On the Money with Dynamic Funds

PARTICIPANTS

Tom Dicker
Vice President & Portfolio Manager

Jason Gibbs
Vice President & Senior Portfolio Manager

Mark Brisley: 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.

Tom Dicker: Welcome to another edition of On the Money. I'm your co-host, Tom Dicker, Vice President and Portfolio Manager at Dynamic Funds. Joining us is my co-host, Jason Gibbs, Vice President and Senior Portfolio Manager with Dynamic Funds. Today, we're going to talk about the stock market, the bond market, and what we're calling the cash trap. Jason, let's get right into it. What's happened in the stock market and the bond market so far this year?

Jason Gibbs: Tom, this is a year that has been very odd, to be honest with you. It's really been marked by a few stocks, both in Canada and United States, taking center stage. In United States, they call it the Magnificent Seven. It includes names like Apple, Microsoft, NVIDIA, Tesla. For now, they've really been driving the market. It's a bit odd because people will see that the market's up this year in the US, but really, below the Magnificent Seven, the vast majority of stocks are stuck in neutral, or they are down.

If you look at Canada, Tom, it's called the Super Six. It's names like Canadian Natural Resources or Fairfax, as an example, that have really been driving the market. Almost everything else is neutral to down, particularly small-caps and mid-caps. It's been a couple of struggling years. I think if we look back, and you think about the narrative of the past several years, including COVID, it's clear that, since 2008, 2009, the financial crisis, we have had over a decade of very, very easy monetary policy.

Interest rates were too low, and then COVID hit, and interest rates, as we know, hit zero. That led to a lot of excess, whether it was IPOs, special purpose acquisition vehicles, or growth companies. A lot of that over the past two years has really unwound.

Tom: The Magnificent Seven, I think they're up as of today, about 50%, maybe a little less than 50%. They were at one point even higher than that compared to the S&P 500 at 10%. The S&P excluding, those stocks right now, I think is about minus 1%. The average stock is actually down year to date. Now, of course, we know that averages lie, and there are the average stock. Can you talk a little bit about how and why dividend-paying stocks have underperformed this year?

Jason: This has been a significant year of underperformance for dividend stocks. We should always remember that, with investing, you have to think in decades, or you're just going to get lost. Over decades, we are convinced, the whole purpose of our group is that dividend stocks will do better over time. Businesses that pay free cash flows, have good balance sheets with dividends that grow, they will do better over time. That's the whole purpose of our group.

However, it doesn't mean that you're not going to have some very bad years, or you could have some very bad years within that. This has been one of them. Tom, very simply, the main reason is interest rates have absolutely skyrocketed since central banks decided to eliminate easy monetary policy. How rapid rates have risen is something that we just have not seen in history.

What's happening is you're seeing a great deal of money go to cash. Cash has given you a return that is quite reasonable, which is a good thing. You're seeing a lot of money going to GICs. Therefore, on the flip side, you're seeing a lot of dividend stocks struggle. That's really what we've seen this year.

Tom: We've talked about this in the past before, this idea that there were, in some of dividend stocks, you had GIC refugees. You had these people who just wanted a decent amount of interest but couldn't get it from GICs or government bonds when they were yielding 1% or 2%. Then they were, for lack of a better term, forced to take on a bit more equity risk and buy these dividend-paying stocks. In Canada, that might be the telcos, the REITs, the utilities.

Do you think it's a bit of an unwind of some of this GIC refugee situation? Do you feel like that is mostly unwinding right now, or are there other company-specific reasons that might be causing interest rates to affect the valuations?

Jason: A bit of both. Definitely, we went through a period where they called it TINA, which there is no alternative. A lot of people that were savers just had no alternative. You were getting nothing on your cash, and fixed income was giving you hardly anything. They had to buy dividend stocks. As you say, that has certainly unwound this year to great effect. On the flip side, some of it is fundamental in the sense that if you are a levered company or a levered person, which is if you have a lot of debt, the tables have really turned on you.

It was very easy to borrow money before 2022. It was very easy, and it was not great to be a saver. The tables have turned. Those companies that do have a lot of debt, as their interest rates have gone up, you have seen a fundamental repricing of some of those companies. Now clearly, what we try to do is buy those companies with the best balance sheets who have taken advantage of lower rates and locked in. For most of our companies, we have been reasonably okay, and if not, we would have sold them. That's what you're seeing.

Tom: I want to go back to the TSX. What are the components of the Super Six on the TSX, and how have they done roughly year to date?

Jason: Tom, the Super Six, as of October 23rd, they've actually returned over 30% this year. The TSX as of October 23rd is down a little bit. That tells you that most Canadian stocks are down. Some are down quite a lot. The actual components of the Super Six, Shopify, a company many know, a technology company that had a very difficult year last year and has bounced back this year. CNQ, the energy company, Constellation Software, Couche-Tard, Cameco, Uranium, and Fairfax, the insurance company.

Tom: There's not really a similar theme to the U.S. where those are really high-growth stocks. It just seems like, in Canada, you had six stocks that perform really well. The average stock's done fairly poorly this year. To me, it would imply people are pulling their money out of the TSX on average. If people are pulling their money out, it's got to go somewhere. Where is it going? Is it just sitting in cash?

