Hello and welcome to The Download. I'm your host, Dave Richardson, and we promised we were going to get him back more frequently, and we hate to break promises. My wife would argue with that, but generally, I hate to break promises. And so we have got Scott Lysakowski back again. Captain Canada.

I'm okay to be the Canadian representative, but Captain Canada, that's pretty bold.

But look, you manage Canadian equities. You're from Canada. Actually though, here's one thing that's on the other side of the ledger: I don't think you drink a lot of Tim Hortons.

For the YouTube folks at home, I did top up my coffee for this. I don't know if you could see this. Can you tell by the color? So this is a vintage RBC mug, and this is the Whistler Reuse-It Center, which is like a community-based Value Village in Whistler. All kinds of great finds. I got this for 50 cents. I'm a big value guy. Got this RBC vintage mug for 50 cents at the Whistler Reuse-It Center. So if you're passing through Whistler, stop in. Always a great find in there.

There you go. Always tips beyond just investing you get here on The Download. And that's one of the reasons why we have Scott on. So Scott, since we are going to talk about Canada, maybe this is because we're in the investment business and a lot of that news flow is from across the border and people pay attention to US markets. But I hear about these massive US companies announcing their earnings. Canada's a little quieter. Maybe when the banks report, it's something. But we've talked a lot already in various episodes here about what's going on with US earnings and really earnings all around the world. And again, if you subscribe to the podcast, you know Scott's on regularly. He did a great synopsis of what's going on with profits across many markets— not just Canada— in his last appearance about a month ago. So subscribe, follow us wherever you get your podcasts and subscribe on YouTube. But Scott, the profits this quarter, you'd have to just say once again, a big huge check mark. Not bad at all.

That's right. Earnings season is always a busy time. Lots of news and information. Sometimes it's too much news and information hitting our screens and our inboxes and lots to take in. But it is an important time because as we all know, when companies report their earnings, it's their time to share what's been happening in their business in the most recent quarter. Also to give updated forecasts on what's happening in their business and how things are looking into the future. There's a time for a conference call where analysts can ask questions about the business. There are opportunities for us as investors— and a lot of time large investors in some of these companies— to have a follow-up conversation with management on our own to discuss the quarter and the outlook. So it's a lot of information. I would argue a little bit too much information, but it's a great opportunity to reset expectations. And then, of course, there's the market reaction. And so we think about earnings in a couple of ways. One, we have to think about the reporting and earnings for a quarter that's already happened. And that information is already in the rearview mirror. As we've discussed many times, the stock market is looking forward. So sometimes companies have great quarters or decent quarters, but the outlook changes, or it's not just about, was the quarter good? It was, was the quarter good enough to meet expectations? So what were the estimates and what were people expecting going into that quarter? And sometimes when those things are misaligned, whether the company misses what people expected, or people expected them to have a good quarter and it was good, but it just wasn't as good as expectations. The stocks can have a bit of a reaction. And as you're probably aware, and perhaps our listeners are as well, there's a lot of new market participants. And I thought you and Stu had a great discussion about levered ETFs and things like this. So there's a lot of different participants, and so when stocks have moves, those moves can be very magnified. But dialing down some of that noise, some of the things that we focus on in the quarter, that’s the opportunity to get an update from management and things like this. But I thought I'd just maybe share some stats. I love the numbers. I've never met a number I didn't like. So in Canada, for the TSX, we've had about 3/4. 75% of the market has reported. The banks are the big ones, they're coming up in the next couple of weeks. So there's probably remaining, but I'd say outside of the banks, most of the companies have reported their Q2 or whatever fiscal quarter they were reporting. And some interesting numbers come out of it. So just over 60% of companies that have reported their earnings so far have beat the consensus estimates. And so that's a good thing. And the median beat has been by around 3 or 4%. So they've been beating, but they haven't been blowing them out on average. That's one of the things we look at really closely. And we could look at a year-over-year number— and that's a good gauge of how things are going in this company year over year and building on where we were last year— and there's some really interesting takeaways from that. And one is that earnings are up 32% year over year, which is just an astounding number. I don't think anybody goes into the year going, I think TSX earnings are going to grow 30% this year. Now, there's a bit of puts and takes because if you think about in the resource sector, energy and materials, and it's not just gold. So energy, we know the oil price has been up a lot given the things that have been happening in Iran geopolitically. And if you think about where we were last year, oil prices were a lot lower. So energy earnings are up over 100% year over year. So that's not really something that we would expect to persist. Materials also up 50% year over year. I think we talked about it last time, the gold price has gone up and come back down and it's below where expectations are, but still year over year, the gold price is higher and therefore gold earnings are up 50%. Base metals, the other part of the material sector, the other mining— copper and things like this— those earnings are up over 100% as well. Those are not things that I would expect to continue because you're thinking about next year, we have to think about where earnings are going to be relative to an $80 oil price environment. There's some interesting takeaways here. I want to spend a minute on operating leverage in a second, but we also think about the estimate revision. So there's 3 components of an earnings report. What did they deliver? How did that look versus expectations? And then, what are analysts now going to do to their estimate forecast going forward? If you had a company that beat expectations that were already high and their outlook was good, but maybe not higher than what people expected, you actually might see estimates stay flat or even revise a little bit lower. What we're seeing, not surprisingly, estimate revisions is a bit of a mixed bag. In the energy sector and the material sector, we're seeing some negative estimate revisions because the oil price has come down from where we were previously. Analysts are calibrating their numbers lower. Same within the gold sector. But outside of resources, we're actually seeing positive estimate revisions, and that's a good thing. I think the last time I was on here, I said going into earnings for the TSX, you're going to get a bit of noise in oil, you're going to get a bit of noise in gold as these things are up, down, lots of volatility there. But it's the rest of the market chugging along nicely, and that's where I want to spend a bit more time today discussing the concept of operating leverage.

