PARTICIPANTS
Jason Gibbs
Guest Host, Vice President & Senior Portfolio Manager
Nick Stogdill
Portfolio Manager
Announcer: 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.
Jason Gibbs: Welcome to another edition of On the Money. I'm your host, Jason Gibbs. Today, we're going to be talking to Nick Stogdill, the co-portfolio manager on our Dynamic Financial Services Fund, the Dynamic Alternative Yield Fund, and the Dynamic Retirement Income Fund. He's in charge of such a huge sector in the market. The financial services sector obviously is a huge part of the Canadian market, the global market. It's the lifeblood of the economy. We're very, very fortunate to have Nick on our team and to have Nick with us today to talk about what's going on in such an important sector right now.
Nick, we have set this discussion up at an interesting time for financials. There just seems to be a lot of focus on this sector right now, so maybe you can tell us, in your mind, what's going on and as well give us a bit about your background.
Nick Stogdill: Great. Thanks, Jason. You're hearing this narrative more and more that the leader of the last cycle won't be the leader of the next cycle, and that old economy stocks like financials could be a part of that new market leadership. Investors should be paying more attention to this big sub-sector and we can delve into that shortly.
First, just in terms of my background and career path, really everything I've done has involved working in and around financial services businesses. There's definitely an element of luck in how we all end up doing what we do. What's funny is if I go back to the very first thing I worked on in my career, it was a high-profile case at a forensic accounting firm in which Marsh McLennan, the world's largest insurance broker, had roped in nearly $1 billion to its clients following a lawsuit brought on by then New York Attorney General, Eliot Spitzer. That was really my first encounter with the financials company.
From there, I went on to work in the financial services tax group at Deloitte and got my CA designation. That experience eventually helped me transition to become an analyst, covering financial services stocks from the sell side at Credit Suisse. I did that for nearly a decade. In that role, you really immerse yourself in the business as you follow. There was two aspects of that job though that were invaluable and made me a better investor.
First, it was getting to work with and learn from so many clients, which included long-only investors, hedge funds, pension funds, Canadian US clients, European clients. When you are an analyst, you have to dig into these businesses, read the filings, build models and learn all those essential things. When you just get a talk with these investors week in, week out, hear the questions they ask and the details they focus on, it really accelerates that learning curve. That was really unique.
Then secondly, it was the opportunity to spend a lot of time with the management teams of the companies I covered. When you get to sit down with them and hear how they answer questions, hear how they present their business, you really get better at reading between the lines, cutting through the noise, and focusing on what matters. That's just something you can't learn from, again, reading filings and building models and looking through financials.
Ultimately that role at CS led me to meet a number of people here on the Dynamic Equity Income team, and that's how I ended up where I am. I mentioned that experience with Marsh a minute ago, and what's funny how it all comes full circle because this is a business I follow, it's one I meet with, and it's on our radar for investment purposes on the dynamic equity income team now.
Jason: How does this experience translate into how you invest in the sector? What are you looking at every day, every week, every month?
Nick: First, what I'd highlight is just the financial services industry is large, it's complex, and it's different than many other industries. To highlight how big it really is, in North America alone, there are over 200 companies with over 5 trillion in market capitalization. It's a really big and deep sector and there's a lot of sub-sectors. From a high level, simplistically, I think there's two factors to success. I believe my competitive advantage rests with the deep sector knowledge I touched on, first and foremost.
Secondly, to quote Warren Buffett, sticking within your circle of competence because when you stick within your circle of competence, that means you have a better understanding of the businesses you invest in, that helps you reduce the number of mistakes, that provides superior downside protection, and as you know, Jason, that's critical to long-term at performance, limiting those mistakes and protecting on that downside.
Jason: One thing that you mentioned at the start, which I thought was a really good point, was this idea that the market narrative may change, like the leader of the next cycle is usually different than the leader of the past cycle. Clearly, the last 5 or 10 years, technology was a leader, specifically the FAANG stocks, and we're seeing that precipitate. Maybe the leader of the next cycle could be financials. Maybe if you could flush that out a bit and, and give us your thoughts on that, that'd be great.
