PARTICIPANTS
Jason Gibbs
Guest Host, Vice President & Senior Portfolio Manager
Ryan Nicholl
Vice President & Portfolio Manager
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 pertinent questions, to find out their insights on the market environment, and navigating the investment landscape. Welcome to another edition of own the money. I'm your host, Jason Gibbs.
Jason Gibbs: Today's podcast is entitled navigating global markets. What a time it's been in the markets the past few years. We've gone from major euphoria post-COVID in certain stocks to a sense of almost despondency in some parts of the market in 2022, which probably shouldn't be too much of a surprise for those who have been in the markets a long time, like my guest, Ryan Nicholl here.
Ryan and I have been working together as colleagues for many years on the Equity Income Team. Ryan is the lead portfolio manager of the Dynamic Global Equity Income Fund and the Dynamic Global Strategic Yield Fund. He's going to talk to us today about how he's navigating the markets in this environment and some of the opportunities that he's seen. I'm looking forward to it. Ryan, how are you? Good to see you.
Ryan Nicholl: I'm great. Thanks, Jason.
Jason: Ryan, maybe we can start off before we get into some major topics, maybe just tell us a little bit about yourself and your background as an investor.
Ryan: Sure, the easiest way to describe myself is as a fundamental intrinsic value-focused investor. At the end of the day, pretty much everything I do is focused on, what are the companies we invest in worth, versus what do they cost. I'm really the guy at the computer screen at the Bloomberg screen digging into the fundamentals of businesses, what is the cash flow look like? What is the competitive moat look like? What are the fundamentals of these businesses?
Then trying to come to a well-reasoned estimate of intrinsic value. Then from that point, it's simple. It's really just buying the best set of quality businesses we can find that trade at a discount to what we think they're worth. This approach has really been developed through my background, if you go back all the way to the start, I started as an investment banker at Goldman Sachs focused on cross-border mergers and acquisitions, where every day for many hours a day I was focused on valuation work, building discounted cash flow models, understanding the intrinsic value of our businesses.
I really built up the solid technicals, and the fundamentals, to analyze companies, analyzing statements, cash flow statements, and really built my fundamentals from the ground up. From there, I moved to the investment side, the pension fund that was very much focused on long-term value investing. The businesses we were looking at were what is the long-term durable, competitive moat? What are these businesses worth? What is their intrinsic value and buying at a discount? I've been at Dynamic now for six and a half years, and my philosophy really hasn't changed.
It's fundamental, it drives everything that I do, and it comes back to the core question of just, what are businesses worth versus what they're trading at. That's my soul day to day focus.
Jason: My goodness, the past few years have been quite the lesson in the motions of the market. We go from a state of euphoria in certain stocks last year to 2022, where there's a bit of despondency in certain parts of the market. There's been a huge comeback in some of those euphoric stocks. What I'd be interested in as a value manager, how did you manage through the 2021 period where so many of these companies and stocks that had no cash flows and earnings were driven up to wild valuations? How did you manage through that?
Ryan: Yes, it's interesting. 2021 is really an extension of 2020. COVID hit and the market sold off very violently. Then it rallied almost equally violently, initially driven by work-from-home beneficiaries. That broadened out over the course of 2020 and 2021 into buying growth stocks, technology focus, but really anything that had high growth potential was being priced at ever-expanding multiples.
We got to a point when you got towards the end of 2021, where there's a pretty clear grouping of stocks in the market. If you looked at the one side, there was the growth stocks that had done so well for about 18 months coming out of the initial hit from COVID. If you looked at the MSCI world growth index, or just individual stocks, pick one like a Tesla or like a Peloton, the multiples that they got two were very, very stretched and couldn't, if I was going to model one with a discounted cash flow model, I couldn't get to a reasonable set of assumptions that will get me to those target prices.
The growth stocks in aggregate started to look like they were in bubble territory and almost approached to levels that they got to in the 2000 tech bubble. Those were a large component of the broader markets and that dragged up the multiple, the expensiveness of the broader indices as a whole. What was maybe not talked about as much of the time and is now more obvious in retrospect was that there was a big group of companies that were left behind.
A lot of them were defensive, higher free cash flow yielding, slower growing but still growing, but quality defensive businesses that are our bread and butter. They got left behind and they never really got expensive. If you look at their multiples, the MSCI world, high dividend yield index, or the MSCI world value indices just proxies for them, they were just trading in line with historical averages at the same time there was a bubble going on in growth stocks.
We positioned us accordingly. That fit well for our mandate. We run a defensive dividend-focused fund. We bought a large quantity of defensive staples and healthcare and utilities businesses with good free casual yields, good dividend yields, just attractive defensive businesses that weren't maybe as exciting as the growth stocks. When we did our fundamental work, we saw that they were undervalued, and we couldn't find that in other pockets of the market.
