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Despite tumultuous market conditions this year, some companies have prospered through the uncertainty. Meanwhile, others were not so lucky. But, as Stu Kedwell, Co-Head, North American Equities, says: fantastic businesses do not always equal fantastic stocks. This episode, Stu breaks down some considerations to think about to before buying stocks, and why evaluating odds can be key to success. [10 minutes, 24 seconds] (Recorded October 14, 2020)


Hello and welcome to The Download. I’m your host, Dave Richardson, and I am joined for (S)Tuesdays on Wednesdays with Stu Kedwell. For those of you who listen outside of Canada, it was Canadian Thanksgiving Monday. So just like the trash pickup in my neighborhood gets pushed back a day, we pushed the podcast back a day again this week.

Slowly coming out of our turkey slumber.

Yes. Did you have a good Thanksgiving Stu?

It was a great Thanksgiving. You?

We stayed distant.

Us too.

And so, looking forward to next year when maybe it’s back to normal, but it’s still nice to see people even online. So, I was going to ask you about U.S. bank stocks; their earnings were out earlier this weekend. And the performance is kind of a boring topic. So I thought we’d go in a different direction. Because I think investors are always torn. And you, managing large portfolios, you’re torn the same way. You look at U.S. markets and bank stocks are almost half of what they were at the peak of the markets in February. Then you’ve got all of these different big technology names that just seemingly continue to go higher and higher and have had massive recoveries from the bottom in March. And that’s exciting. We’re seeing a lot of individual investors, particularly younger investors, go out and start to dabble in those stocks, buy those stocks. But there’s obviously risks to that. How do you balance out these big established companies? It’s not very exciting right now. There are obviously better times ahead down the road, and these exciting technology companies that you have to pay a lot for in terms of price to earnings, price to sales. How do you think about making those decisions Stu?

Well, it’s a great point and it can be frustrating at times. I think you have to acknowledge — like we try to do in other conversations — that the pathway the stock market takes in the near term can be pretty varied. There is a lot of excitement and enthusiasm around certain businesses and not as much around others. When you buy a stock and you’re going to own it for a long period of time, what you have to recognize is that you are buying a set of assumptions. That so much cash will come out of that business over the length of your investment and that the prospects for that business, whenever you decide to part with it, will be strong enough to support a strong share price at that time, so that you’ve made money. And ideally, the best investments are the ones you don’t have to sell. They just keep generating more and more cash. They take that cash, they reinvest in their business and they find new growth avenues. From time to time, the assumptions that the stock market is willing to make about certain businesses seem to get stretched in one direction or the other. You mentioned that the bank stocks had started the week. If you look at JPMorgan which reported on Tuesday, a stunning amount of earnings. A couple of things were interesting: the first was, they released some provisions for credit they had made in the past, which means that the experience that they’re seeing in their actual charge offs, the actual loans going bad, was not quite as worrisome as they had originally thought. The trading business was very strong and the capital that the bank has is stockpiling. Eventually they’ll be able to use it to buy back stock, but not yet because the regulator is asking them to be prudent around Covid. All seems fairly reasonable. But the capital is not being wasted. It’s just stockpiling and eventually that will come back to us as shareholders. So you look at a business like that and say, probably eighteen months from now, when some of the concerns around net interest margin have started to dissipate, some of that capital can be used for share buyback, loan growth starts to resume and the multiple that the earnings trade for returns closer to normal, and you could see quite an interesting share price return. You think about that business over a very long period of time, generating excess capital, buying back stock, supporting the economy; that is a company that we would want to own for some time. But that is out of favor, so you get to buy those kind of assumptions for what we think is a fairly reasonable price in the stock market today. In some other instances, and you mentioned some of the technology names where there’s a tremendous amount of growth right now. Many of these are fantastic businesses, but fantastic businesses aren’t always fantastic stocks. And that’s something that investors have to try and separate, because when you buy a set of assumptions that is very robust and you are assuming that that will persist forever, that is something that can be more challenging for even the greatest of businesses to actually deliver upon. So we have a database of 4000 companies that hit a billion dollars of sales in their history. What did they compound at over the coming 10 years? How fast did they grow their revenues? Two of the fastest stocks are Google and Wal-Mart. They compounded their revenues at greater than 30% for ten years. Not every year, mind you, but over the ten years, they compounded at 30%. So you can look back on that database and say, wow, that is a very challenging task. If I’m banking on fifty companies today when only a handful have done it historically, the odds are low. It’s not to say that one of those companies won’t be the one, but if I’m betting across a whole swath of companies that these are going to be the ones, then I have to really study my assumptions that I might be making. So that’s what we do as investors. We say, what is required for success in this investment going forward and what are the odds of that actually happening? When it comes to some of the shorter-term momentum, it’s hard not to be drawn to the spectacular gains that some of these stocks have shown in the near term. But we have to acknowledge that the toolkit required for success in that endeavor is very different than investing. Very different than investing. It requires momentum, it requires rate of change. You have to understand that one day you might see a business report growth of 40% and go down 10% because it was supposed to be 41%. So these are things that we have to study quite carefully. When we think about the very long term, the odds are that your equity investments will compound somewhere in the neighborhood of 7 to 9% over a very long period of time. That is the figure that gets people to retirement. We have to be careful that we don’t make decisions in the short run that compromise our ability to realize those long-term return expectations. So it’s always a very interesting environment because some of the stocks that have lots of enthusiasm normally are not the greatest companies. But in times like this, where you have companies that are redefining pockets of business, the level of enthusiasm is understandable to some degree. But we have to judge, will the actual experience of those businesses live up to the high expectations that exist in the stock market for them?

And so, very clearly, that means you’re not avoiding them completely. But you need to look at them with a different frame of mind to work them into a portfolio that’s designed to deliver something to an investor for a particular purpose or time down the line.

That’s right. You have to take into consideration the mandate you have; value mandates and dividend mandates and things like this, where you’re not as likely to see those stocks. There are growth mandates where we would acknowledge many of them are great businesses and some of them will be in that new 30%-for-10-year club. But it requires a different toolkit to go after some of them because we need to really understand the expectations embedded in that valuation and identify where could those expectations fall short and try to avoid those growth stocks where we think the expectations could, in fact, still statistically be a very good business, but not be a great stock.

Well, Stu, because we try to keep these podcasts fairly quick, we’ll stop there. But this is something we can come back to and the nice thing about doing something on a regular basis like we do with the (S)Tuesdays — one day late this week — is that we can delve into some of these deeper issues that really get at the tough decisions and constraints we have to work with as investors. You as a professional investor, those like me who are more novice investors. And it really helps start to pull all of these challenges together into a framework where we can start to make better decisions around our portfolio. So this is one we’ll keep going down to and it’s a much better discussion than talking about boring banks anyways.

OK, thanks, Dave.

Thanks, Stu.


Recorded October 14, 2020

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