Nick: Sure. I think part of it's just coming from high-level observations of how different parts of the market have been performing over the last few months. If you look at the last three months, the S&P was down something like 5%. It was being dragged down by areas like technology, consumer discretionary, real estate, and even utilities. While the financial sub-sector, along with industrials, materials and energy are actually up over the last three months.
I'm not going to make a market call or anything like that but if you think about this long-term bull case for financials, the opportunity, there's actually a few interesting points to consider. Just before I give you these points, I think when you hear about this change in leadership in this theme, I think they're really referencing US banks. We can come back to Canadian banks, which are very important to Canadian investors and us, and the Dynamic Equity Income Team, and we can come back to some of the other sub-sectors as well.
I would highlight the following points that investors should consider as to why banks could be a place to be on a multiyear basis going forward. First and foremost, higher interest rates are good for banks. Now, that may not be obvious given what's transpired over the last 12 months so let me provide some context.
If we go back to the beginning of the year, there was a lot of excitement about how rising rates were coming. It was going to be good for banks, and that's because banks make a lot of money, call it 50% or more of the revenues by lending money to borrowers at, say, 5% and funding that with cheaper deposits and deposit holders that kept paid, say, 2%. Banks get to keep that spread between the 5% and the 2%.
What was unique in early 2022 is that once the Fed and the market started to realize inflation was becoming a problem, it became apparent rates may need to go up a lot and quickly, and that just meant we were going to accelerate the cycle, put us into recession, and ultimately cause borrowers to default on loans and loan losses at the banks would go up.
The other issue is that when rates move up quickly, there can be some tying this match on the rates they receive from borrowers versus the rates they pay for deposit holders, and it can negatively impact margins for a period of time. When we look at the US banks between January and October, they actually declined by over 35% on those spheres. However, in the last month or so, US banks have rallied more than 20%.
What's happened in the last month or two? Well, first we're actually seeing very good margin expansion at the US banks in the latest results so they're benefiting from rates going up and those loan rates going up. Secondly, loan losses are still very benign. Everyone's been very worried about this. Losses will come, they're going to go up, but generally, it appears banks are prepared and so it will mute earnings growth for a period, but it should be manageable.
Lastly, and most importantly, we think rates are probably going to peak soon. We don't know when, but if they do not go back to zero, that will be good for banks. We expect the Fed will cut rates at some point, but if they lend at something higher than zero, that will be good, and I think that's critical. That will bring lots of long-term benefits for those interest spreads, but I want to emphasize long term because it takes years for the loans and investment securities that a bank has to reprice.
Which banks do I think will win? It will be those banks that have a large, stable base of core deposit accounts and those core deposit accounts tend to be sticky, and they tend to be lower cost. Again, if you think about a bank that makes a loan at 5% and they fund that with a checking account that pays very little, that's a good outcome for a bank and that will play out over the next number of years if rates don't go back to zero.
Jason: You're certainly seeing the market change as interest rates go up and leadership is definitely changing. I think it makes a lot of sense. Was there anything else that you wanted to mention on that?
Nick: Sure. There's a few other things that could be quite positive for banks looking out over a multi-year period. This theme of reassuring supply chains to North America could provide a boost to loan growth in the coming years. This isn't a figure that's easy to measure or pin down, but when we go through bank results and listen to management teams, they're seeing businesses continue to spend and invest, and maybe that's reassuring that could be one of the reasons driving that.
Again, this isn't a theme that's going to provide a boost in one or two quarters, but it could be a multi-year theme that could be good for the banks. To touch on one more point, is just that I think it's fair to say concerns from FinTech and other emerging companies are subsiding as higher rates mean the cost of capital for these high-flying competitors has gone up.
There's lots of headlines about them doting back spending, cutting jobs, and they have to focus on their results and cash flows. That should be good for the banks because over the last few years there's been a lot of concern that these companies were going to eat banks' lunches. To give you two quick examples, the first would be buy now, pay later lenders. There was the thought that they would have a meaningful impact on the consumer lending that banks do, but now these companies are starting to see more signs of stress in their loan portfolios, and they do things like make a three or four-payment loan for a pair of shoes or furniture or groceries.
Maybe we're getting to the point where they realize it's not a good idea to be financing shoes and some of these items that they were financing. There's been a lot of concern about cryptocurrencies, digital currencies, and the thought that they could displace banks. Well, clearly, with what's transpiring in the crypto space now, that does not appear to be an imminent threat.
