PARTICIPANTS
Tom Dicker
Guest Host, Vice President & Portfolio Manager
Bill McLeod
Vice President & Portfolio Manager
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Voice Over 1: You're listening to On The Money with Dynamic Funds. The podcast series that delivers access, insights and perspective from some of the industry's most respected active managers and thought leaders. From market commentaries and economic analysis to personal finance, investing, and beyond, On The Money covers it all. Because when it comes to your money, we're on it.
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Tom: Welcome to another edition of On The Money. I'm your host, Tom Dicker. Joining us is my partner and co-manager on the Dynamic Equity Income Fund, Bill McLeod. Today, we're going to talk about the Canadian stock market, but before we get into the Canadian stock market, I wanted to talk a little bit about Bill. Bill, can you give me a little bit of background, how did you end up in the financial services industry?
Bill: My path is fairly unique. I came through undergrad wondering what I was going to do with the next phase of my life, and I ended up doing a couple of back-to-back summer jobs with my brother-in-law. At the time, he was a stockbroker. I have to admit that that lifestyle seemed pretty interesting to me, and long story short, it really opened my eyes listening to the morning calls that the research analysts and salespeople would have, and subsequently, the retail brokers would come in and glean ideas.
It just seemed the path of least resistance for my intellectual curiosity was to want to be one of those people, to be an expert in a particular subject matter. That was really the catalyst for me to investigate more about this world with which we now operate in and it really just morphed from there.
Tom: What about those early years made you want to be an investor?
Bill: I think it started with a combination of things. I'd be lying if I didn't say that there was a bit of perceived glamour. I think [chuckles] now that I'm here, it's a lot less glamorous than maybe I thought it was 20 or 25 years ago. It did rekindle a passion. I wasn't sure exactly what I wanted to do, and I found myself being drawn to the dynamic nature of that business. One of the difficult things that we deal with is blocking out the firehose of information that comes at us. There's a lot more noise than signal, but the flip side of that is that it is dynamic.
If you have intellectual curiosity, there's an endless number of things that you can sink your teeth into. Then also getting paid in some cases fairly well to do something that not a ton of people were doing. That seemed very exciting. Again, no two days really seemed to be the same and that interested me.
Tom: Really, not a lot of people were doing it where you were out in Vancouver. What was it like starting on the buy side, in a fairly remote location-- Vancouver is not a remote place, it's a big city, but in the investment world, it's remote.
Bill: That is a truism for sure. Vancouver does have a vibrant money management scene, but the seats are few and far between. I consider myself very fortunate to transition from the sell side to the buy side. After about a year and a half, an opportunity came up, and I figured at that time, it was important for me to get my institutional bona fides, as it were, within a real money management firm that had a process of developing and adhering to core fundamental investing principles. You don't ultimately know how you're going to fare when you make a change, when you change an industry, or make an abrupt change even within an industry.
I was very fortunate, again, that not only the opportunity came, but slide in with an investment team that had two very important characteristics. They wanted each and every one of us on the team to have our own independent thought and that really worked out well for me because, again, I got my hands dirty, but it ended up being in a safe learning environment. Again, 12 years later led me to here and the rest is history.
Tom: I want to talk a little bit about having a safe learning environment. What did that look like for you and how did it let you really dig your teeth into learning about the Canadian stock market?
Bill: I think the way I would frame it is that my boss and the senior people that I worked with, at the time, had a very good balance between the carrot and the stick. We talk on our team about continuous improvement, cooperation, collaboration, but all within the umbrella of holding each other accountable and just trying to get better at our craft every day. Looking back, I can appreciate it now much more than I could then. My boss at HSBC, he was just one of those people where, ultimately, he cared most about doing better for our clients.
His way of treating us as junior analysts and junior PMs coming along, helping him deliver that ultimate goal, was to provide a bit of tough love but always, again, give you latitude to make mistakes as long as you were willing to learn from them. Sometimes you would walk into his office, and you really thought you had one on him, you had done some work and sometimes he would just surprise you.
He would pick 10 or 20 holes in your thesis that you clearly hadn't thought about but it was all in the endeavor to make you think better, to have more conviction, so that he knew that when you ultimately were bringing him ideas that he was going to act on, you had done the requisite amount of work. We make decisions with imperfect information in this business. You're never going to bat 1,000, mistakes happen. I found it a very challenging, but safe place to learn my craft.
Tom: Can we talk a bit about your decision to move to Toronto and six years that we've been working together? Can you take us back to what was that decision like for you?