Coming out of 2021, we were sitting at something like 55% of our fund was in, call it defensives plus cash versus just 45% in traditional cyclical, which is a huge defensive positioning skew versus what say the MSCI World Index would be, which is only 30% defensives and 70% Cyclicals. Part of that is our defensive mandate, but the largest part of that was where we saw the opportunity and that positioning has played out well year to date.
The rise in interest rates has driven a sell-off in growth stocks and we've been relatively well insulated from that, and the funds have benefited as a result of our positioning. That just all comes back to our focus on valuation and not chasing what's working, but simply focusing on businesses, what their long-term value is, and holding the ones that we think are undervalued.
Jason: I guess that brings us to this year. Many of our listeners will certainly want to hear your thoughts on what's going on this year. As everyone knows, this has been one of the toughest years in the equity markets in a long time. Again, for those who know their history and who have been invested for a long time, it won't be too surprising. This is what markets do, they run the roller coaster.
However, saying that there's got to be a lot of opportunities out there. I know, Ryan, you and I could talk about it quite frequently. Maybe for our listeners, talk about some of the opportunities that you're seeing this year, and maybe some of the changes that you've made in the fund.
Ryan: It's hard for me to exactly say a specific opportunity. It's because the opportunities are now so broad-based. I was talking about before how there's a select group of attractive options at the end of 2021, where we are now with the massive sell-off and growth in cyclical, there's a lot of broad-based opportunities across the market. I think it's easiest to tell the story and to say how our fund has shifted over the course of the year.
If you look at the end of 2021, we were massively overweight defensive businesses because that's where we saw the value, but also because that's our mandate, we're essentially running a defensive dividend yield-focused investment fund. We were, at the time of the end of last year, we were at about 55% of our fund was in defensives plus cash, and about 45% was in cyclical.
That was very defensive when you consider that the MSCI world index, which is our benchmark, is about 70% cyclical and 30% defensive. What we've done progressively throughout the year was, we've taken our cash down as the market has sold off. Not surprisingly we're valuation focus investors, stocks look cheaper, we're getting more ideas, more upside in the names we look at. Our cash has gone down throughout the course of the year on the sell-off from about 9% at the start of the year to about 2% as at the end of last quarter. We have been selectively trimming some of our defensives.
They've held in relatively better, which means they have been they're now relatively a little bit less attractive than they were. I've been adding primarily to a lot of those old growth stocks that I used to think were far overvalued that I think are now a lot more recently priced. Where our adds have been throughout the course of the year has been into technology, into internet media and retail stocks, into consumer discretionary stocks. You've seen the composition of our fund shift.
It's a pendulum. It's not a wholesale shift, but it is a shift over time where we've been buying some of those previously two expensive growth stocks. We've been improving the growth characteristics of our fund and the quality of our fund by adding to tech and internet media and discretionary, as I said. The mix has shifted from being 45% cyclical, 55% defensives to now being 10% the other way. Now 55% cyclical, 45% defensives, and cash. That change has mostly been the cash coming down, but also a little bit of a sale on the defensive side.
The fund has changed a little bit because the opportunity set has changed. Overall, the projected growth of the fund has gone up. The discount that we would've seen in terms of our price-earnings multiple, and our premium free cash flow yield has narrowed towards the index. Certainly, our growth and quality has improved throughout the year as it's progressed. Where we sit now is I think better balanced between growth and value, better balance within sectors.
We have been focused primarily on businesses that are overpricing recession versus avoiding businesses that we think may be underpriced the impact of COVID normalizing. If I look at it now, we're sitting at a fully deployed cash position with a well-balanced sector mix. I am very positive on the risk-reward characteristics we see that today in our fund.
Jason: One of the interesting aspects I've always found in the markets when the headlines are most positive, that's probably when your risk is a bit on the high side in terms of putting new money to work and investing. When the headlines are the most negative, that's when your risk is the lowest speaking in very general terms, and that's where your future opportunities are the best.
Of course, not that you can ever 100% time these things but looking at individual stocks. Ryan Recession, speaking of headlines, that's certainly something that a lot of those listening will want to ask about. Given it is in the headlines, how do you look at recession risk in terms of how it impacts your companies and your investment process?
Ryan: I don't think I have a particularly strong ability to call whether there'll be a recession or not. I'm a fundamental company-focused investor. I'm not really trying to predict will there be a recession or won't there be a recession. I can see arguments for both sides as I look at it on the argument for recession, it's pretty clear that higher interest rates are impacting, and inflation is a problem. You are seeing cracks in the foundation if you want to call it that. Things like the semiconductor cycle rolling over, FedEx cutting their shipping estimates, consumer discretionary stocks, and profit warning as demand has fallen.