Jason: Nick, you mentioned cryptocurrencies. That has certainly been in the news, I must say they're not entirely surprising that it's come crashing down certainly a bubble in retrospect, but you had some thoughts on crypto.
Nick: I'm no expert in that space, but about a year ago, I actually got a sit-in on an interesting meeting, a small group meeting with Jamie Dimon, who gave us his thoughts and I would say he's pretty well placed to make a statement about what may have been coming and what may have been happening in the space. This is timely because this was about a year ago.
His thoughts were really that a lot of what was happening in the space was just people riding a wave. Sure, one of the concerns was that Fiat currency, paper currency could be debased, but he was [unintelligible 00:10:12] that it is fully backed by the government where these currencies and coins are not.
He also thought cryptocurrencies could eventually be regulated, and if you moved to a certain amount of them, it could not be reported to the anti-money laundering authorities or the tax authorities. If you think about it, that defeats the purpose of having this untracked currency or these cryptocurrencies.
Interestingly, when he was asked whether it could be a source of the next economic or global crisis, he was unsure. He didn't think the market was big enough, but what investors should pay attention to is how much leverage was being used in the system. Ultimately, leverage means forced asset sales, so that's probably something investors should keep an eye on if they are worried about the space.
On central bank digital currencies, which would be currencies issued by the Fed, the Bank of Canada, his thought and the most likely outcome was that it could be used for small amounts, for things like government transfers, but, ultimately, the central banks know they cannot get into the lending business, they can't set up call centers, collections, bill payments, nor do they want to do that.
It's interesting because he also noted that Americans probably didn't want the government knowing how they were going to spend their money. Those were some reasons he gave why he thought this ecosystem wouldn't displace the banking sector. There's one more opportunity for the US banks that I want to talk about that could be good over the next three to five years. It's really this idea that the global financial crisis is still lingering in the back of investors' minds.
That was the biggest crisis of our generation, you had major banks go under, there was a lot of reckless behavior. Today, from a high-level, capital positions are much stronger, balance sheet leverage is much lower, the banks don't engage in proprietary trading the way they did pre-GFC, so there's just generally less risk on balance sheets. There doesn't appear to be any major areas of excess like there was with housing during the GFC.
Lastly, the banks go through these onerous trust tests every year and their results are on full display. Now, ultimately, we probably need to see the banks navigate through a downturn to show that these businesses are more resilient and that credit losses won't blow them up this time around. Maybe we'll see that in the next 12 to 24 months, and that will alleviate this big overhang or concern for the sector.
Jason: Nick, that discussion that we've had more centered around US banks, but what about the Canadian banks? A big part of our audience is certainly going to be interested in, given all the headlines about housing and consumer leverage time, so maybe we can spend some time on that.
Nick: Sure. Let's break this into three sections, and I'll try and give you a high-level view of everything I think you want to know to make an informed investment decision. Why I'm framing it this way is because we're seeing these stocks swing pretty wildly on the pendulum. They've gone from euphoria at the beginning of the year to closer to despondency and now somewhere in between.
Let me touch on the fundamental trends of the banks. I'll give you some long-term thoughts on performance and valuation, and I'll save the best for last. I'll touch on housing at the end because that comes up a lot.
On the operating trends of the bank, loan growth and credit losses remain quite good. As of the third quarter, loan growth was running at 12% year over year, and that's actually very strong, and loan losses for the group were running at just 16 basis points. Yes, the fear and the focus is that loan growth is going to slow, and it should, and that would be healthy on credit to give some context through the cycle losses are normally more in the 45 to 50 basis point range, so we're well below that at 16 basis points.
Yes, of course, losses will come up throughout unsustainably low levels and that is going to present some earnings headwinds. If we look at some of the other business lines, capital markets, that's been a source of softness and results this year because 2020 and 2021 were record years for investment banking and trading. We're seeing some softness in wealth management, should be no surprise, and that's related to the weaker equity and debt markets.
