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This episode, Stu Kedwell, Co-Head of North American Equities, provides a brief overview of scenario analysis to explain how he anticipates companies to perform under various market and economic conditions. [16 minutes, 16 seconds] (Recorded: January 17, 2023)


Hello, and welcome to the Download. I'm your host, Dave Richardson. Once again, everyone's favorite day of the week, Stu's days. Stu, you seem a little glum today.

I've had one of these flash colds, Dave. These days when you get a cold, it's a non-COVID cold, but it really messes with you. Like, what do I do? Do I go outside? Do I not go outside? But I'm on day four, so I feel like I'm through it.

Yeah, you don't look like you're through it.

I appreciate that, Dave.

Along with all the fluid, you're filled with great market insights, as always. And what we were talking about doing today, we sort of laid it out last week, the year ahead and some of the reasons why things could go well, things might not go as well, what you think might happen. But I was thinking maybe we should put some numbers around that. If we start crunching the numbers, what could we see as an upside on things? What's the range of outcomes, upside/downside, on this year? And then because we use the terminology so much and we've got lots of new listeners coming in, I might push you in a couple of spots just to get you to define or explain exactly why you're using a particular number. Sounds okay?

Yeah, it sounds great. People always ask the hardest question in the world: what's the market going to do? And the market is made up of lots of stocks that all have different earnings profiles, and the valuation of each of those can change in any meaningful way. But just like the meteorologist or the weather person needs to be able to say this is generally what's going to happen, that's what people ask you about the market. And sometimes the market drives results. Sometimes it's a stock market and sometimes it's a market of stocks— the last six or eight months has definitely been more a market of stocks than the stock market—, but nevertheless, people always want to know the goalposts. So I might be sitting here with a portfolio filled with companies where I think the return potential is pretty good, where we are what we call scenario-based investors. So if I run a bear-case scenario, I think my stocks are not too far from the bear case. And if I run a bull-case scenario, it looks pretty good. And the nice thing about stocks is they don't expire. So even when you have the bear-case scenario that you're thinking about, management's thinking about that bear-case scenario too, and figuring out ways to eliminate it. And we see announcements on new products, we see announcements on restructuring divisions, we see streamlining becoming more efficient, all these things that management do to take that bear case off the table. But company by company, there's always a bull market somewhere. You can always find a company that looks interesting, but people ask you what is the stock market going to do? So we're mostly focused on North American markets, but say for the S&P 500, you have 500 companies, they each earn a little bit of money. So if they were all equally weighted, you'd take a quarter of a percent of each company's earnings and add it up. And that would be the S&P's earnings. But they're market cap weighted, so it's a little bit different. But generally speaking, if you thought about the S&P 500 as one big conglomerate with all these divisions— a Microsoft Division, a Johnson and Johnson Division, what have you—, you can estimate what those earnings might be in a variety of scenarios. So this year, if we have a recession, those earnings might be around $200. The interesting thing this time around is that we might have no real growth, but we might have nominal growth, which isn't as bad for earnings. So the current estimates are around $230. And then while this year may not be better than 230, say we had a slowdown and then we had a recovery, and people started looking out to 2024 and 2025, you might say, well, the recovery earnings could be $250 or $260, that type of thing. And you're trying to think of it as an investor. You're creating this grid, and you've got a bear case, a base case and a bull case. Now, earnings are one thing, multiples are another. So the valuation of an asset is a two-legged stool. You have the earnings or the cash flow that comes from it, and what multiple we're going to pay for it. And the multiple that we're going to pay for it is driven by interest rates and risk premium. So if I gave you a dollar of earnings that was as guaranteed as a government bonds earnings, then you would expect to trade that at the same earnings yield. And the invert of an earnings yield is the multiple. So if I have a bond that yields at 3% and I pay $100 for it, I paid 33.3 times for those earnings. So if I had two things for you to choose from, and I told you they were equally as guaranteed, one was a dollar of government bond revenue, and one was a dollar of earnings. And I told you both are guaranteed. And I said one was at 33 times and the other was at 17 times. Well, of course you'd take the one at 17 times. Why wouldn't you? They're exactly the same. The thing is that earnings are not exactly the same. And even though over time they're not that volatile, they grow around 6% or 7% a year. In any given period of time, they can be quite volatile. So the question that we have to ask ourselves then is the risk premium— which is the lower multiple that we pay for earnings relative to bonds or, in reverse, the higher earnings yield: is there enough cushion on those earnings to deal with the volatility? There's part science. You can measure risk premium over time. It can be impacted by inflation. It can be impacted by growth expectations. It is significantly impacted by optimism and pessimism because of the human nature that's involved in it. And that's where you get more art than science. So I could tell you that earnings could be this in a recession, and we could try and apply a multiple to those earnings for a period of time. Now, a rational person might say, those earnings aren't going to last, so why would I value the stock market on them? And the answer to that would be, yeah, well, over time that's true, but in that given point in time, someone's likely to value them that way because in the absence of knowing what the future might hold, people tend to focus on the here-and-now. So you have these earnings that are going to come out and you have the valuation that they might trade at. So, during a recession, the bear might say, well, 15 times 200 or 16 times 200 or something like that. And even though we know that likely wouldn't present it for itself for very long, that would be the low 3000s on the S&P 500. The interesting thing about that is that those types of scenarios often present themselves for very brief periods of time. And the reason it's good to be a scenario-based investor is that when something is negative, you also want to have in your head, okay, say there was a recovery in 2025 or 2024 and those earnings were 250 or $260 and inflation was back and contained, and interest rates were in the neighborhood of 3 to 3.5% or whatever they might be on ten-year bonds, then the S&P might trade at 4500 or 4600 in that scenario. We say investors want to be like a first responder. In the middle of the crappy weather, when people are very focused on recession and say the market gets pushed down towards 3600 or 3500, whatever it might be, in the back of your head, you're like, yeah, but when this changes, all of a sudden I'm going to be up. If tomorrow we were presented with the S&P at 3000 in a recession, I know that on recovery I might be up 50% in that scenario. So I try and keep those scenarios in my head because what we know over time is that those multiples will normalize around 15 or 16 times and those earnings will grow over time by around 7%. And I'll receive two in a dividend. So I kind of know what's at play in the longer term, but in the short term, I've got to deal with small changes in earnings and much larger changes in behavior and personality and optimism and pessimism. So everyone needs a road map to try and get themselves through that. And I've just tried to articulate what our roadmap is.