Scott, maybe just before we go there, when was the last time you recall seeing earnings this powerful? As you say, we'll cut out energy and gold, because they're going to bounce all over the place based on the underlying commodity, and you see these big moves up and down in terms of their profits, but again, broad-based. Astounding was the word you used. And when was the last time you saw anything like this? Or have you seen anything like this?

Yeah, that's a good question. I would say coming out of periods— the thing that comes to mind, out of the pandemic where especially as you had companies managing their cost structure a little bit better through the pandemic. And then, you're getting that reopening trade. We just said, when people can go out and do things again, there were certain parts of the market and certain businesses that were getting lots of activity because people were at home with nothing to do. Think about our exercise equipment and things like this. But the other parts of the business that were a little bit more impacted by people being home. So that's something that jumps off the top of my head. But you get these moves in commodity prices and that's going to really drive the numbers a little bit more wildly. But if we think about the cyclical parts of the market and outside of resources— so ex-resources Canada— the cyclical parts of the market are doing better than the more defensive sectors. We're seeing positive earnings growth, positive estimate revisions in things like industrials, discretionary, financials and technology sectors. And that's what I was referring to as the middle of the market— maybe it's not the middle, maybe it's just the rest of the market. And that's where you see this idea of positive operating leverage. In the quarter, in the companies that have reported earnings so far, revenues were up 13%, but earnings were up 30%. That's a great example. In the US, it's very similar. We're a little more through the earnings cycle in the US, but similar type of numbers there where year-over-year earnings growth north of 30%. 85% of the companies have beat. The median beat is around 5 or 6%. Same thing, you're seeing revenue growth of 13%, but earnings growth north of 30%. And that’s this concept of positive operating leverage. We talked about it a little bit with the banks, but we see it in a number of sectors. We see it more cyclical businesses, but more, the industrial types. The rails have reported, they showed really good positive operating leverage. And that's something that's really important, that you get more earnings growth as incremental revenue gets added to the equation. And that's a real benefit to shareholders, particularly in industries and sectors of the market that are more cyclical, more tied to economic activity. I was trying to think about how do I describe this? I had some family visiting or spent the weekend with my family and I was explaining to my brother-in-law how positive operating leverage works. Now, operating leverage works positively and negatively, but we'll stick to the positive.

By the way, Scott, that just sounds like a fabulous family gathering. I'm glad I wasn't invited.

Talking operating leverage.

Come on over and watch the ball game. Or come on over and talk about operating leverage. I'll give you a primer. But it makes for a great podcast, Scott. So fire away with your example.

Usually when I get going on it, my wife would give me a look of like, nobody really cares about this. But he seemed engaged. Maybe he was just humoring me. So I was thinking about how do we explain positive operating leverage to the brother-in-laws and the mother-in-laws and our moms. And I thought, what if we just stripped it down to the most basic business example that we can? Let's think lemonade stand. So I'm thinking about a young Dave Richardson out on the driveway with the table set up and selling lemonade. Back then, Dave, was it a penny a glass?

