Hello and welcome to The Download. I'm your host, Dave Richardson. It is a sunny fall Stu's Day here in Toronto and live from the new Nancy Hanninen Memorial Studio, we're here with the podcast today. Stu, thanks for coming downstairs. I know it's a big walk down. How many flights of stairs is it, Stu?

It's just two flights of stairs. It's not a big deal. This is very exciting with live official equipment.

I know. I was telling you, I got about 50 emails over the weekend. They started last Wednesday. We must have triggered something in terms of the popularity of the podcast because all of a sudden I got about 50 emails, and I'm guessing they're from bots, with people that wanted to be guests. A lot of them suggested that they could do a little better than you. I was tempted, but I'd never bail on you like that.

Anything for ratings, Dave.

All about the ratings. Although if it was all about the ratings, they'd have a different host. I guess it's all about the guests as we know. Everyone loves Stu's days. That's what everyone tells me as I travel across the country, and I travel a lot this time of year. So obviously, lots of compliments for you. We missed last week because things were looking a little quiet. We did get together to tape Stu's days, and it was: I'm not sure we have anything really interesting to talk about because the market's just drifting along, hitting a new high every day. All the news is quiet. We've forgotten about tariffs. We've forgotten about all the stuff that's going on around the world. Then boom, all of a sudden, we were reminded on Friday that volatility is still a part of markets. Of course, we're coming into a big earnings season, and we kick that off today, really, from a significant perspective, with some of the US banks. Things are back to being exciting.

Yeah, we had some trade wobbles last week, and then the market was particularly weak on Friday and then rebounded yesterday. Today, it's following through in a different manner because the AI stocks have been quite strong, and this has been this succession of announcements that on the one hand has created a lot of enthusiasm, but on the other hand has created a lot of questions that need answering. I think even when you look at last week, if you bought stocks on Thursday, say, and then Friday, you have a sell-off of a couple of percentage, and it's rallied back since. But when you buy the market in this environment as a longer-term investor, you would be expecting to have some volatility at some point because valuations are elevated. We're going to talk about the S&P 500 earnings. But when you look in the next year, there's two ways to look at earnings. There's the bottom-up forecast, which is where you take all the analyst estimates and you add them together and you come up with, say, $300 or $310 or something like this. And then you look at what they call a tap-down estimate, which is based on the economic growth, how much earnings could be created. And that's probably about $20 lower. So one way or the other, the market is trading at 22 or 23 times earnings, which is not at all-time highs, but it is elevated relative to history. So it's one thing to be an investor and say, I might experience some bad news at some point. The experience of that bad news when you start from a somewhat elevated valuation can be a little bit more harsh or quick than you might otherwise be used to. It doesn't really interfere with the longer-term reason to own stocks, but we've been up for some time. A couple of weeks ago, we talked about a couple big bankruptcies in an automotive parts company, an automotive lending company. Consumer credit in the United States has gotten a little bit worse. There are some things out there that would be signposts for a little bit of weakening. It's still a resilient economy, but a little bit of a weakening economy. We've had the central bank talk about lowering interest rates, which would be a help to that. But there have been some cross currents. And even though we've had on the AI front these spectacular announcements where NVIDIA was going to invest in OpenAI, and then OpenAI was going to use AMD chips and get a piece of the equity of AMD. And then this week it was working with Broadcom. What has been brought to the attention is that, yes, the opportunity is very large, but the amount of capital that's required to put all these chips and data centers together is immense. So we've seen some movement around some of the power providers and all sorts of things where some of the second derivatives and third derivatives that need to come into play. But when we look at US economic growth, there's no question that AI has been a significant percentage of it. It's the same when we look at the S&P 500's earnings as we get into the third quarter. The growth is still expected to be mid- to high-single digits, which is a deceleration from the second quarter, but still a healthy number. It's largely led by technology, industrials, which is a lot of the artificial intelligence trade as well, financial stocks with strong trading, the slope of the yield curve, that type of thing. But the rest of the earnings pool is a little bit more benign. The one other thing, too, is that the cost of tariffs has gone up in the third quarter relative to the second, which has acted as a bit of a headwind. We still have healthy mid-single-digit earnings growth, not as robust as it's been, and still waiting for those signs that it's broader than just artificial intelligence.