These are all classic signs you would see early indicators in a recession. On the other side of that, it's a pretty one-sided argument right now that investors think a recession is coming. On the other side, the more positive side, if there is a recession coming, someone forgot to tell the consumer because they keep spending at incredible rates. If you look at the nominal year-over-year consumer spending out there, it's running close to 10% just based on credit card data and other sources. That is an incredibly high level that is not indicative of a recession.
At the same time, employment is very strong. Unemployment is very low. Perhaps most importantly, for stocks, earnings have held in very, very well. I think we've come about two or 3% off the peak, but earnings are still up year to date and year over year basis, that is not indicative of a recession. There's opposing factors, there's clearly a hell of a lot of headlines around recession, there's clearly some signs of things cracking, but a lot of the core drivers like earnings, like consumer spending are still very, very strong.
That leaves me at a point where I don't know if there will be a recession, there might be, there might not be but what's more important I think from my perspective, is to a certain degree, whether there is a recession or not, doesn't really matter that much for the long term outlook for stocks. If you think of stocks in bond terms of their duration, the duration of stocks is very, very long. If you think of a higher yielding, slower growing stock, if you go and you model at DCF, you project out their cash flows into the future and you discount them back appropriately. The duration, the midpoint of future cash flow is greater than 10 years.
If you go look at higher growth stocks with higher multiples, the duration is measured in 20, 30, 40 type years. Whenever you're looking at stocks, you're really talking about the future value of businesses that are determined and measured in decades rather than certainly not in months, and not in years. Back to the point of recession, whether GDP on a global basis is -2% this year or +2% this year, it doesn't really matter that much to the long-term intrinsic value of the businesses we invest in.
It, of course, matters more to stocks and stocks are more volatile than their intrinsic value, and there then lies the opportunity. Year to date as we record this, the market is down almost 25%, but earnings have gone up so it's really been entirely multiple contractions thus far. Certainly, earnings can break down as we go forward, but you're at a starting point where the multiple has gotten a lot cheaper. A lot of businesses are certainly pricing in a recession and whether or not that's going to come through is certainly debatable at this point in time.
Jason: Ryan, in the context of the major sell-off that we've seen generally this year, why don't you talk about some of the opportunities you're seeing in your global funds?
Ryan: The opportunity set now is more attractive than it's been in a long, long period of time. As I mentioned, there's been a pretty much entirely multiple-driven derating and stocks year to date, they're off almost 25%.
That's put us at a point now where historical multiples if you look at it on price earnings multiples are free casual yields are basically back to in line with their long-term averages. You could say, "Okay, they're in line with long-term averages, that means they're fairly valued." This is obviously a more complicated argument than that. You could say, "Okay, maybe earnings risk is a little bit higher now than it's been on average historically because of interest rates and inflation and recession."
On the other side of that, I would argue that the opportunity set, the quality of businesses that make up the global indices at this point in time, is probably better than they have ever been. If you look at how the global stock indices is made up these days, the biggest bucket of it is what I would call IP-driven businesses are in E-driven businesses. Things like technology, internet media companies like healthcare.
These are businesses that drive their competitive moat through R&D, through network effects. These businesses have very, very high margins. They have very, very sticky businesses with high switching costs. They have good long-term growth prospects. That's a very, very large chunk of the index right now that is in very high quality, high growth, strong, stable businesses.
You start going through the sectors and then you get into energy, which is in a very, very strong supply and demand balance right now that puts them in a good position. You go into things like financials and materials that are generally beneficiary of inflation and higher interest rates, financials beneficiaries of higher interest margins, materials beneficiary of higher commodity prices, and you add all those up and you're getting to something like two-thirds of the sectors that are in a relatively good position to weather the current environment that are the core backbone of the market is in very, very good businesses.
I haven't even got to some of the other defensives like staples and utilities and some other good business in discretion industrials. It's easy to build a very, very diversified set because there's a lot of high-quality businesses out there. Now that we've had an entirely multiple-driven derating, the opportunity set is much, much more broad. There's still the board defensive businesses we thought were attractive at the start of the year. Those are still attractive. Now a lot of the more growthy names that have sold off are also more attractive.
What we're doing on a day to basis is just trying to understand where the opportunity lies. That includes things like going say okay, which of these is really just COVID over earners that have sold off? That is not an opportunity, but how much of this is just a recession being priced in that there may or may not be a recession, but regardless, it might be a bit overpriced. We're just focused on saying where intrinsic value is. How much has it shifted and where are the price opportunities? We're finding a broad set of investible ideas now that is far better than we've seen at the end of 2021 and the best I've seen in a long, long time.