Oh yeah, Jesus. It was not that lucrative, but I knew about operating leverage back then.

Okay, so let's think about our basic lemonade stand. In a business, you have two types of costs. You have fixed cost and variable cost. So in a lemonade stand, your fixed costs are fairly low. You borrow the table from mom and dad, and really, your only cost is the variable cost. Water, that's pretty free. Lemons, if you're going freshly squeezed, maybe a little bit higher end, but if you're just going with the mix, it's pretty cheap. So every glass has probably got a couple cents of variable cost, and then the rest is profit. When you're thinking about positive operating leverage, it really applies to businesses that have some fixed cost component to it. So let's say we've got a lemonade stand and it's going well. We're in these hot days of the summer. And somebody goes, what I'd really enjoy is one of these frozen daiquiri-style lemonades, non-alcoholic of course. And you say, wow, that's pretty cool. Then young Dave Richardson goes into— I guess it wouldn't be the internet; it would be the Sears catalog— and looks up this frozen lemonade machine. Let's keep things simple, let's say it's $100. If I got this frozen lemonade machine and I spent $100, instead of 50 cents a glass, I could sell my lemonade for a dollar a glass. And I think that's a really good idea. So even though your variable cost is a still water and lemonade mix, it's still quite low, now you've added a fixed cost component you got to pay back. Maybe you had to go borrow money from mom and dad and say, can I borrow $100 to get this frozen lemonade machine? But you got to pay them back. And so let's just keep things really simple and let's just say that you're making 50 cents a glass. Now, how many glasses would you have to sell to pay back the cost of the machine. You're not really making any earnings because you're still paying off the cost of your machine. But at that point where the cost of the machine is paid off, that next glass is pure margin. And that's something that we see in the economy. We see it in stocks. If you think about a railway company or we were looking at a trucking stock's earnings this quarter, they grew their revenue 7%, but their earnings grew 50%. And so there's this massive amount of operating leverage because they're increasing price, they're getting more volume as demand is strong, and there's not as much trucking capacity in the industry anymore, or currently, and they're getting increased volume, higher prices, and it's not really coming at any incremental fixed cost. Their fixed costs are covered. Once you hit that positive operating leverage, a lot of that incremental revenue comes at a really high margin. Same thing for a bank. If you thought about whether it's net interest margin or capital markets revenue, if it's a really busy quarter or year for the capital markets business, they might be hiring more people, but you're really getting a lot of this revenue over a fairly fixed cost base. We're starting to see that really show itself in these earnings this quarter. This could also be a really important thing to think about as we move forward into a world where the use of AI is driving more productivity, more efficiency within businesses. Maybe businesses are using AI to get more revenue without really taking on a lot of additional cost. So this growth and revenue will come at a really high margin and that'll be a really big benefit to existing shareholders as that incremental revenue comes at a high margin that leads to increased earnings, free cash flow, and ultimately flowing back to shareholders. I hope our little lemonade stand example lands with the audience, but I think it's a really important thing to point out.

The other older people like myself who are listening may be somewhat offended by a couple of your comments, but no, it was a solid example. Because it was back in the old days that I was doing a more traditional lemonade stand. So, you did nail it. But I think that was where I was going with that question earlier about, have you seen earnings like this before? And it leads into this whole idea of artificial intelligence, and you addressed it, but how much of an impact do you think this is going to have over an extended period of time instead of just what we're seeing over a handful of quarters? Is this a story that's going to really play out over a number of years, which ultimately leads to some of the things we've talked about with some of the other managers— and you're involved in investing in some of these companies too— all this CapEx that these companies are spending, is it going to produce a return down the line? Maybe we're seeing it already in the companies that are using AI, which should promote the use of AI and then trickle down. Do you see where I'm going with this? Do you see that as part of this bigger picture narrative driven by what's going on with AI?

