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In every investment process, there are key principles fund managers rely on to position portfolios for success. This episode, Stu Kedwell, Co-Head of North American Equities, details his time-tested principles, and shares how everyday investors can also use them to guide through shifting markets. [13 minutes, 02 seconds] (Recorded March 8, 2022)


Hello and welcome to The Download. I'm your host, Dave Richardson, and it's Stu’s days. I'm actually in Calgary, Alberta, the center of the oil industry in Canada. Stu, you look like you're at home.

I'm still at home, Dave.

And as usual, no one dresses up for Stu's days quite like you.

Well, you got to look sharp, right? You would know.

Is that cashmere, that sweater? It looks very soft.

Merino wool. Cashmere is too hot.

That's nice. You should try Alpaca; Arnold Palmer's old favorite. We're now two weeks into the Russian invasion of Ukraine, and we've seen what happened with markets, both fixed income and equity. This is probably a good time for investors to go back to first principles, to go back to their plan, to go back to thinking about what their risk tolerance is. It's these kinds of moments that test what your real risk tolerance is. We'll circle back to that at the end of going to you as a professional investor managing billions of dollars of assets. You also go back to first principles. You've got a core set of principles that you follow, things that you look at when things are shifting and you want to make sure that you're in the right spot or understand what actions you need to take. Why don't you walk us through— I think we've done this before, but this is a particularly interesting time or different time. What are you looking at and how are you using those basic principles to make decisions right now?

As an investor, inside of the funds, the things that you're looking at— we've talked about this in the past—, but the first is the balance sheet of the business. That is your first protection against volatility. Looking at a company's balance sheet, looking at the ratios relative to their equity, relative to the cash flow that they might generate and working through, is that a potential stress? It's a potential stress for a couple of reasons. The first is, if we're going to get more volatility in the revenue line, we can go talk to management about what might you do to change things, what might you do to expenses to preserve the cash flow? But what you really don't want in this environment is a business that has to focus on its balance sheet. You want them focusing on dealing with the task at hand, which is managing the business through this process and also looking for opportunities that inevitably will present themselves to get them through to the other side. The balance sheet is the starting point. Then you're on to discussions around margins. Margins are going to move around in some businesses a little bit more than they might have. Energy businesses are going to see expansion. Some domestically oriented businesses are going to see expansion. Some other businesses where their input costs are going to go up, are going to see contraction. We need to go through company by company and have a look at that and then compare those scenarios relative to the share price that exists at the time. You've seen big spikes, and we've talked about this in fertilizer companies, energy companies, some gold companies. We need to think through that. We've also seen others that are pressured. If you have a share price that's pressured and you're not worried about the balance sheet and management is capable, then time is on your side, because you know that eventually will sort itself out. If you have that same situation but you're a little bit worried about the balance sheet, then you might take that one off your list in this environment. Those are the things that are going on inside of the funds, as it always is. We call it back to basics, but it's really an ongoing process of basics. Scenario investing is very iterative. As soon as you're done with the scenario, you start again. Never more so than today when things are changing at very quick paces. You have rising energy prices. You have to figure out what that means for energy companies. But it's also going to have some impact on some consumption. You need to work through all the pros and cons across all the businesses that are available and keep doing that on an ongoing basis.

So Stu, when I look at my portfolio right now and I look at the ups and downs every day, even within days, I just feel that desire, that sense that I should be doing something, I should be taking action. Does that creep up on you when you're managing through a situation like this?