Yeah, so a lot to unpack there. That was an amazing summary, as we expect from you, Stu. But we just had David Lambert in who manages European equities at RBC Global Asset Management. We highlighted that a couple of years ago, he was really pounding the table on European equities, and it was from a valuation standpoint. But you needed something to trigger a move higher in those stocks on a relative basis other than just valuation. The one thing I like about buying value—and I know you do as well, and I often talk about this when I'm out with investors—is the idea that if I'm buying a market when it's cheap, I don't know exactly when it's going to move, but what I do know is if I buy a market when it's got a relatively low valuation, the one thing I do benefit from is lower volatility. My expected returns are higher. Again, it doesn't mean I'm going to get them right away. My expected returns are higher, provided everything plays out the way I think, but I don't have as much volatility, which turns then to you and your comment on volatility, which is when you're looking at some of these stocks which have come so far, so fast, and that everyone's piling money into it—and they're doing it for a good reason because there's obviously something transformational about what's happening with AI and quantum computing, and then, as you say, all the second and third derivatives beyond that of those areas—but when you get high valuation stocks and you get some bad news. So all of a sudden the President says, oh, we're going to slap 100% tariff on this and that and the next thing. You can see big market moves, and you have to be prepared for that as an investor if you're investing in those areas. It's one of the reasons why diversification is so important. But that volatility is something we talked about at the start of the year, it's something we thought would be a factor this year, and I guess in a lot of ways it has been if you look back to the inauguration and tariffs. Then things settled out through the summer. Even August, September were pretty good. But again, you got a taste of it there. You would likely say that we're going to face a little bit more volatility here, wouldn't you think?

I think it's bound to continue to some degree. I'll maybe just break down into an example because this morning I was looking at the math of a data center. You often have one company that will construct the actual physical structure, secure the land, get the power in place. That looks like a more traditional lease. Then you have another company that often goes and buys all the servers and all the equipment that goes into creating the inference, if you're asking the model a question, or the training, if you're creating a new version of the model. You look at the economics of the person putting the server in place, and it's highly dependent on the price of power that you have to pay for, the cost of the server itself. And then the second thing is how long you depreciate the server over however many years. So what we're seeing in the marketplace, the concerning component is this. The unit of value that you sell if you're doing a data center is called a token and so the price of a token has been declining, but the usage of tokens has been accelerating. On the one hand, if you didn't have any change in the number of tokens being used, you'd be quite concerned because the price is declining. But in this case, you're getting an acceleration of the usage. So if you have the state of the art data center with the best server, you effectively have the lowest cash cost to create a token. If you've got a reasonable power contract, you open up the server, you're getting so many tokens per box, call it. So if you're providing at the lowest cost at that juncture, then you're doing reasonably well as the demand picks up. But if you have an older server, the question is, are you producing tokens at a low enough price because maybe now your server is not quite as effective as some of the new servers. This description is at a very high level. There's lots of other variables. But as we get into any situation where the price of something is high, and then you go and look at the model and you say, boy, a little tweak here, a little tweak there, and you get a different outcome, both positive and negative, we have to think through, does that match the level of enthusiasm that might exist in the given security? Then you have to make a decision. The math does or doesn't line up for me relative to that price, and I'll make a decision, or I'm going to hold on for some of the momentum, even though I don't quite have all the facts totally nailed down in my favor. If you get investors holding on for momentum, then they're a bit more vulnerable when there's a small change or a small hiccup. Because don't forget, we don't use any leverage when we buy stocks. Most of our unit holders don't use leverage when they buy stocks. But the marginal owner of a stock has normally used some type of leverage, so they're much faster to react to a given change in news. As a result, that's what causes the volatility. If we were all long-term investors that didn't use any leverage, there wouldn't be any volatility, but you might not also see these dramatic changes in valuation from time to time.

Yeah. Actually, we saw in the cryptocurrency markets on Friday, what they describe as a flash crash, where a lot of the players in that market are leveraged. Bitcoin dropped from 120 thousand to 110, I think, in a very short period of time. Some other cryptocurrencies, even further and faster. You start getting people squeezed where, as you say, they lose their actual capital and all that's left is the debt that they have, and they've got to unwind those positions pretty quickly. And then that just pushes the market down even more and creates that panic and uncertainty. Not what you generally see in the stock market, but it was interesting in the crypto markets as it is a more speculative market that it's not surprising that you've got that froth there.

Yeah, like any market, when you own something, you either decide, I'm going to own this for a long period of time, in which case you're willing to put the volatility to the side and say, this business's earnings are going to compound, or these set of events are going to happen to make this business more profitable, and that will change its valuation. There's a handful of things that would come into your investment case. If you're not in that camp, then you have to be more wary of some of the short-term changes that might come to the asset and say, am I willing to ride through those? Because the changes in the short-term nature of an asset are often totally unrelated to the long-term investment case.

Yeah. The ultimate leveraged asset that most people have here in Canada is their house, right? That is that ultimate long-term attachment. You're aware of the value of your home, and you're aware, obviously, of the size of your mortgage and the mortgage payment, but you're not looking to be flipping that house anytime soon if you're living there. You ride with the ups and downs in it. Whereas, again, in some of these markets and with some of these stocks and different asset classes, people have bought an awful lot on an asset that moves around an awful lot, and they're not really planning to hold it forever. And so you see that volatility created.