Bill: It's pretty shocking to me that it's been six years. I think I had been at HSBC for 12 years. I started as the most junior analyst on the team, and my last few years, I was the head of Canadian equities, making all of those portfolio-level decisions, having full discretion, and running the team. The growth agenda of being a small regional office in a very big, maybe if not the biggest global financial institution, has its own pitfalls in terms of resource allocation and just dedication from the top of the house to want to grow that platform outside of its core biggest markets.
I think I was having some internal frustration and the opportunity to come here presented itself. From that perspective, it wasn't really a hard decision, but it was just really an opportunity to have more responsibility on a bigger platform that was empowered to grow and work with a team that was six or seven times bigger than the team I was leaving. That satisfied a lot of itches.
Tom: You joined us as the Canada expert. I do want to talk a bit about the Canadian stock market today. There are some things about Canada that are structurally good and some things that are structurally bad. Canada has underperformed the US a bit this year. Could we talk a little bit about why Canada has underperformed the US this year?
Bill: It's actually quite common for equity market returns between Canada and the US to be different in any given year or even through a part of a business cycle. Over time, they actually correlate fairly closely together, but anytime we see a difference in those return dispersions, I think I come back first and foremost to, "What are the structural differences?" The Canadian index is a lot more cyclical between financials, industrials, energy, and material, that's three-quarters of the index. The Canadian economy, and by definition, the index just is a bit more prosaic.
It has more export orientation, more commodity exposure. It's much more geared toward a few sectors, like financial services and real estate. The US market and economy, it's broader. It's more diverse. The opportunity set is much bigger. The US economy is 10 times bigger. The US equity market is 10 times bigger, and I think just an extension of the differences in the economy also happened to show up in the equity markets. The US is the gold standard for entrepreneurship, small business development, always at the forefront of leading cutting-edge developments in terms of technology, startups, healthcare, biotechnology. I think we've seen a little bit of that play out this year.
The Canadian equity market is on track for not a bad year, it's just the US equity market is doing much, much better. Drilling down as to why that's the case, we have to understand the constituent makeup of the index. If we use the TSX as the Canadian proxy and the S&P for the US, there are just different companies and sectors that are leading the charge in terms of size and relative importance and the aggregate weightings of the companies that are performing less well or better year to date.
The three top-performing sectors in the US this year are technology, communication services, and consumer discretionary. There's been some gangbuster returns this year. I would say really what's driving that is a couple of things. We had peak valuations in those three segments of the market. Through pretty much all of 2021, interest rates were zero, the cost of capital was low. There were some very obvious world leading companies that were COVID beneficiaries within those segments of the equity market. Really, they were on fire up until the end of 2021.
2022 was pretty brutal. Sentiment changed, interest rates increased, the perception that growth would slow down, just changed the outlook, not only for growth, but for valuations. Those three segments from a valuation perspective just got hit too hard in 2022. The pendulum went from drastically overvalued to, in hindsight, maybe undervalued through the lows of late 2022.
We've seen I think year-to-date 2023 an inflection where that pendulum is normalizing, especially in those segments of the market and the very important constituent individual components that make up those parts of the market with companies that continue to show outsized growth. When growth is harder to come by, people will pay more for growth. In this case, not only just positive organic revenue growth, but there are also some self-help stories and cost-cutting stories that have really just ricocheted back.
I would say, somewhat surprisingly, in spite of the fact that interest rates are sustainably higher than maybe the market would have anticipated 12 or 18 months ago. We have companies like Nvidia, Amazon, Tesla, and Netflix that were really just hit too hard in 2022, have normalized and rebounded to something probably more appropriate in terms of evaluating fundamentals and the valuation that's being ascribed to them. That's driven the outperformance.
The last thing I would mention is anything that is close to the AI theme, which I think is the breakout story of 2023, has really had an exceptional year by and large. Canada just doesn't have that exposure. The big TSX heavyweights, energy, materials, financials have had much more meager or paltry returns. Really, with the exception of Shopify, which actually has had a pretty good rebound year, the heaviest exposures in Canada, the biggest weightings, the most consequential names from an index perspective, has just been drastically outperformed. I think that gives some context as to why that's been the case so far this year.
Tom: Definitely we can't talk about the Canadian stock market without spending a bit of time on the Canadian consumer and the banks and financials. We see in the news all the time that people are very worried about the Canadian consumer and their debt load. Can you talk a bit about what risk you think the Canadian consumer poses to the financial system? Is it risky right now and how broadly are you thinking about our allocation to banks in, say, the Dynamic Equity Income Fund where we can own them or not own them?
