Hello and welcome to The Download. I'm your host, Dave Richardson, and it is a frustrated Stu's days. Stu, you headed off to the UK last week and we're going to talk about that. It's always interesting when you get traveling and talking to people and observing things. You always come back with some interesting thoughts. But we did a couple of podcasts while you were away and people borrowed your headset and they really made a mess of it, didn't they?

Well, not that I'm overly particular, but I do like the arm control on one side. And it turns out it was really just my inaptitude. You and producer Nancy straightened me out on in terms of how to actually use my headset. So it wasn't as bad as I was revved up about.

Yeah, it was a temper I haven't seen from you very often, Stu.

You mentioned the UK, and I heard a statements that I hadn't heard in a long time, but I threw my toys from the pram.

Well, we had a couple of really good guests on last week. I'm roaming the country today. I'm in Saskatchewan. This is where I buy my genuine seal skin bindings. But we're also doing a big investor event here. I think the wind chill is minus 30 overnight. So that was wonderful. And we've got lots of interesting stuff going on. But the thing I'm most excited about, and I think this is going to cheer you up. So of course, I'm a huge Oregon Ducks fan, and the Ducks are 12 and 0. I'm going down to Indianapolis to watch the Big Ten Championship game where I'm hoping to get a national championship out of my team. I've got an inflatable blow-up Oregon Duck on my front lawn. He puts up his finger, number one. And then I've got this giant penguin with big googly eyes and he's so darn friendly. He's just so welcoming. I get home from traveling last week, and the local MP gives out awards to houses that appear very festive and welcoming during the holidays season. And we won the prestigious Griswold Award for our neighborhood. And I know you probably do quite a bit of decoration out front.

Yeah, we do. We have a 50-foot blue spruce, and we put the lights up on it. I don't do it. It's amazing to watch. Some guy climbs the tree and gets the lights all on it. It's pretty cool.

Now, I'm sure there was a point when you did it.

I wish I could claim that there was, but that would be a lie.

Wow. I'm surprised. I mean, you washed windows. You have no fear going up high and stuff like that. We know all that.

That's true, but you almost have to be a contortionist to work your body through all the branches. Then you have this big, long stick. You're hugging the trunk and then pushing the lights out with the stick. It's really quite something to watch.

Wow. It's a feat of engineering. That segues exactly where we're going to go. One of the big things you were doing over in the UK, you were at a meeting talking about portfolio engineering, which is a term I love. We talk about it with investors a little bit, probably not as much as we should, because it's such an important element of the way a professional investment manager builds a portfolio relative to the way someone like me would build his. You talk about portfolio engineering, what it is, and then how you use it in the management of your portfolio, and then how we might use it in the management of more broadly diversified portfolios?

So the way I think about portfolio engineering is as if I was flying a plane and I have all this instrumentation that I'm looking at when I want to fly the plane successfully. When I'm looking at the portfolio and we're thinking about return and risk and all sorts of things, we can measure the portfolio a number of different ways. And what portfolio engineers are helping you do is the return that a stock might offer is made up of all these factors. And then at the end, whatever is left over is what they call idiosyncratic. And that is a stock-specific risk. By that, I mean, if my stock went up every day as interest rates went down, if that was the 100% driver and that it was 100% correlated between my stock and interest rates, then that's what it's exposed to. It's exposed to the interest rate factor. If my stock went up and down every day and oil prices went up or down, then it is a 100% exposed to the oil factor. And if my stock just goes up on its own, it doesn't seem to be affected by anything, then that is 100% idiosyncratic. All that return is on its own. So we started off looking at a variety of these factor analysis. So you have a portfolio and you say, these are my factors — value, growth, momentum, quality, maybe interest rates, different sectors — and I can look at how my portfolio is exposed to those factors. And by and large, there are some factors that generate return reliably over time, but it's not something that you really want to embed, huge factor exposure into a portfolio. What you really want as a portfolio manager is you want that idiosyncratic, you want that stock-specific. So as an example, if I had two energy companies, and if we looked out over five years and one had doubled and the other was still flat, that's idiosyncratic because they're both exposed to the same energy environment at the end of the day. But that's management, skill, asset, quality, all sorts of things coming into play. If we're reasonable analysts and we can find that idiosyncratic return potential, it's going to generate good returns for us over time. So what we were doing at this symposium, for a lack of a better word, was slicing and dicing portfolios and thinking of new ways to study the return potential of our portfolios and what it might be and what it might be linked to.