The softness in those two areas was largely anticipated and earnings have actually been relatively in line with expectations. If you look at bank estimates from the start of the year versus now, they've actually gone up a little bit. Part of that is some acquisitions have been announced. What it highlights is that the decline in share prices we've seen this year is really coming from compression and valuation multiples as the market discounts slower loan growth and rising loan losses in the future. That's a snapshot on the fundamentals. If we flipped the valuation performance, where we stand today is, again, quite a bit different than we were a month ago.
Let me just first give you a few statistics on bank performance. Similar to US banks, Canadian banks had quite a large peak-to-trough decline. They're down about 25% from the peak in February to mid-October. The driver of that was what you'd expect, the macro outlook, concerns around high inflation, geopolitical uncertainty, and a pending recession, and then the elephant in the room for Canadian banks is always the over-levered consumer and the housing market. Since mid-October, however, banks have rallied 10% to 15%, and they're now down only 8% on the year. They delivered a total return of about negative 5%. I'd say this reflects a combination of the broader market rally, and the fact that if US banks did okay with recent results, Canadian banks may be okay. The bottom line here is I would say Canadian bank performance is actually quite respectable given the market backdrop.
Let's just run through some more facts on performance and valuation to help contextualize everything for the listeners. When you go back over the last 40 years, bank share prices have only had double-digit declines about five times and that was really only during recessions. We look at the statistics on share price declines of a double-digit amount or more, it happened in 1981, 1990, 2007, 2008, and 2018. 2018 was really the only one non-recessionary year which related to the Fed policy mistake, if you will.
If we look at bank valuations now, over the past 20 years, they've really only traded at depressed levels a handful of times. It was the GFC in '07/'08, the euro crisis in 2011/2012, the China market global market scare and oil price collapse in early 2016, the Fed policy mistake in 2018, COVID in 2020, and now today.
As I've noted, they bounced around and aren't quite in the zone anymore, but they were in that zone for part of this year. The point I'm trying to make is that if you buy banks, when they reach these valuations, and you have a good time horizon to hold them, history shows you vastly improve your odds of making money. This brings me to the last point on housing, which is really the overhang on the sector and the key risk.
Now you can't go a week without reading sensational headlines about Canadian housing. Just a quick story here, but I went pulled up the first Canadian bank and housing market report I helped put together on the sell side. Believe it or not, that was published 12 years ago this month. It's amazing how long this fear has been out there, and I pulled a quick quote from that report. Trends in the housing market raised significant concerns, notably among foreign investors that the banks are overly exposed to a housing correction, given that Canadian residential mortgages and HELOCs represent nearly 50% of balance sheet loans.
A gravity-defying rising home prices and increasing Canadian household debt levels have done nothing to ease these issues. That was said 12 years ago, so not much has changed. When you look at residential mortgage loan growth, it's been very strong over the past 12 to 18 months, with banks delivering double-digit growth. The pace of mortgage growth is slowing, it will slow meaningfully as higher rates dampened activity, and that's going to be positive and healthy for the housing market.
For banks, the headwinds from slowing loan growth will largely be offset by the benefit from rising mortgage rates. The risk here is really that rising rates caused consumer stress and result in loan losses and you're hearing a lot about consumers having variable-rate mortgages and other payments are going to be adjusting upwards. That's absolutely going to cause some problems.
At a minimum, it's going to reduce disposable income and have a knock-on effect on the broader economy through reduced spending. At this point, we're just not seeing broad-based issues, but it is coming and that's something we're watching for. To give you a little bit more context, Royal Bank has given a lot of statistics on its mortgage portfolio, and they only have 16% renewing in 2023 and 14% in 2024. What that tells you is that this is going to take some time to play out. We've had discussions with bank management teams and pushed on this issue on variable rate mortgages and housing.
They, along with our regulator, the Central Bank, and the federal government are all aware of this risk, and they're all tracking it closely and they're prepared to take actions if these issues become more widespread. Again, there's going to be stress, but it's hard to see how an issue that's so visible can create a doomsday scenario.
Jason: We've spent a lot of time on banks, but how are we going to the other financial sub-sectors? I know in the financial services fund; you've done a good job diversifying that. Maybe we can talk about some of the other sub-sectors that are in financial services.
Nick: Financials encompass many other sub-sectors. If you think about banks being the only area, you're missing out on some great businesses, not just great financial businesses. They include things like the payments networks. Visa and MasterCard, these are businesses that are effectively a global duopoly. They have high margins, they generate a lot of cash, and they even offer some inflation protection because a portion of the revenues are tied to dollars that actually gets spent.