Jason: Ryan, maybe we can talk a little bit about some of the common mistakes that you see investors make. This being a very humbling profession of course, but just your thoughts on that.
Ryan: Yes, I can think of mistakes at a professional institutional level, and then there's obviously different mistakes at a more individual investor level. At the professional level, the mistakes that bothered me the most I would describe them as short-termism. If you look out in the investing environment today whether it's on CSME, if you look at the sell-side analysts covering companies, just in investor news, there's a lot of focus on short-term issues, on things like momentum, things like catalysts that could drive shares higher or lower. This has led to an environment of people thinking of stocks and little bite-sized chunks that don't really tell the whole story.
When I look at a stock, I focus on when we buy a stock, we're not just buying like a quoted share price on a Bloomberg, we're buying a proportional ownership in a business. When we look at these businesses, they have a long-term value that is pretty sticky and we do our best to focus on, "Okay, what is the entire future value of this business, of this share, of this proportional ownership that we own?"
That is often not impacted much just by how much they meet or miss by on the next quarter or what's a short-term catalyst. I find the market gets driven by a lot of short-term narratives to the point where there's a lot more volatility and share prices than there should be relative to the underlying intrinsic value. Therein lies a mistake that others make but also the opportunity that we find where there's a lot of short-term noise even at a professional level, investors focused on issues that are meaningful on a short-term basis but don't have that much impact on long-term intrinsic value.
When we see that happen that's where we get opportunities to sit back and focus on our fundamentals, focus on what we think our business is worth and take advantage of that volatility and share price to add to positions or trim positions when the opportunity arises. It's different at an individual level. My advice to individual investors now is that it's easy to feel fear when the market's sold off by almost a quarter as it has now.
I would just highlight the point that stocks are now less risky than they were a year ago. It's hard for a lot of people to understand that, but there's two fundamental risks in investing. There's fundamental risk and there's valuation risk. Fundamental risk is always there, it's always present. It's always a risk that the business is not as good as you thought it was that something can go wrong.
The other side of that equation, valuation risk, that risk is much, much lower now. Stocks are cheaper. You can build a high-quality portfolio with a good free cash flow yield, something like a 7% free cash flow yield, 3% plus dividend yield with good businesses that are certainly going to grow over their time. Buying stocks at depressed prices and holding them for a long period of time, compounding attractive returns or long term.
This is the appropriate lower-risk way to generate good investment returns over a long period of time. The key for individual investors is to stay invested and take advantage of opportunities and just highlight the point that stocks are less risky now because they have sold off, they're not more risky. Take a long-term view, follow Warren Buffet, and be greedy when others are fearful.
Jason: Ryan, putting it all together, who do you think should invest in your funds, the Dynamic Global Equity Income Fund, and the Dynamic Global Strategic Yield Fund?
Ryan: Yes, anyone who's familiar with the Equity Income Team will know our approach. We're running a defensive quality dividend mandate and we're trying to generate a smoother path of returns over the long term. Global markets but all equity markets are volatile and we are trying to smooth out the downside. The expectation for our funds would be for them to outperform and drawdowns and then to do our best to keep up with the market when they're rallying.
We're never going to have as much immediate upside when the market first rallies but our focus on quality businesses with attractive valuations tends to compound very attractive risk-adjusted returns of a long term. If you want to think of our funds in terms of characteristics, if you look at Dynamic Global Equity Income Fund, if you were to compare it to our benchmark, the MSCI World Index, the fund would have a lower beta, it would have lower stock level volatility so that our share prices on average would move around less than the average stock.
We would have better credit ratings and lower leverage. We would have higher margins, we would have higher free cash flow margins, higher free cash flow conversion, higher return on equity, higher return on invested capital, so all the characteristics of what we would call a defensive quality fund, but there's also a valuation focus. We would have a lower price-earnings multiple, higher free cash flow yield, higher dividend yield.
If you really want to summarize the funds at a basic level, they're defensive, they're high quality, and they're attractively valued. The best investors are-- I think these funds would target maybe those who are a little bit nervous of losses. Our funds are designed to have defensive layers of production built throughout them to go down less when the market sells off, and just to really develop a smooth path of returns with lower drawdowns and nice steady, attractive risk-adjusted returns of a long-term. Our funds are defensive and predictable, and high-quality attractive value.
Jason: That's great. Thanks, Ryan. I think that's been a wonderful summary for our listeners, of how you're looking at the markets and some of the opportunities that are out there. There certainly are a lot of opportunities, and how you've invested in your funds. Thanks so much, Ryan, and thanks to all of our listeners. This is another edition of On The Money, and on behalf of all of us at Dynamic Funds, we wish you all continued good health and safety. Thanks for joining us.
Speaker: 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, @dynamic.ca.
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