Bill: For sure, there's been a few factors that have exacerbated the Canadian consumer debt level. There's been an imbalance in the supply and demand of housing for a long time. Again, just forcing people to reach given the lower interest carrying burden of very low interest rates. When I think about it as a risk and how existential it might be, conventional wisdom really says that the two most important factors as it relates to consumer and financial system stability are jobs and interest rates.
As of now, the Canadian economy is still sitting in a pretty good spot in terms of the unemployment rate. It's low. We still are creating jobs and people are employed and that's always the first most important thing because Canadian consumers are quite responsible, maybe not in terms of the debt they've taken on but servicing that debt and trying to stay true to the obligations that they have financially. Interest rates have been low for so long. I have to admit that we're about to see what a pivot and a sustainable move higher after an inflection is actually going to impact the real economy.
We are seeing fatigue from higher interest rates concurrent with the rampant inflation that consumers have had to deal with for the last couple of years, but the main thing that is constraining is the variable rate mortgages. They reset in real time and the consequence is really one of two things. You either allocate a higher portion of a payment to interest versus principal, so your amortization schedule is going to be a lot longer than you would have thought or you just have less disposable income because you have to make up the difference between what you thought you would owe under a certain interest rate regime and something more punitive right now.
We are seeing stress in terms of less disposable income. It probably manifests itself in the short term in terms of just lower economic growth than there would have otherwise been. Longer term remains to be seen. I think jobs will always remain the most important variable when we think of how bad could a credit cycle be, how much pain can the economy see in terms of going from low growth to a recession, credit losses going from something that is within the realm of normal in terms of historical ranges to something quite beyond that.
Only time will tell, to be honest.
The biggest hill that people will have to climb as it relates to interest rates, unfortunately, hasn't even been hit yet. There was a lot of mortgages originated, fixed-rate mortgages, three and five-year, and those will reset or come due and need to be refinanced more in 2025 and 2026. We really don't know enough about what the macroeconomic background will be looking out two or three years, but I will say for me right now, this is the key domestic financial risk that we have to monitor.
Tom: What gives you the confidence that the banks have done a good job adjudicating credit so far such that in 2024, '25, '26, when some of these really cheap mortgages, when they reset, that things are going to be okay? What levers do they have to pull? How do you think about the credit underwriting at banks? I know you were in your previous life a bank specialist, so I'm sure you've got lots to say on this.
Bill: What makes me most confident on the Canadian banks and their ability to get through any economic distress that we have is that the business model is tried and tested. They have incorporated lessons from past mistakes in previous cycles and they're just better at managing their business and their business risk and their credit risk than they ever have been before. They have stressed mortgages originated a couple of years ago at interest rate levels much higher than they were actually originated at.
There's a buffer just inherently in those mortgages that are going to reset and come due in a couple of years. They have a very pragmatic relationship with the regulator. These are things that are being looked at weekly. There's a lot of eyes on this from a macro-prudential sense. The banks are super well-capitalized. Not only are capital levels today higher than they were previously, but the quality of that capital is of better quality. I never assume that things can't get worse.
You always have to prepare for a scenario that might be outside of the most recent experience. The simple fact of the matter is Canadian mortgage loss rates at their worst are still de minimis relative to any other bucket of credit that they lend, whether it's an unsecured personal loan, a credit card, things like that. The Canadian mortgage market is very resilient. The loan-to-value ratios are low. There's insurance on high loan-to-value mortgages. These are just some of the things that I think we take comfort in, in terms of the business models being resilient, management focusing on this in many cases where they can, getting ahead of any problems that they see. These are things that we take comfort in.
Tom: Bill, you mentioned quality. Maybe we could switch gears away from the financials, the banks, and talk a bit about the railroads. Can you talk about why the rails are a good business and maybe give us a bit of history?
Bill: There are many things to like about the Canadian rails. First and foremost, it's just the structure of the industry is very favorable, really at all points in the cycle. The assets are irreplaceable. The rights of way are invaluable. You just cannot replicate the physical infrastructure that the rails have. The industry structure is also very attractive in terms of a certain segment of customer being captive.
There's also just less competition because the rails have just structural relative efficiency advantages versus other modes of transportation, especially if we took truck, for instance. Once you get into long haul, heavy bulk segment movements on an energy equivalent basis, it's just very difficult to compete with the railroads.