Jason: I think a lot of it is going into cash, where you've had GIC rates right now that are, frankly, quite attractive, just looking at the nominal number. We'll get into why they may not be as attractive as people think. Presumably, it's a bit of a deleveraging cycle. If the COVID and post-COVID period was all about leveraging, taking on more debt because it was so cheap, the tables have turned. We are now into a bit of a deleveraging cycle. Maybe paying off your mortgage a little bit or paying for other expenses.

Tom: I understand the attractiveness from an investor's perspective. However, I think that higher inflation rate needs to be factored in. How do you think about the higher inflation rate and the high rate on cash?

Jason: This is why we call it a bit of a cash trap. If you have a very long-term time horizon, and anyone that's buying equities, this is pretty basic stuff, you should have a time horizon that's in decades. That's pretty basic stuff because when you look at what equities do over 10 years, your risk is frankly, a lot lower because you're going to get earnings growth, you're going to have a diversified portfolio.

When you look at cash today, if you're getting 5%, 5.5% on a GIC, or just cash that's sitting there, always remember that one, it does just sit there. There's no growth unless rates go up from here, which they may, but that may be a bit tricky given how high they are now. There's not a lot of growth or no growth. You have major reinvestment risk.

What does that mean? When that GIC matures, or whether it's cash, or whatever it is, short-term notes, the rate could be substantially lower. You just don't know. You have major reinvestment risk. This is pretty basic. That's why they call it short-term money. It's short-term. The final thing is you are going to get taxed. If you have this in a non-registered account, you're going to get taxed at the highest rate.

What I would say is, look, I have cash, I have some GICs, but I would note that you must be accepting that you're doing that for short-term reasons. That's why it's called short-term investment. Now, what we do, Tom and our team, what we've done for decades is we buy dividend stocks and equities that grow. This gets back to why we are so excited about the future, recognizing it's been a very tough couple of years for those that have invested.

If you look at the future, why do we invest in equities, look at 100 years' worth of data, the best way to maintain, preserve, and grow your wealth is to either own your own business that, hopefully, does well. If you can't do that, buy another business. Buy an Amazon, buy an Apple, buy a diversified portfolio of equities. Become a part owner in those businesses because over time, if they are the right businesses, they have good balance sheets, and they have free cash flows, that grow with inflation. Think about that.

Free cash flows and dividends grow with inflation as prices go up versus owning a short-term investment in cash where you may have an interest rate that's lower in the future, so you now have, with an equity, a growing stream of dividend income that you have locked in at very low prices today, not to say, they can't go lower. If you look forward, say, 10 years, and compare the dividend in 10 years to what it was today, I think you're going to be very happy.

That's why, Tom, we call it a cash trap, because things always do turn around, and negativity quickly can turn into something that's more optimistic. We've seen it time and time again. This is not the first year where people have been worried in the market, and it won't be the last, but over time, you're going to do very well in the great stocks. I do think, in a few years, some may look back and say maybe they should have put more into equities if they're a long-term investor.

Tom: We've seen the stats that fixed-term deposits are up almost 50% year-over-year, so a lot of people are getting sucked into these high deposit rates. There's a name for that as a behavioral bias. It's called money illusion because you're drawn by the high headline rate, but of course, that 5% GIC rate is happening in the context of inflation that is north of 3%, so your real returns are actually still quite low, especially after tax, they're even lower, so it's not 5%. Certainly, on a real basis, it's not 5%.

If you're locked in for a long time, not only do you have the reinvestment risk, but you also have the risk that you're going to miss opportunities, be it in the stock market or the bond market, where you can buy a much cheaper asset at a much more attractive price, lock in those really attractive dividend yields, or for that matter, bond yields, which are quite attractive right now, too, and not benefit from the capital appreciation that you get, not benefit from the tax-advantaged returns that you get from dividends.

Those are a few of my thoughts on the subject. I want to change gears here and ask a little bit about where you think you're seeing some opportunities in the stock market right now in dividend-paying stocks.

Jason: You know what? It's everywhere. To be honest with you, it is everywhere. I guess we need to step back a little bit and talk about the emotions of the market. Markets are very emotional. They never fully reflect everything that's rational. As the old saying goes, markets are a voting machine in the short term and a weighing machine in the long term. They do tend to reflect earnings growth in the long term, but they go through periods of exuberance where people just get way too optimistic about the future and overprice.

They also go through periods of despondency, where people tend to get way too negative and underprice. That shouldn't surprise people because those who are pressing the buttons on buying and selling every day are humans, and humans are very emotional people. Having said that, if you want to be a successful investor, try not to buy when everyone thinks things are going to the moon. Try not to sell when everyone's negative because what happens is you're going to get caught in the loop of buying high and selling low, which is, frankly, why so many fail at investing.

