 65% efficacy, that's probably a little bit worse than we'd expect just given some confounding factors like they were in the middle of reopening, but something like 75% efficacy seems reasonable.
If you layer on the 4 R0, the higher spread ratio combined with pretty low vaccination coverage in the US, and the vaccines just being a little bit less effective, meaning that even some vaccinated can still be carriers of the virus, that puts us at a point now where we no longer think the US has that herd immunity.
Canada is in better shape. We have a higher vaccination coverage. Our vaccines were also deployed more recently, so we're not dealing with fading efficacy yet and we also have a lower broader case count as a starting point. The US is in a bit more trouble. They have regional issues where there's large number of southern states that have low vaccination rates. What we're seeing now is that the US is going through a pretty significant Delta wave that is likely to get worse before it gets better. It's not clear yet how far that will go.
Eventually, you'll get the number of prior infections up to a high enough level to slow the spread, but I think we're in for a period of the wave getting worse before it gets better. Canada's a bit harder to call. We'll likely see some spikes here and there, but I think we're more broadly in good positioning. Overall, Delta is a more significant risk compared to where we thought we would have been a couple of months ago.
Mark Brisley: That all makes me think about implications going forward, especially as we're talking about investment opportunities in healthcare today. When this pandemic started, we had no idea what it meant for markets or investing or opportunities. Now that we have data and we have more information, we have vaccines, what implications do these spikes that we're talking about have for investors?
Ryan Nicholl: We can look at that from a healthcare perspective or just a more broad market perspective. On the healthcare perspective, our analysis of the situation with COVID led us to believe that vaccine boosters would be necessary, that the waning efficacy leads to the need to get that efficacy back up close to 95% if we can. It also makes vaccination of children more likely. That gave us more confidence in the vaccine manufacturers from an investment perspective. It also gave us more confidence in the testing companies and medical technology and life sciences. That as numbers went up, testing numbers would likely go up as well. That the offset in healthcare would be that elective procedures are likely to be deferred in favor of treating COVID patients, so that maybe is a bit of a headwind for the medical technology companies. Puts and takes in healthcare, but more so positive in the investments that we have.
On the broader economy, it's clearly negative if you see a spike in cases. Most people will still be in the reopening mindset. If you're younger and you're vaccinated and lower risk, you're probably not changing your behavior all that much. If you're older, if you're immunocompromised, even if you're just risk-averse, you probably do change your behavior to a certain degree, just given the spike in cases. At least the things like less people going into offices, less people going out to restaurants and events.
That does have an impact on the broader economy. It maybe takes the wind out of the sails of the grand reopening theme and it's maybe a bit more muted reopening than we would have thought of a few months ago. It does just make us a little bit more hesitant, a little more cautious on the more cyclical, more reopening-focused investments out there.
Mark Brisley: As we think about the social impacts and the impacts on health care and ultimately investors, thinking a little bit more about the science then, what new avenues of opportunity and actual innovation have been created by all of the accelerated R&D that we've seen during the last 18, 20 months?
Ryan Nicholl: It's really interesting. There's probably three different ways to think about it. You could think about it on the treatment side. You could think about it on the hospital side, you can think about the vaccines themselves. On the treatment side, they've been able to retrofit antivirals designed for other diseases to a fairly successful degree. Although I wouldn't call anything in there innovative to the point that it's changed the landscape at all. There have been major improvements in the hospital system that are important. They've greatly expanded testing capabilities with the installation of PCR machines and rapid antigen machines. Those can be repurposed for other uses, treating disease, and testing. That's very beneficial.
There's also been a broad buildout of ventilator capacities, so hospital systems are much better prepared for both future pandemics and for things like a bad influenza season. The system is better prepared to deal with widespread respiratory diseases. That's all positive.
The one area that its landscape is changing in terms of innovation is the mRNA vaccines themselves. We now have a clear use case where they work very, very well. If we went back a year or so, expectations, hopes would have been for a vaccine to be 75% or 80% effective. The mRNA vaccines came in at 95%, which is just a huge home run compared to what expectations were.
mRNA is a unique technology. Essentially, it's coding. Sending code to your body to produce proteins and be able to fight off infection and just generally be a useful mechanism for attacking disease. That has implications for a lot of other areas. The most direct would be in terms of other vaccines, the key one being influenza. Influenza has similarities to COVID and that it's a mutating respiratory virus.