That's the reaction we saw towards the end of last week. As a long-term investor, you're always trying to turn volatility into your friend to do your work around the scenarios for an asset. And if the price hits a level that gives you a bunch of scenarios for free, then you're trying to act.

Just before we move off AI, because I know something we've talked about on previous episodes and some of our other guests have talked about, is this whole idea of at some point, all this investment in AI has to start dropping down to the bottom line, not just for the pick and shovel companies and the chip companies, but the actual companies that are going to employ artificial intelligence to lower the cost base of their company, improve service, or offer different types of services. As you're looking at earnings this quarter, is that something you're going to be looking for, or are we still too early for companies to be really punished for not demonstrating an immediate payoff on everything that they're putting into artificial intelligence?

Well, I think that question breaks into two. The first is, for companies that have big cost bases, increasingly, the management is being asked, how could this business be more efficient a couple of years from now with the benefit of artificial intelligence? I think the good answer there is, it's not so much the outright removal of costs, but the efficiency ratio, which is the total limit level of expenses divided by the revenue. People hope to see that declining with the benefit of artificial intelligence. So I don't think you have to have been able to prove that outright today, but you certainly have to be able to talk about the laundry list of projects that you might be looking at. The second question is, will artificial intelligence affect your revenue line? And could there be more competition that traditionally hasn't been there? And I think the answer on that one needs to be pretty good in order to stop weakness. There's a lot of businesses out there where artificial intelligence might change the construct of the business environment. And when you go back through time and you look at newspaper, whatever it might be, where a technological change had a very significant impact on the top line of that business, even though the stock price might have been volatile one way or the other, the downtrend never really gets broken once the stock market worries about the terminal value of the business. There are some business lines out there where artificial intelligence might impact them. Say, if you're putting in a new software, you might have hired a bunch of consultants to transfer data from the old system to the new system. Now, artificial intelligence might be able to do that. So that's one thing where it's just replacing. Software is a very complicated discussion point, but people do worry that artificial intelligence will be able to rewrite portions of software. It's not like businesses today are necessarily ripping out software that they've previously purchased, or if they have so many seats of subscription, they're not changing that today. But the stock market will worry about the growth going forward, and then they will compare it to the valuation and say, well, this valuation reflects growth, and that growth doesn't have the same degree of certainty, so the stock price needs to often go down to reflect that. We've seen some of that, but I expect we'll get a lot of discussion on each transcript around which parts of your business could benefit from artificial intelligence, which parts might be exposed. There is not going to be immediate evidence on either one, but the evidence needs to be pretty smartly presented.

Yeah, I know we talk a lot about artificial intelligence on this podcast. It seems to come up in every episode, whether we're talking about European or emerging markets, we're talking about dividend stocks, about anything, artificial intelligence comes into play. It's such a transformational technology. It's just one of those things that is going to change the world, maybe in ways that we've never seen it change, at least not in our lifetime. We had a similar thing happen with the internet in the 1990s that created a boom. All anyone talked about at that point in time was the internet. Of course, we've seen the way that's transformed our lives, the way it's changed business, everything we do, our habits, our lifestyles, everything. What was interesting back then—and I'm going to pull at straws here and see if I actually connect—but back then, if I'm thinking about value stocks, what was happening during the tech bubble with all the dot-com companies, all that, those stock prices flew through the roof, some for good reason, most for not any real good reason. But it left a lot of value stocks behind. Just hearing you talk about the impact that artificial intelligence is going to have on all companies and maybe disrupt the revenue side of companies. Is it just the unknown of AI, just as it was the unknown of how a website might change the profitability and business model for a bank, an old traditional bank. Is that one of the things that's holding back what would be a transition of value? Because ultimately, the winners and losers were found out in the dot-com bubble. Then we went through a period of time where value companies did exceedingly well because the valuations just got to a point where they were so compelling that money shifted there. Do we ultimately get to that point in this cycle as well, do you think?