When you think about your grocery bill, your gas bill, or your clothing bills going up, they're benefiting from that inflation because they're taking a sliver of that on $1 spent basis. Then there's the rating agencies. This is another monopolistic business model and the most well-known ones are S&P Global and Moody's. They are critical to the functioning of the capital markets because companies need to have ratings to issue debt, and these two companies have the dominant share in issuing debt ratings for businesses.
Similar to the payment's networks, they are in very good margins. They generate a lot of cash, and they have capital-light balance sheets, so they don't have really any credit risk on their books. Then there's the exchanges. Intercontinental Exchange owns the NYSC. There's NASDAQ, there's CME, and these are not only plays on trading volumes, but these companies have very big and growing data and analytics businesses in many cases. Just another financial sub-sector that generates durable revenues -tends to be defensive because when volatility spikes, trading increases, and the revenues go up. To give you a sense of maybe one or two more sub-sectors we look at, there's the alternative asset managers. In Canada, think of Brookfield, south of the border, you can think of Blackstone and Apollo.
There's been a secular trend of investors allocating more of their portfolio towards alternative assets, and these are some of the biggest beneficiaries globally of that theme.
Lastly, we have property and casualty insurance. In Canada, we have a couple companies that are very high quality but there's plenty more in the US and globally. This is another group that doesn't really take credit risk like the banks because they're not lending to consumers, and their revenues and the pricing is short-tailed, meaning it can be adjusted more frequently.
When you think about things like your home and auto policy, if they misprice that, if losses go up, guess what, they reset that the next year. When there's a bump in those claims, the good companies adjust for that, and they move on and maintain their margins. That's just another defensive sector that has some high-quality companies with steady long-term growth profiles.
Jason: Why don't we wrap it all up and talk about how this all comes together in the Dynamic Financial Services Fund and the financial holdings in the equity income team?
Nick: Sure. This will be a bit of a plug for the dynamic Financial Services Fund but when most investors hear about financials, they go back to thinking about rates. This one is so much more than that, because we brought together a combination of banks and insurers, those rate-sensitive sectors that we talked about, along with everything else we've just discussed previously.
I'd argue most Canadian investors tend to have far too much exposure to Canadian banks. Now, Canadian banks are great. They've compounded at 12% a year over the last decade. We own a considerable amount of them in the Dynamic Financial Services Fund, but this one has delivered very attractive long-term returns as well. The question I have is, why not consider something that keeps that Canadian bank exposure, but also gives you that diversification? As you know, they say diversification is the only free lunch.
[music]
Jason: Well, thanks, Nick. I think we'll wrap it up there. Again, thanks so much for your time today. I think you've given us a great behind-the-scenes look at everything that you think about and that I think about when we're trying to manage these portfolios on a daily basis. What are the opportunities out there? What are the risks, and how can we make sure we have the right stocks in our funds? You're such a valued member of our team, so thanks for taking the time today to talk to us.
Nick: Thanks, Jason.
Jason: 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.
Announcer: 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.
Speaker 4: This audio has been prepared by 1832 Asset Management LP and is provided for information purposes only. Views expressed regarding a particular investment economy, industry, or market sector should not be considered an indication of trading intent of any of the mutual funds managed by 1832 Asset Management LP. These views are not to be relied upon as investment advice, nor should they be considered a recommendation to buy or sell.
These views are subject to change at any time based upon markets and other conditions and we disclaim any responsibility to update such views. To the extent, this audio contains information or data obtained from third-party sources, it is believed to be accurate and reliable as of the date of publication, but 1832 Asset Management LP does not guarantee its accuracy or reliability.
Nothing in this document is or should be relied upon as a promise or representation as to the future. Commissions, trailing commissions, management fees, and expenses, all may be associated with mutual fund investments. Please read the prospectus before investing. The indicated rates of return are the historical annual compound total returns including changes in unit values.
Reinvestment of all distributions does not take into account sales, redemption or option changes, or income taxes payable by any security holder that would have reduced returns. Mutual funds are not guaranteed. Their values change frequently and past performance may not be repeated.
[00:24:17] [END OF AUDIO]