Potentially. I would hesitate to attach what we're seeing today to AI just yet, although I'm sure there are some examples of it being used. There is some limitation. At some point, in order to keep your revenue growing, you may need to add incremental fixed costs. So if things are growing really well and if we want to grow our revenue in our lemonade stand another 10 to 15%, we might need to get another lemonade machine. We might actually need to open a new location. Send your younger brother down the road. Hey, take a table, borrow $100 from mom and dad, get another frozen machine. We're going to expand. So you will be growing your revenue but that will come with additional fixed costs. Same thing, this trucking company, at some point they may need to expand, get more trucks, get more people, need more training for more drivers. It may come with more investment. And that investment will have a fixed cost component to it as you're trying to pay that back. So I would say there are limitations. We're not emerging out of a weak economic cycle, but we had a period where people were somewhat concerned about trade and tariffs and what's the future going to look like. There might have been a little bit of hesitation on growth and capital investment. What we've seen is that despite all the noise from this trade— and we're not out of the woods yet, there's always something. There are a few things happening. The next couple of weeks or months are pretty big for Canada on the trade file. I don't want to say we're out of the woods because there's certainly some surprises that could come down the pipe. But it's this idea that people have hesitated, and we've seen economic growth or the economic activity continue just to trundle along in a positive direction. So they haven't invested, but we're getting that top-line revenue growth. So you're seeing the positive operating leverage. There is a limit to that. So at some point we will have to reinvest. And add to the fixed cost base, which would be a good thing because you're driving even more revenue growth. As it relates to AI, there's two things I would observe— and I am by no means an expert on AI; we're users and we're heavy adopters and it's really helping us get through earnings seasons, I'll tell you that— but in terms of a hyperscaler and where all the CapEx is happening, this is not my area of expertise, but as an observation, we've seen all these huge CapEx numbers and the biggest question in the market was, what is the return going to be? Is there going to be a return? Is it going to be big? Is it going to be small? And when are we going to start to see it? And one of the things that has really impressed me— and we just got out of our quarterly strategy sessions as a group at GAM last week— and I think people walked out of the room or this 2-day session really impressed with the rotational aspect and strength of equity markets and that rotational aspect adding to breadth. I think I've mentioned this in the past. When we're thinking about equity market strength, you want to look at the returns and think about where is the return coming from? Is it coming from a small number of stocks, a small number of sectors? You want to see breadth. You want to see strength from a wide number of stocks and a wide number of sectors. Through the earlier part of this year, we saw the big hyperscaler companies spending all this money in the stocks, and the stock market was a little bit hesitant of where this was going. They weren't going down, but they were moving a little bit more sideways. They were saying, where is this return going to come from? Then what we saw in this quarter— and it was just a glimpse, but I think the market sees a glimpse of something and says, oh, I think we could see a lot more— we’re starting to see early signs of that payoff or starting to see some of the early returns of that CapEx getting spent. And of course, the stock market, as it looks forward, says if there's a glimpse, there potentially could be more in the future. And they bring that forward basically by the share prices going up. They're bringing that growth forward, expanding the multiple, stock prices are going higher. And that really led a positive rotation into the market, back into these big bellwether names in the US market. So that really took the markets to new highs. And then you've had the rest of the market performing well, as we talked about, similar in Canada— industrials, discretionary, technology— these sorts of stocks. And then you have this re-emergence of the big stock accelerating higher as well. I'm not trying to dodge the AI question completely, but I think what the market is saying is like, I think there's something here and we'll see where this goes. The problem I think— if I were to worry about something— is that it's back to this expectations game. What are the expectations? If you're thinking about the US, it's showing strong earnings growth, trading at a fairly healthy valuation multiple— and even as these big stocks accelerate, the market is expanding the valuation of these stocks as well. So bringing some of that growth forward. So the expectations for future earnings growth go even higher. And then you also have this concept of we're trading at a fairly robust valuation on fairly robust earnings growth. And the other thing that we have to think about is that current operating margins, profit margins across, if we just use the S&P 500, are at their highs. And Stu has pointed this out many times. And so when you think about that, you say, wow, okay, this AI, I could see the productivity enhancements, the productivity improvements in the future as we drive more revenue growth and optimize and are able to grow our businesses without adding incremental cost because we've outsourced it to AI capital investment. That would be really good for margins, but it would basically have to take current margins that are already high and make them even higher. So I would hesitate to jump into that idea that AI is going to change the operating leverage for the S&P 500 or for equity markets going forward into that bucket just yet, especially given that we are on the higher end of a lot of these things: earnings growth, margins, and valuation. There could be a wobble in the near term or at some point over the next couple of quarters. This idea that you could continue to see that scenario, I wouldn't put it in my base case. I'd probably put it more in a bull case scenario where AI investment, even if it's just optimization of existing capital investment, driving revenue growth without any incremental margin, or you're making some AI CapEx investments, but you're also driving a lot of additional revenue from that. Then that's going to have some positive operating leverage as well. So it's something that we're going to stay really focused on as companies report quarters over probably many even years to come, but certainly over the next couple quarters. We're going to keep looking for this evidence of the return on CapEx from AI investment from the big hyperscalers, and then also the productivity enhancement and margin improvement from the users of AI, thinking just industrial companies, discretionary companies using AI to drive and enhance their revenue growth with attractive margins as well.