The Canadian rails also pioneered what's called precision scheduled railroading. This really pushed the envelope in terms of efficiency from both a service and cost perspective, drove market share gains against other forms of transportation, and ultimately, allowed very strong pricing growth and significant asset optimization, CN and CP. They have these quality characteristics that we on the Equity Income Team look for, structural advantages in the asset base, well-managed, well-capitalized, strong balance sheets, able to control their own destiny because of all those factors and the interplay between them.
CN Rail has a new leadership team, but they have shown a renewed commitment to operational excellence which has been a bit lacking in the last few years, but we expect this renewed focus on execution during the next cyclical growth phase, to lead to very strong operating results.
There's a ton of operating leverage in these models. This will drive earnings growth and cash flow growth and very aggressive shareholder returns through stock buybacks and dividend increases. CP Rail on the other hand is going through and absorbing a recent transformational acquisition of Kansas City Southern and given its status as having the best management team in the industry, we would expect similarly attractive if not better fundamental and financial outcomes, as I referenced for CN.
Tom: When you think about the telcos in Canada, that's a business that has some characteristics that are similar to the railroads and then some that clearly aren't. Could you talk a bit about whether or not you like the telcos? They've definitely underperformed a bit this year and maybe shed a little bit of light on why. How are the Canadian telcos different from the US? Does the Rogers-Shaw merger change your long-term view? How are you thinking about the telcos these days?
Bill: The telcos are another area that we find domestically, that can be the foundational component to a portfolio. I referenced off the top that the Canadian equity market is a bit too concentrated for our liking. It's a bit too cyclical, but there are still ideas that create the foundation of that portfolio that we find domestically. We usually look for industries that have a few different factors going for it. We like market concentration. We like rational oligopolies. We like industries that have healthy relationships with regulators and the Canadian telcos would be a poster child.
What makes Canada and the US different from a telco perspective, Canada is less competitive. It's been functionally a three-player market for the better part of the last 10 or 20 years. You do have a more serious fourth player now, after the Rogers acquisition of Shaw and subsequent divestiture of the wireless assets to Quebecor but given the financial leverage that Quebecor and Rogers have after this acquisition spree, we would expect the marketplace to stay rational, albeit slightly less attractive than before.
Another key difference between Canada and the US telcos comes down to geography and population. Physically, Canada is just a huge country but demographically it is quite small. There's just not as many people. The Canadian participants need to spend and build on massive infrastructure across a vast area, but with only a few heavily concentrated pockets of population. The regulatory backdrop is also very important and seems to be more topical in Canada than I think some people would like. It's important as it relates to pricing.
It's important as it relates to spectrum auctions, commercial access and potential wholesale relationships for participants that don't have physical infrastructure like the incumbents. We do have to acknowledge that any potential changes in that regulatory framework could have consequences that would impact revenue growth, margins, return on invested capital, free cash flow, and dividend growth. We certainly pay attention to that. Post acquisition the long-term view, while moderately less attractive because there will be a healthier fourth competitor, is that the outlook under most circumstances remains fairly compelling.
Canada has a growing population which at least, in relative terms, I think is probably one of the highest in the world from immigration and we do have relative under penetration of wireless handsets. To me, these augers well for a solid steady state, and the industry is also going to be more focused on operational efficiency. The Canadian telcos do have a lot of opportunity to be more disciplined in terms of taking operating costs out.
We would also expect future capital expenditure levels to trend down. When we look at that in totality, at current valuations, the group seems attractive on a risk adjusted basis for that portion of the portfolio that you would want to be relatively more defensive and stable in terms of dividend growth and payment.
Tom: Why did they underperform so much this year? Was it really just around that fourth player coming in or was it interest rates or a bit of both?
Bill: I think it's a function of a few different things. First and foremost, higher interest rates are not going to be constructive. They are a yield-oriented sector, so there is a negative correlation to that interest rate proxy. There's also been some confusion exactly how the competitive landscape will evolve, now that the fourth wireless player is in more stable healthier hands. The Shaw-Rogers acquisition took a lot longer to consummate than we thought. There was a vacuum of information during that period. We also lapped some very easy comparables coming out of a pandemic, which traditionally would've been received quite well.
Going forward the growth comparables that were once easy and got better now become more difficult. I think we are just waiting to see exactly how competitive Freedom will be in Quebecor's hands and what the other Canadian telcos will do in terms of matching any aggressive pricing action to protect market share. We still think that more rational heads will prevail. We don't think it behooves anyone to have a race to the bottom in terms of fighting for a marginal sub with an uneconomic plan, but I think the unknown around that is causing some consternation and is not helping sentiment and valuations.