It certainly does because it's human nature. But that is where the process really comes into play because volatility can do one of two things. You can turn it into your friend. Warren Buffett has written about this. You want the market to serve you rather than vice versa. Some of the other things that really come into a play— we've talked about technical analysis— there are conditions inside, when you look at a chart, if something is overbought or if it's oversold. Those are indicators that we use. What that really says is, are you late to the party? If something is really overbought and you're like, I can't stand this, I have to buy some. You look at that indicator and you say, wait a second, I am the last one to arrive at this concert. I'm just going to wait for a couple of days. Even if the price stays the same, but the overbought condition works itself off, it gives you a little bit more confidence. The same when you go to sell something; there's things where you're just like, I can't stand this anymore. You go, look at it and you're like, this is as oversold as it gets. I'm going to give that some time just to see how things might progress a little bit. When you're doing portfolio management, you have three silos that you're looking at. The first is, is it a business that I want to own over a long period of time? You try and answer that question. Doug would say, those are the horses in the stable, and when do I pull them out onto the track? I put them out onto the track when the scenarios are in favor. That's where you get into some technical analysis. Am I bringing this horse out of the track right? Has everyone already acknowledged that that's a good thing to do and vice versa? Then you have your portfolio characteristics where you're looking at the risk positioning you might have. How is my portfolio exposed to this factor versus the market? Is it dividend stocks? is it balance sheet? These different factors. That also can result in some tweaking to the portfolio. But generally speaking, over a long period of time— and this is where there's strong alignment with the same thing that our investors are trying to do— if I own a collection of businesses where the odds are generally in their favor over a very long period of time and they're good businesses, I'm going to get a pretty reasonable return from that. That's why we also spend time, thinking about the market where in the long term we get earnings growth and we use normal valuations and what type of return is available to us. That doesn't change nearly as much as the day-to-day volatility might suggest. Then we have a bunch of tools that help us deal with the short term, which is often a function of liquidity and sentiment and some of the emotions that we've discussed today. Probably the one thing that has changed a little bit in the last week is some of the liquidity indicators. We have to be a little bit wary of that because credit spreads have widened a little bit more than many would like to see in the last week. When you get all this massive volatility, it removes liquidity from marketplaces. When you remove liquidity, you need a higher return to incent it to come back. That's what we see with higher credit spreads. But if that is a real governor on some earnings and some economic activity, we have to work that through in the short term. It doesn't really impact the long term, but it can impact the short term. We have to always have that on our radar screen.

When you're talking about credit spreads, just to be clear, we're talking about the difference in the yield that a very low-risk company or government would have to pay, or their bonds would trade, versus a higher-risk company or government. When risk appetite is reduced or liquidity gets tighter, those spreads widen. That's just a reflection of the risk environment that we're involved in right now. Is that correct?

That's exactly right. Companies have credit ratings. Triple A rated credit, like Berkshire Hathaway or something, would trade very tight. They are very low-credit spread to the government, but even that might widen by a basis point or two basis points during a period like this. If you are an investment rate credit, your triple B, those are wider yet, and so forth. Yes, you're exactly right. It's that spread between what companies borrow at and what governments borrow at.

My one brother-in-law always pays me back; I lend him money. My other brother-in-law, he's got to give me a lot before I'm going to give him a couple of bucks because he never pays back. I'll warn you about him after the broadcast. But the big thing here, I think, for the audience to take away, is really around the idea that you have a very set process. We talked about this throughout Stu’s days over the last three years as we've been doing them, when things start to get uncertain, when things start to get really almost overwhelming from an emotional standpoint, you fall back to those principles, that process that you have, and it avoids you making emotional decisions that will hurt you as an investor in the long run. This is your profession. You spent your whole life learning this profession, and you're in it every day. You're working almost twenty-four hours a day doing this. For some of us who aren't as deeply involved, we may not go to the depth or have the detail of process that you have, but just having a basic plan in place of what you're trying to achieve is so critically important, particularly at moments like this.

I think that's bang on. Investors in the markets prepares themselves for all sorts of activity, much of which you can't even dream of in advance. You just know that there'll be something, but you also do it with the notion that a good business generating cash flow, either paying that cash flow back to me or reinvesting it wisely, will compound value over time. I can look at a broad group of stocks and compare that valuation, both on absolute terms, or relative to what's available in fixed income. Normally there's a risk premium, which there is pretty consistently. If I give it time, I'll capture that. That is one of the central tenets. Simultaneously being aware and acknowledging there will be volatility and also being confident that in the long term, businesses drive a fair amount of value for shareholders.

Excellent. Well, Stu, thank you, as always. That's fantastic guidance. Again, so important to have those core principles, a core process, an approach that you use that you can always come back to when faced with uncertain and emotional time. So, Stu, thanks and we look forward to hearing what you have to say on things next week.

Great. Thanks, Dave.


Recorded: Mar 9, 2022

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