The current vaccines for flu are actually not very good. They pick what strains they think will be dominant months and months ahead of time. Sometimes they're right and sometimes they're wrong. Sometimes the vaccines work and sometimes they don't. The technology to manufacture flu vaccines is pretty archaic. A large number of it's still growing in chicken eggs, so it's not a new technology.
mRNA technology, as we've seen with the adaptation to the variants, they can turn these flu vaccines around much quicker if they're successful. They can see what variant is dominant in the flu market, rapidly go for that, rapidly produce those vaccines, and get them out much quicker. It's pretty likely that the flu vaccines will get much, much better using mRNA technology. That has major implications on a disease. That's very dangerous for elderly populations and it causes a lot of problems. That's a potential innovation that could be very impactful.
There's other vaccination opportunities from mRNA, whether it'd be against something like Zika, against HPV, maybe even down the road against something like HIV, but it's not just limited to vaccines, that technology can also be used to just more directly attack diseases themselves. There's initial research going into using mRNA technology to fight cell tumors and cancer or to attack cystic fibrosis or even, down the road, maybe to help with other immune diseases.
If we look at all the innovation that's come out of the COVID situation, it's the mRNA technology that we're focusing on as having the greatest potential to really shift the landscape in healthcare.
Mark Brisley: As we think about what you've just referred to and what's happened since the pandemic started, what are some of the areas that are in progress right now that you see in pharma or medical technology based on the work that you're doing that are the next progressions?
Ryan Nicholl: When we look at healthcare, we have to remember that the core of these businesses, what they really are, are the research organizations. They research medical innovations that lead to better quality of life for their patients. It's the lifeblood of their businesses. We approach looking at R&D like business analysts, like investors. We look at, what are the biggest potential markets? What are the areas where there's an unmet need that can be actually improved by the technology? When you have a large addressable market and then advanced technology at least to better outcomes, you tend to get very strong uptake. If you have very strong coverage by insurance giants, and you tend to have pricing power.
The two largest causes of death are cardiology and oncology. Those are giant addressable markets. The third one I'd highlight is genetic diseases as an area of focus. The one I won't highlight but is worth mentioning is Alzheimer's. The issue we're seeing there is more from a business analysis perspective. I'm not actually sure if those drugs work or not and it's really hard to model anything concrete when there is uncertain use case for the underlying product. That leaves you open to competition and pricing pressure. We don't see those in oncology and genetic diseases, and cardiology is different.
In terms of oncology and cardiology, they're kind of interesting because their innovation is very, very different. The oncology, the cancer innovation is coming very, very much from the pharmaceutical side, from the biotechnology side. That's mostly happening through immuno-oncology. This is similar in a way to mRNA. It's using your own body to attack cancer. If you think of how cancer has been treated in the past, it's been, essentially, cut it out, or chemotherapy and radiation, which is not always effective and not very pleasant.
Immuno-oncology, essentially, trains your body to better find the cancer and then use your own immunity to attack the cancer than you were previously. This technology works very, very well. The biggest use case right now is in lung cancer and it's doing something like doubling the survival rates of a very deadly disease. The key here is immuno-oncology is already a very large industry, but the potential for a long runway of growth. It's enormous. Cancer is very, very complex, diverse across a number of medications. The survival rates have improved, but there's still a long way to go so they can make innovations in improving survival rates, and by combining different drug platforms to reach the best survival rates. We think immuno-oncology has a very long runway. Has very, very strong pricing power, and is a big investment opportunity.
On cardiology, which is the other major cause of death, there's not actually a lot of innovation on the pharmaceutical side. Where we do see innovation is on the medical technology side. This can be anything from just more evolution of old products, like, for example, pacemakers are now leadless. They're very small, they're very non-invasive, and they're much, much better to something that is more innovative, like transcatheter aortic valve replacement. In the past, you would get open-heart surgery, which is very, very dangerous and includes things like cracking your ribs open.
Now, they're able to do incisions and go through arteries and essentially implant a valve system within the artery that expands and replaces the old one. It's much, much less invasive, and it's just a dramatic improvement in outcomes. There's a wide range of innovations going across the med-tech companies in cardiology that are very investable for us.
The third and final one I'd highlight would be genetic diseases. This is not as big an indication as cardiology and oncology. Any individual genetic disease is pretty small, but when you add them all up, they're pretty significant.
What stands out here is just the absolutely enormous step function and standard of care that we are starting to see and may continue to see in gene therapy, gene editing, essentially.
They're now able to go in and replace the defective gene or copy over it, and then manufacture the protein and avoid genetic diseases that are often very, very serious, crippling, lead to early death, and are often occurring in children in many example. It's almost a cure or at least a very, very effective treatment. That just has massive positive implications both for the patients themselves and for the hospital system, they're reducing costs.
That would, again, lead to a large investable market with an enormous amount of pricing power.
If I just summarize, I'd say the two biggest ones: cardiology and oncology and then genetic diseases as a unique case where there's a major step forward in the underlying technology.