Tom: As you mentioned before, there are some great defensive areas in the Canadian stock market but there are a lot of cyclicals. When you think about cyclicals, are there still some areas that are investible? I'm thinking energy pipelines, that sort of thing.
Bill: Yes, for sure. I do think the Canadian marketplace, while being more concentrated than we would like in certain areas, do have world-class opportunities. The energy industry in Canada is much better managed in terms of the companies and their adherence to principled capital allocation and also focusing on production and exploration in a way that's much more responsible than maybe previous cycles. You mentioned the pipelines, energy infrastructure is getting much more challenging with each passing year to increase the size of.
It's almost impossible to get a new pipeline sanctioned, approved, financed, built, and operational. Just by virtue of that, legacy pipeline should be worth more. We do have energy infrastructure opportunities in Canada and exploration and production companies that are world class at our disposal.
Tom: What about some of the areas in the Canadian stock market that are really big relative to the US like gold, metals, mining? How do you think about that whole materials sector which makes up almost 20% of the Canadian stock market? How do you think about the materials sector?
Bill: The materials sector in Canada is one that we are underexposed to. Quite simply, over long periods of time, the materials space has created the least amount of value with the highest amount of volatility. Those are two characteristics that are doing the opposite of what we want them to do in terms of the Dynamic Equity Income Fund. That being said, there are sometimes in a cycle and some opportunities that present themselves even within materials that we would be interested in.
We have exposure to agriculture because we think that is a secular growth area. Canada does have a robust agriculture space. Nutrien is a company that is very well balanced and diversified by product mix and by segment. Not to say it's not volatile, it still is a basic commodity, but they have a history of stable production, healthy cash flow. I think they've gotten more discipline in the last 5 years than maybe the previous 10 in terms of capital allocation, managing supply, and treating shareholders more favorably in terms of share buybacks, dividends, and at the margin making smarter capital investment decisions that we think will create value over time.
Tom: What's the Canadian stock market missing that you think is essential for an investor trying to construct a proper equity portfolio?
Bill: If we take the starting point that the Canadian equity market is overly cyclical in terms of how we would want to construct an optimal portfolio, we have to go elsewhere to fulfill what we're trying to accomplish. We're focused on investing in quality companies at reasonable prices. We want to protect capital. We want to find companies that generate sustainable and growing distributions, and we want that with lower volatility where we can get that.
The Dynamic Equity Income Fund adheres to that philosophy, and we construct a portfolio with balance and diversification in mind, not only by geography but across sectors and within industries, and of course, always search for that next best idiosyncratic investment idea. The foundation of the portfolio remains Canadian-focused. We go to those segments of the market that are structurally the most attractive and resilient. To overcome the fact that the Canadian marketplace has a relative dearth of higher quality, large, liquid, well-capitalized, dividend paying companies, we do go to the US market for that exposure, and we get opportunities that are not available to us domestically.
The US has a multitude of best-in-class technology companies, really across the whole information technology spectrum. We go to those spots in health care that have durable secular growth trends, pharma, medical devices, tools, managed care. Finally, we have access to globally recognized consumer brands, just to mention a few. This flexibility, in my opinion, gives us the potential to create a higher quality portfolio.
Tom: I just wanted to change gears a little bit and talk a bit about investing more broadly. How do you deal with an investment mistake? What's your process for identifying an investment mistake and learning from them?
Bill: For me, a good starting place to keep myself honest and try and hone my craft and get better is by having a heavy dose of humility. I'm not going to fool anyone if I don't accept the mistakes that I make and move on and try and learn from them. Any process where you're going to do that has to first start with admitting and accepting a mistake. One of the beneficial aspects of having experience in this business is that there can be pattern recognition. What sort of biases seem to precede certain mistakes that you're making? Are you taking an analytical shortcut for an easy win? Are you abandoning a core principle for fear of missing out? With all of that said, you do have to have some degree of rigor.
It's a lot less fun to focus on the losers than on the good calls. I think it's absolutely necessary to continue becoming a better investor. The beauty of this is it allows me to move on relatively unencumbered by too much scar tissue where I'm not afraid of making mistakes. I can get back to making decisions, accepting the fact that there will be errors along the way. It's all incumbent on first making an honest effort to learn from previous mistakes. If you can do that, it minimizes the cognitive dissonance of future decisions, and again, I think will make you a better investor over time.
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Tom: I think that's a great place to leave it. Thank you so much, Bill, for joining us today. It's been a pleasure working with you for the last six years and I hope you come on again.
Bill: Thanks, Tom.
Tom: Thank you for joining us.
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