Stu, what you're basically trying to do is eliminate all the factor risk within a portfolio or balance it out somehow and just rely on the idiosyncratic risk, or is there something more to it than that?

Well, the first thing you're trying to do is really understand what you're exposed to. If I thought interest rates were going to drop, I could run the factor exposure and see what is most exposed to interest rates dropping. The question then would be, do I have as much risk and return potential in the portfolio as I actually want relative to that view? Half the battle of the portfolio engineering is just seeing what risks do you have in the portfolio, and do you have enough return to offset them? And then you can go through, and you can also test and say, well, based on the view that I have embedded in the portfolio, what would be the downside if we look at, say, the worst 20 days of that exposure over time. It would give me an idea about how much potential risk I have. And that's why I go back to that very first analogy. It's just like instrumentation. If I'm flying at a certain altitude and I'm prepared for all sorts of things that might otherwise hit what I think is going to be a pretty smooth ride, I just want to make sure that I've got all those exposures dialed into at a level that I'm comfortable with.

So again, as much as anything, you're trying to understand what your exposures are. Is this something that you're setting up the parameters, or is there someone working behind the scenes for you, arranging those parameters for you and signaling where the portfolio sits?

Every team here at GAM has a portfolio engineer on the team. And then you start with what we call risk models. These are predefined risk models that you're buying off the shelf. But then we construct a whole bunch of them ourselves. And part of that construction is maybe our definition of certain themes, but also looking at how our stocks are correlated together, because there's very traditional ways to look at exposure, which is your weight versus the market weight or how much the sector exposure you have. But increasingly, if we took something like artificial intelligence, that theme spreads across a whole bunch of different sectors. Of course, you have things like NVIDIA, but you also have some of the power companies and what have you. So if I said to you, Dave, how much exposure do you have to artificial intelligence in the portfolio, you might answer your exposure to NVIDIA. But artificial intelligence goes far deeper than just NVIDIA. And then the other thing that happens is right now, one of the big themes in the market has been the enablers of artificial intelligence. You could create a risk model that would look at all the people that are exposed to enabling artificial intelligence. And then you might do another one that is how much is artificial intelligence in terms of who's going to be enabled by artificial intelligence. And you can look at your exposure in the portfolio to these different themes based on the portfolio engineer's work.

And then coming back to your analogy of the pilot and the control panel, do alarms go off for you at any point in time? Do you get a warning if something's going wrong, fasten seat belts or your turbulence, whatever it might be?

Well, the warning idea is an interesting one, although it can be exposures on two-fold. It could be one, I have too much exposure to something. It could also be, I don't have enough exposure to things that are generating performance in the market. So it's a multiple fold. It's like getting this long list of things that might generate performance and then hearing how much of the portfolio is either underexposed or overexposed to each one of those factors or themes. And is that comfortable with in terms of my general view? And ideally, you want to keep those types of exposures to not really high levels over time. And you want the benefits of the companies that you own and the good management teams you own and who's got good assets and what have you to generate reliable performance over time.

But it's not setting up like it's some autopilot. The factors go in and it’s just the plane itself. You're still flying the plane and it's just giving you that data to understand and the analytics to understand the potential impact of the position of the portfolio, right?

Yeah, 100%. And the baskets of things that you're exposed to, those change over time. So if you take the momentum factor, it would redefine itself, say, every month, based on price momentum. The value factor would redefine itself every month based on if a stock does really well, then maybe it's not value anymore. So it's not exposed to that factor anymore. So it's a very iterative, a very vibrant process.

When you look back, having used this now for a number of years, is this doing more to enhance returns or reduce risk for the given level of returns? Or does it do a little bit of both? What kind of results have you experienced since you've been using more portfolio engineering? Because this isn't something that's been around for 30 years. This is something that's been more important in the investment industry over the last 10, 15, 20 years, no?

I think it's always been in existence from a standpoint of gut instinct of what you’re exposed to. Now it's much more measured. To use the flying-the-plane analogy, if you've sat there and said, I think the plane is flat and it was off by five degrees, you'd feel it. If it was off by one degree, you might not. But that degree over a long period of time is going to land you in a very different spot. So the tools that are available and the ability to monitor the portfolio in real time, the ability to monitor these different exposures, or to understand new exposures, all of that has really gone through the roof recently. And the big benefit is when an investor comes in and says, this is the type of exposure and experience that I'm looking for in my investments, our ability to meet those expectations is a lot higher than it used to be because of all these tools. And that has a number of benefits. The first is you get the experience you want. But the second is, when you don't get surprised with the experience you expect, the chances of remaining invested following the financial plan, all of that goes up. Those are some of the big benefits we get from this.