Having said that, Tom, I did answer your question, what are we seeing now, we're seeing a lot of despondency in dividend stocks. We've seen it before. It does remind me of the late 1990s. It was another period of hyper, hyper-optimism on technology stocks. The only thing anyone talked about was the NASDAQ, and you could not get anyone to get any interest in a dividend stock or anything real estate-related or fixed income. It's a bit similar today, except now, we have the Magnificent Seven and the Super Six.

We are seeing despondency in some names. Tom, I can tell you the telecom names, which have been an area of focus for us for many years, the Canadian telecommunications companies, we all have their products. We're seeing multiples, which means price earnings, multiples, free cash flow yields, dividend yields, the likes of which we have not seen in years, in some cases, decades. We're still very comfortable with that investment thesis. Pretty simple, population grows, more people buy phones, use phones, the internet, pretty simple business.

When I look at utilities, and we've had Frank Latshaw on our podcast before, Frank was telling me recently that this is going to go down, if this continues, as the third worst year in history for utility stocks compared to the market. When were the others? Very early 1980s, when we had a major inflation scare around the world and again in the late 1990s when we were going through the Nasdaq tech bubble. That has led to valuation multiples that again, it's a constant reframe that we have not seen in many years and, in some cases, decades.

Now, the question is, what are we doing with that? Well, where we can, we're adding. This is what you have to do, and this is what we get paid to do, is add when prices are reflecting a lot of pessimism when you still have a good, positive, fundamental backdrop in those businesses, so that's what we're doing. How about you, Tom? What do you see in your area?

Tom: Well, it certainly feels very contrarian to be buying utilities right now, but it is something that we're doing. I think the other most contrarian thing you can do right now is go out and buy real estate. We need to take a bit of a longer-term view in real estate and look at where are the opportunities because, certainly, you can't just say, "Oh, nothing changed. The operating results are fine. Interest rates have moved. That's temporary."

Things for companies on at least the financing side have gotten worse, that the asset market has moved down in prices everything from residential housing and apartments to obviously offices, cell phone towers, self-storage. The cap rates for these assets, i.e. the multiple that someone is willing to pay on the cash flows to buy the asset, those prices have moved down.

Have they moved down as much as the public REIT stocks have moved down? Definitely not. Public REITs have looked ahead, and of course, they're easy to sell. Selling a private asset is hard to do. It's slow. It's illiquid. Finding a buyer for a $100 million or $200 million asset, that's hard. Selling $1 million or $100 million of public REITs is really easy. We know that people in the public markets get ahead. Sometimes, of course, the pendulum swings too far.

Our view would be we're in a situation where the pendulum has swung way too far, especially in some specific areas, some specific companies, where there's been a company-specific issue. I would point to the cell phone tower stocks where the growth has slowed a bit. Certainly, higher interest rates are not great for telcos. They need to spend more of their cash flow on interest, and they can, therefore, spend less on capex, meaning they can spend less money building cell phone towers, so that's going to lower the growth profile of cell tower companies.

However, the in-place income, still very solid. The telcos are still going to need to invest in their networks over a long period of time. Cell phone is absolutely a critical thing that everyone owns. We really believe that that business is very stable. You can now buy the cell tower stocks at valuations that are lower than they've been in the last 10 years, so really, really attractive prices because interest rates have gone up.

Now, there are areas in real estate that we wouldn't touch. We still don't like office. We don't like things that have too much floating-rate debt. I think that's really risky. We don't like a lot of development exposure. Development exposure is really risky right now, especially if you need to lease up into what's probably going to be a weaker economy. I think that presents a lot of risk, so you have to be very careful. There definitely are infrastructure-like investments like American Tower, where the cash flows are going to be stable and the valuations really attractive.

Jason: Now, Tom, what about apartments?

Tom: The private markets in the US have moved down a bit. In Canada, they've moved down a little bit, not that much, certainly not as much as the stocks have moved down. The long-term situation in all of North America, but especially in Canada, is that there is a housing shortage. The CMHC wants to build an additional 3.5 million units between 2023 and 2030, which would imply that we would need to take our rate of building from about 250,000 a year up to over 700,000 a year. It's just not possible for us to do that.

That means to us that it's going to be a good rental market for a really long period of time. The inflation that we've seen take place over the last couple of years in Canada, you're going to continue to see that in rent growth over time. Now, will there be some more new supply? Sure, there definitely will be, but it certainly won't take place at the rate that it has in the US.

I wanted to end the podcast on a positive note. I know that dividend investing has had a really tough year, certainly in the markets. Higher uncertainty leads to higher amounts of opportunity. We found this quote from Warren Buffett which I thought was really apt right now. It goes, "Opportunities come infrequently. When it rains gold, put out the bucket, not the thimble." We do think that, right now, it is more of a bucket opportunity than a thimble opportunity in some of these high-quality dividend-paying stocks.

That's our opinion. Of course, it's not going to come as a surprise that equity managers are excited about equities. I want to thank everyone for listening. It's been Tom Dicker and Jason Gibbs with Dynamic Funds, and we wish everyone good luck in the markets.

Mark Brisley: You've been listening to another edition of On the Money with Dynamic Funds. For more information on Dynamic and our complete lineup of actively managed funds, contact your financial advisor or visit our website at dynamic.ca. Thanks for joining us.

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