Yeah, and then, as you say, using the scenarios, it helps you emotionally. Because one of the hardest things for investors to do, when things feel really bad and the news flow is terrible and the market is down, to actually step in and take advantage of that opportunity that's being presented to you. You gave that mathematical example— $200 in earnings, 16 times multiple, so 3200—, that gets in your mind. And then on the upside, if we come out the other side, maybe you're up to 250 and an 18 multiple. So say you got up into the 4200-to-4500 range, it helps you go, wow, if things did creep down into the 3200-to-3400 range, I should really be watching for that. That's going to be an opportunity, and it's going to help you move forward to take advantage of that opportunity because you've done that analysis in advance. Or am I missing something? You're obviously going to reevaluate when you're at that point, but is that one of the things that helps you act when you should be acting and not getting emotional or pessimistic about where you're at at a particular point in time?

100%, and I was using this analogy with my kids. Today everyone uses Google Maps. You say, I want to go from Toronto to Montreal, and I put in Google Maps and it says it's going to take you 5 hours and 32 minutes. And it shows you the little red lines of construction. It's very precise, relatively speaking. When I was a kid, you'd get that trip book from the CAA, and it was like, turn the page. And you'd have the one page with the highlighted route, and it would show you where construction was. And back then, that was quite liberating because the number of times you get on the highway and then there'd be a traffic jam and you had no idea, and it totally threw you off, at least now you'd have your trip tick, and you'd be like, oh, there's construction up a front. That's kind of like a scenario-based investor. I don't know exactly how long it's going to take me to get through but I know I'm going to get through it. At least I'm aware. So a scenario-based investor says, I want to be aware of all these things even if they don't present themselves. So I kind of know what I might do in advance today because of Google Maps and everything. We're looking for precision, and unfortunately, when it comes to markets, because of the behavioral aspects to it, it's hard to have that precision that some people might like.

Yeah, but as you say, the one thing about being taken off course, as long as you know where you're trying to get to and know that you're going to get there over time, as long as you stay the course, you ultimately do get there. The tools you have available to you now are going to help you and the tools that you would have versus someone just sitting at home investing are very powerful. So it's going to allow you to have a little bit more precision but it's still about making the right calls, moving through traffic, moving around traffic, finding a different route, but ultimately getting to where you need to go that you're trying to do as well.

100%. And then, what you want to keep in mind is that when things seem congested, the incentive to find your way back to the normal path is very high. Everyone has the same incentive. When we're all in traffic, we all want to go home. So the incentive for us to eventually all get in line, get the car straightened out and get on with our business is quite high, even though at the very moment in time it might be like, well I can just deep here and I can deep there and this and the other thing, it doesn't really speed it up. But you know what I'm trying to say. I think when you can't figure out why something might get better, it's always a good reminder just to say that the incentives in the system are for it to get better.

Yes. A lot of what we've been over the last year, the bounce out of COVID, the incentives in some ways got a little bit out of whack. Inflation rose, you had to have interest rates come up and you had to tap the brakes short term on that. But as you say, ultimately things will get back on side and things will move forward as they always do because over time the incentives are for it to get better. That's actually quite a brilliant outline of scenario analysis for a sick guy. So, you came through on the smarts. You still look terrible but you came through, or you had to, smartwise.

There must be something in the Vicks VapoRub, I don't know.

Excellent. Well Stu, like I said, that was really nice, particularly for new investors. And this one, take and listen to this with an advisor maybe you're working with. There's some really great stuff around how you want to think about the range of outcomes and prepare yourself for the potential for that to happen. But think of it in a very positive way about how that can create opportunities for you to gain some upside when things are down, and to protect yourself when things get too far ahead and have some more success investing. And whether you're buying an individual stock or whether you're buying a fund or ETF, the same thing applies. We always say, don't get too excited when things are good, don't get too pessimistic when things are bad. And there's tools and analysis you can do to be better at focusing on the numbers and the objectivity instead of emotion.

You nailed it, Dave.

Wow. But I'm feeling really good right now. Last month I couldn't have done that— if you listen back to some of the old episodes. So Stu, another great Stu’s days. Thanks. We'll see you next Stu’s days, I think. I think we're going to get into a little bit more earnings, hopefully, and maybe we can start to dig into some actual data to show us what might be playing out this year.

Great. Thanks, Dave.


Recorded: January 17, 2023

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