And this is one of the reasons why there's so many more serious mathematicians coming into portfolio management and investment management.

No question. One of the big differences as time has progressed is there's a lot more people with physics degrees and math degrees involved in portfolio analysis than there would have been some time ago.

Wow. And of course, you can handle all of that because you've got all those degrees. But it is amazing to see just the overlay and the constant improvement. Sometimes it's big things, sometimes little things. But as I've been in this business for 30 years now, just to see incrementally, and then sometimes in big leaps and bounds, how much has been done to refine the process, to improve the process. Keeping with your analogy, we got to have a great pilot flying the plane. We don't want me flying the plane. We want you flying the plane. So we got to have a great pilot, but we can make use technology and use math and use physics and everything we have at our disposal to give that pilot better information, better tools for better decision making. And that's really what you're all about, ultimately. I think that's what I've gotten from talking to you on this podcast from the last four years. It's all about critical decision making. And the more information you have, the better off you are, right?

Yeah. When I think back to 25 years ago or more, with Dan, we used to do the three discipline scores, which was a quantitative score, a technical score and a fundamental score. It's really just the constant evolution of a very disciplined investment process. And portfolio engineering is really just an extension of that.

I guess your core beliefs in terms of what's going to drive the market and the stocks in your portfolio don't really change, except that you've got better tools to make sure that what you have in your portfolio is exactly, precisely what you want.

At the end of the day, we want a good business that has the potential to grow and own it at a time when it's neither really over-earning or under-earning, and its valuation is consistent with ranges that we've seen before. If we start off with those two things, the odds of the business compounding over time are very much in our favor. And then as we take collections of businesses, we know that some of the things that affect that business are within management control, and some of them are without management control. So we want to make sure we understand all those exposures and really see inside the portfolio, are we overloading to one of those exterior focuses? And then we want to mix and match amongst those good businesses to get the exposures we want and then let the portfolio compound on our behalf.

A great overview of what portfolio engineering is, how it helps you, why it's important, how it continues to evolve, the role that you play in conjunction with that. I'm sure the listeners appreciate that. And I bet the listeners appreciate that they weren't at that symposium last week. They're glad you were there and not them, because it just sounds like a blast, Stu.

Well, it was a very good thing to do. US Thanksgiving often is a bit quieter in the markets because the US market, of course, is shut. So it was a great time to kick around some ideas about how to improve our portfolio process even further into the future.

Sure. Now, you may not have heard this since you got back, but a lot of stuff was happening while you were over there. We had an announcement. We had Eric Lascelles on last Tuesday. We got him on quickly on the announcement of additional tariffs on Canada and Mexico. And we've talked a little bit about this and with other guests that we had on the podcast about the potential for tariffs and what that could do to the global economy, US economy, how it could impact Canada. When you heard this announcement overseas, what struck you as the impact on the companies that you have in your portfolio? Was it an immediate reaction, like run to the portfolio engineer or to the control system and say, what companies do I own that are exposed or that'll be particularly hurt by higher tariffs? You start to think about talking to companies, with leadership, at management and say, what do you think of this? How is this going to affect your business? How does that play out when you hear that announcement? Because it created quite a stir over here, at least to the government level.

Dave, we would do something very similar to what you did with Eric. First and foremost, understanding what's exposed, going through the portfolio, revenue sources that are highly dependent on exporting to the United States. But like many things in the stock market, and if you own good companies, you need to go and check with the management teams, too, because they have ancillary plans and they have a good understanding about some of the second order impacts that might come from these potential changes. So we were talking to one producer who otherwise would be impacted by the tariffs, but then had done some work. What they sent the United States would get a tariff. As a result, the manufacturer that they compete with in the United States would likely keep more product in the domestic market because they would get the benefit of likely higher prices induced by the tariffs. And then they would stop exporting from the United States, so the Canadian product might be able to then go and export to where the US product used to go. Not that there wouldn't be an impact, but it might not be as significant as you think of on day one. So the analysts and the portfolio managers are certainly taking into consideration those first order impacts, but then also making calls to all the management teams to understand the second and third order impacts as well.