Mark Brisley: It's an incredibly well-rounded overview of that question. Ryan, it's got me thinking that, as much as we all wish we didn't go through this scenario, healthcare technology and future healthcare innovation actually comes out the other side probably better and stronger. That's probably not uncommon when we go through things like this, is it?
Ryan Nicholl: No, I think there's, obviously, been a lot of negative that's come out of the COVID situation. The positive we can take is that people, when faced with a problem, work together and innovate, and that's when you see real change in the healthcare system.
Mark Brisley: I want to move just for a final question a little bit beyond the healthcare sector. Eric, I think our listeners would appreciate an outlook overall for global equity markets. We certainly saw themes that emerged during the course of the pandemic. We're now seeing broader participation in the markets globally. Where are you seeing the most compelling opportunities as we sit here today?
Eric Benner: Equity markets, in general, do look a bit expensive compared to history here, but that might be for good reason. The world's economies are generally directionally reopening and recovering, and this is driving some pretty broad-based fundamental economic growth in earnings growth. Also, it's an inescapable fact now that interest rates and bond yields are really low here.
Where equities are trading today, there isn't that much in the way of viable competition for this asset class and the dividend yields and growth that it offers. It's understandable that stock valuations could be higher than history here. It's important to remember that high valuations, historically, don't tell us when the market will correct, or even if the market will correct. They just tell you that stocks have a little bit further to fall if there is a correction. Think of that as a risk indicator.
Importantly, though, we would not say that all stocks look expensive. The broad market and certain growth stocks, in particular, especially growth stocks without a strong track record of earnings are trading at a premium to their recent averages. That might be justified by recent trends, but they are definitely still trading at a premium. Meanwhile, defensive high-quality dividend-paying stocks as a group are actually trading at price-to-earnings valuation levels that are more or less comparable to their recent history. So, no premium.
Since the onset of COVID, we've gone through a few different periods in terms of the types of stocks that were driving market performance. First, starting in March of 2020 or so to around September, it was really growth stocks, particularly, those that were stay-at-home beneficiaries that drove market performance.
Then, starting around November when the vaccines that we've been talking about today, when their first trial results were published, it was the cyclical value reopening stocks that took the baton and drove continued market performance.
What these two periods had in common, though, is that in both cases, it tended to be higher volatility stocks that performed. First, more speculative growth stocks, and then more speculative cyclical value stocks, including these meme stocks that new retail investors are so focused on right now.
Which stocks were left out? Defensive high-quality dividend-paying stocks. There is some historic precedence for this. In 2001, and then again in 2008, when central banks provided large amounts of monetary stimulus into the market in a relatively short time, it did lead to a brief but sharp period of relative underperformance and quality stocks or what is sometimes referred to as a dash for trash in the market.
Importantly, though, in both cases, that's at the table for multi-year periods of strong performance from quality stocks as central banks slowly took away the punch bowl over time. Combined with the fact that defensive high-quality dividend-paying stocks as a group have delivered relatively attractive earnings growth through these tumultuous times, we see this as a potentially attractive setup for the group.
In terms of specific sectors that we like with exposure to this theme, in addition to healthcare, which we've obviously covered in some depth in this conversation, we'd also flag consumer staples businesses, particularly those with exposure to emerging market consumer spending growth, as well as utilities with exposure to renewable power opportunities.
In terms of regional opportunities, the US equity market, in general, and in aggregate, has a higher proportion of growth and technology stocks. We see that market as relatively well-positioned for things like any type of global COVID-related stumble, an economic slowdown, or a continued falling bond yields and interest rates.
Meanwhile, equity markets in developed Europe, developed Asia, and even Canada have a higher proportion of value stocks and cyclical sectors. We would see those markets as relatively well-positioned for continued reopening, recovery, and growth. For that reason, we try to strike a balance between US and international stocks and our global funds, with the US accounting for a little over half the funds' investments.
This is also true for our healthcare sector investments, where we see compelling opportunities in healthcare in the United States, as well as internationally. We are overweight the sector in both regions in the global funds.
Mark Brisley: Thanks very much for that overview, Eric. To both of you, I want to thank you both for your insights. It's such a timely subject with respect to the healthcare sector and just how that has permeated our lives, but also, where do we go on the investing side and try and leverage some of these great innovations and advances that we've talked about.
For our listeners, if you'd like any more information, please feel free to visit us at our website at dynamic.ca for more information on these portfolio managers, including the entire range of the equity income teams' offerings and viewpoints through various commentaries and other pieces of information. I want to thank everyone for joining us today and Eric and Ryan for sharing their thoughts. Again, this has been On The Money. We continue to wish everybody good health and safety.
You've been listening to another edition of On The Money with Dynamic Funds. For more information on Dynamic and our complete fund lineup, contact your financial advisor or visit our website at dynamic.ca.
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