I think we will. It is interesting in the last couple of months, even the Russell 2000, which is a bunch of mid-cap companies, has started to perk up against the big S&P 500. You got 2000 companies in there. Certainly, there's going to be subsets of winners versus losers. But I think as a mass, what tends to happen is when you buy a bunch of value stocks—so even today, if we looked at the headline of the S&P 500, maybe it's a 22 or 23 times earnings, the average stock is nowhere near there. It's in the mid to high teens. So the valuation is not as concerning as long as you have confidence in the earnings. The second thing is, stock markets love to see earnings grow, however small. And as a group, as I mentioned, the economic activity outside of artificial intelligence is still muted. So people are waiting to see some benefit outside of that. But you mentioned it at the get-go, when you don't quite know what causes the spark, but when you have more value, you're sitting there on a bunch of options that just because the stock market won't pay you today, doesn't mean that they don't have value. It's like the different tools in the toolkit. When a stock has value, you don't maybe need to lean as heavily on, say, price momentum or technical analysis, because you think, I've done the math on this one. I don't know when I'm going to get paid, but I'm going to get paid. Versus if a stock doesn't have quite those characteristics, then you're more dependent on the near-term sentiment. Then you use a different part of your toolkit as you try and negotiate these. And then you'll get to the point on some stocks where you're just like, I can't make sense of that value, so I'm not there anymore. And that might cost you some near-term performance, but it's the same thing in your head, you're like, well, I'm avoiding a longer-term negative option that I think will present itself. I don't know exactly when. And I've filled the portfolio with a bunch of positive options that I also don't know exactly when they'll present themselves, but I think they will. And the crossover of those two buckets is what generates some reasonable performance over the intermediate term. And that's what you're always working on.

A few things we're going to want to pay attention to in this earnings season that's coming up. We touched on AI and some of the other areas. But the one area where we have seen some earnings already is the big US banks. We always like to take a look at those. They come up before Canadian bank earnings, so that's always interesting. It gives us some clues about what's happening in Canada and all around the world for that matter. Was there anything you glean from the reports that are out so far that caught your eye and lead to something economic or something that's happening in the market that people should be thinking about?

Yeah, I think there was a handful of things. The first, there was one bank that raised what they call their return-on-equity target. We talked about that a month ago in the context of a Canadian bank that had done similar. So the idea that banks can make more earnings from the same capital base as we move forward, which helps them not only grow, but trade at maybe a different valuation. The second thing was that the trading businesses and some of the investment banking businesses were quite strong. They beat expectations, but expectations turned out to be quite elevated. The third thing was, in some cases, depending on the bank, while a steeper yield curve is a benefit, as some short-term interest rates get cut down, it costs you a little bit of net interest income, ever so slight relative to expectations. But that's something that we need to be wary of. Then the fourth thing was asset growth in wealth management. It was still quite strong. One of the big bellwether asset managers, the numbers were quite strong. I think the net flows were like 160 or 170 billion in the quarter, which is quite strong. We're always looking at each part of the business. But I say in order for the stock to do incrementally better at this time, people tend to be focused on those ROE targets. So that changed the dynamic on a couple of stocks. As far as just the ongoing operation of the business, it was strong, it was expected to be strong, so not seeing quite the reaction that you might expect.

Yeah, and then just a little bit of volatility in markets. But you would expect in these big diversified banks that have all kinds of exposure to markets in many, many ways and like strong markets, or at the very least, they like volatile markets, that's paid off for them, even against very high expectations.

Yeah, and the trading component was quite strong. So the uncertainty that we saw in the spring, even though the market kept rising, different pockets of the trading business did better. That was ahead of expectations.

Was there anything in the reports that gave you any hints about the US economy and where it's sitting? There's a lot of debate. We've got short-term interest rates being cut. We have all kinds of talk that growth is picking up and the big beautiful bill is kicking in, energy prices down. But we've seen the 10-year US Treasury drop about 20 beeps over the last week and a half. Again, worries about trade. Anything in the comments? I guess none of the US banks are as large at a relative level as the Canadian are here in Canada. But anything we can glean from it?

Yeah, I would just go back to those. The labor market is, I would say, sanguine is the right word. It's not really growing the way that it did. I think some consumer credit pockets are a little troubling. The bifurcation of the US consumer is very much on display. And I think the fourth thing is around these two bankruptcies. Bankruptcies tend to come in packs. My mom used to say, bad news comes in threes, that type of thing. If there's been a couple, it seizes liquidity a little bit in the system. We've seen some of the funds that had lent money to these institutions get redemptions. Then that forces them not to make the loans that might have been in the queue. That liquidity is tightening a little bit. That can be offset if the central bank lowers interest rates. But I think just at the margin, there was a couple of things that might chip away at outright bullishness on the US economy.

Well, it’s going to be very interesting to watch. Glad to hear that you were up this morning doing that data center deep dive. That sounds fascinating. I was making bacon and eggs. And I know as well that as we move deeper into the fall here in Toronto, the temptation for you is going to be to go out and rake, pick up that last leaf on your front lawn instead of doing that analysis. Can we expect less time for Stu to do that digging and analytics around his real job?

No. Any leaf activity takes from other social work, not from analysis, that's for sure.

Well, we'll keep getting updates from your battle with the leaves because I know that's very important to you. This was fantastic. We missed last week, and I'm glad we did because we were able to pack an awful lot just watching the way things flowed over the remainder of the week. I think that added a ton of value in terms of people's thinking about how they want to manage in this economy. Again, how you're thinking about managing your big portfolio in the face of everything that's happening. So, Stu, thanks as always.

Great. Thanks, Dave.