Would this be one where you would really want to get a sense of the quality of the management team? Now, you already have that with the companies you own, but would this be another test, particularly for those companies who are particularly exposed to this, and that this wasn't something that just came out of the blue. The 25% did. But the possibility of Trump's election and more tariffs being applied or a change in the free trade agreement between Canada, US and Mexico. Can you use that as a gage to see which management teams had modeled this out and figured out how they were going to work around it versus maybe some others that get caught blindsided? It exposes you to maybe a little bit of disappointment in that management team that they couldn't see beyond what was sitting right in front of them.

Well, right off the bat, you're just measuring the response you're getting to basically the same question to a whole bunch of companies. So that's going to give you a bit of a score. But through time, we've seen it, even when you look at some of the lumber producers in Canada, which have been impacted by a soft wood lumber tariffs for some time. And we've seen some dramatically reorient their business to more US sawmills to the point where they move beyond 50/50. We watched others keep a more conservative balance sheet so that they weren't as impacted by having to potentially pay the tariff. So if you take the long haul when you were in with a good management team, the outcome over a very long period of time can be dramatically different. And most of them look at the business and, not dissimilar to portfolio engineering, they're doing the portfolio engineering of their portfolio of businesses and saying, what do we want to be exposed to in the long term. And if our assets are just in Canada, then we're exposed to a large factor that's out of our control. So you see businesses work their assets just the way a portfolio manager works his or her portfolio over time. You're 100% correct. The good ones, the cream rises to the surface in this case as well.

I've had a chance over the years to do a few visits with portfolio managers to see different companies and interview management teams. And there is that job interview element of it where, if I'm hiring someone, I expect them to answer questions a certain way. But then there's some other things that stand out. You learn something and you get a feel, not because you're looking for the quantitative element, but the qualitative elements. You ultimately walk with a different sense beyond just the numbers of what you're investing in. That ends up being sometimes the difference between whether a company wins or loses in their industry.

Yeah, we're going on a bit of a tangent here, but over time, I've driven into some businesses and you see signs on the wall from two or three owners ago that have gone bankrupt a handful of times. Right off the top, you're like, wow, two or three people have gone bankrupt owning this. I better be pretty careful. And then we've had other times where we go in to meet management, and before we even begin the meeting, they go through the safety precautions and inform us where the fire escapes are and all sorts of things. And you're like, wow, this seems pretty intense. But then you look at their safety record and it's pristine. And they take it really seriously. So, yeah, there's all sorts of little things you pick up on. And going through the tariff discussions is certainly pretty illustrative of who's ready to go and who's not.

One last frivolous question. So you're over in the UK and you're just a couple of weeks after the election and you're working with your colleagues, but you're also seeing people that you know as you're out and about in London. How are they reacting to what's going on over here with respect to the US election? Did you get any sense of their feeling? And I imagine you were also over there during the 2016-2020 term. What are they talking about?

We talked a couple of weeks ago about how there's this level of energy and enthusiasm in the United States and a bit of a malaise in Canada. I would say it's somewhere in between. Like Canada, their economies don't have the exposures to these explosive technology and explosive growth businesses. Taxes not likely to come down the way they are in the United States. So there's a little bit of malaise, but not quite the same interest rate concerns with the consumer side. So it's somewhere in between. There's definitely a lot of enthusiasm for US stocks and global portfolios and things like that, just like we've seen here. And a big value difference, just like here, where Canadian markets are cheaper than US markets, so are many of the UK and continental Europe markets. Part of that is what they're exposed to, not as much technology. But nevertheless, there's good dividend yields, all sorts of things. You can find that in lots of markets. But yeah, it's this what's going to be the next move. The tweet storm of what might come our way, positively, negatively, how it will affect things, the exact same discussions that we're having here.

Any American actors or actresses move in beside them over in the UK? That hasn't happened to anyone you bumped into?

Not in my social circles, which might be sad, but no.

See, that's what my neighbors appreciate is having a celebrity in the neighborhood. With my big award for my duck and penguin out front. Kind of a big deal in my community. Maybe I'll move to the UK and set up shop. They'll love the duck on my front lawn over there.

No doubt.

So, Stu, thanks. Great to have you back. And next week, I'm not even going to announce it. I'm just going to preset everyone that next week it's not going to be frustrated Stu, it's going to be super excited Stuart, because this is actually what we would refer to as Christmas coming early with Stu Kedwell. Don't tell. Don't let it out. We want people to come back and watch. We also want people to subscribe, leave five-star reviews, tell a friend, get people listening to the podcast, and particularly what is always exciting, which is Stu's Days. Thanks, Stu. We'll see you next week.

Thanks, Dave. Enjoy the football game.