That's what's so fun about markets. There's going to be some people who are of the opinion that we're going to see all this continued productivity growth, and it's going to lead to better operating margins and bigger profits across a broader range of companies. And there's a whole bunch of other people who think, ah, we don't see any signs that this is going to produce anything, they're just throwing money down a hole. And people can bet either way with buying and selling stocks every single day. I've just been thinking, we talk about breadth quite a bit on this podcast with the various guests that we have on. And I've always tried to think of what would be a good way to lay out the concept of breadth. And your lemonade stand gave me an idea. If you think about it, say you had 3 kids, and they all open up a lemonade stand. You're a parent. You love all your kids the same. And one kid makes $100 the first day and the other two both make nothing. And of course, they come home, the two that made nothing are sad or disappointed. What I'd rather see as a parent, maybe one of them makes $50, but the other make like $40 each. So I'd rather have breadth. I'd rather have everyone doing well than just one doing well and the rest not doing as well. And your family, your extended family is the Canadian stock market. So that's why you like all of your family to do well profit-wise, operating margin-wise. And when there's breadth, everyone's doing well in your family, Scott.

That's exactly right. Especially when you think about in Canada, this is something that Canadian investors are really faced with. Other markets are a little bit more broadly diversified across sectors, but in Canada, you know there's going to be volatility in the more commodity resource-driven sector. So you just live with that. Sometimes it's exceptional and you look at these 100% year-over-year earnings growth numbers and you're like, okay, I don't actually think it's 100, it's just a fake level up from last year. But it's really that the other parts of the market— technology, industrials, consumer. And when you see that that those sectors are growing their earnings 10+%, you're seeing them beat earnings, you're seeing estimate revisions there, that's a really good sign of the breadth of the earnings. The other way we measure it is in the behavior of the stocks. We could say, the TSX is up 13% year to date— or 15%, when I look at my screen— and you say, that's great, but how many of the stocks are up? Not every stock is up. One of the measures we look at and it was really important to focus on it even this last couple of weeks— I talked about this dynamic where these big US stocks started to accelerate and you see market reaching new highs. We look at something that we call the advance-decline ratio. How many stocks are going up relative to how many stocks are going down? What you'd want to see, if you see a stock market, you see the stock market acting well and making new highs, you want to see that advanced decline line going up as well. So it means the stock market's going up, and it's not just a couple big stocks driving the bus. It's actually the stock market's going up, and you're seeing more advancers than decliners. So we saw that. That's a good signal of breadth. And the other one, which I think we've talked about— we have explained it, so we won't go through the explanation— but how many stocks are above their rising 200-day moving average? And so you think about those stocks, they're high and they're higher than they have been in the last year. And we're starting to see more of them get above the last year's average price. So that's really an important signal of breadth. But you're right, you love to see the stock market go up, but you want to see a wide amount of participation in stocks that are going up. That's that breadth feature that we're talking about.

And just to finish up, Scott, I think you're going to finally understand now. You said that managing money in the Canadian market is hard because of all this up and down and fluctuation of the resource sector, which is such a big part in Canadian market. Not as much broad diversification, not as many big industries across Canada. That makes managing money in Canada hard. So if you're a great Canadian money manager like Scott Lysakowski, you're a superhero. You're Captain Canada. That's my argument for it. Maybe you like it more now. No, you don't? You look frustrated.

I'll take it. I'm taking this Captain Canada on the road. We're going on vacation next week. So I'll make sure I put a little Canadian flag on my backpack so people know where I'm from.

There you go. There's my Canadian flag always with me. My Maple Leaf. Scott thanks again. Always fun catching up with you. Have a great vacation with the family, and we'll catch up with you maybe in a month or so.

Great, thanks, Dave.