Hello and welcome to The Download. I'm your host, Dave Richardson, and it is a hotter than July Stu’s day. Or smokier than July. It's hot and smoky, which I love with my barbecue. I was down in Dallas having some barbecue, so I had a nice spicy, smoky brisket and barbecue sauce. But I don't necessarily like breathing it in. Are you doing okay? I know you've got fairly sensitive skin and eyes and all those things.

Yeah, I've been fine through it all. It is quite wild. It's apocalyptic. I have trouble with that word. But when you wake up in the morning and that footage of inside the train going through Northern Ontario is just wild.

Yeah, crazy. So I hope everybody's okay. I guess it's par for the course that you're going to get some fires. But 2 years in a row to walk outside the front door and breathe in smoke that's 1,000 kilometers away or a couple of thousand kilometers away is something else. And Stu, we've been off a little bit. By the way, Stu Kedwell is the global chief investment officer at RBC Global Asset Management. So he's been globaling and that's making it hard to connect. But Stu, there's just so much going on. It's going to be great to catch up this morning. Why don't I just throw it to you. What's topping your thoughts today in terms of what's going on across what are really some incredible markets that we're seeing right now?

Yeah, there is a lot of news flow going on. So you always try and distill it down to the basics a little bit. We've dealt with 3 things in the last couple of weeks. We've had a resumption of attacks in the Strait of Hormuz between United States and Iran. And that has caused a movement in oil prices, but not the same as before. The first time you see a movie you react a certain way, and the second time, you say, well, I've seen this movie. So there is puts and takes from a market standpoint as this develops. Obviously the most important thing is gasoline pricing. And in particular, there's an article in the paper today about the tightness in diesel versus, the last time, the worries around aircraft fuel is not the same. So there are some things that we have to worry about on that front. The second is you had a lot of strong reports from memory and semiconductor companies, and then not really the same vibrant reaction that might have taken place in the past. And some discussion around what they call tokens. We've talked about this before: if I'm going to use artificial intelligence, tokens is the measure of my usage. And companies going through this initial period of time of spending left, right, and center, and then going, oh, look at the bill. Let's optimize it. And so, like anything, as it happens the first time, people think, well, these tokens are just going to be up, up and away. And now there's going to be more efficiency around it. And there are some new models that have poked their head out that can do similar tasks for a lot cheaper. This has entered the discussion. There's maybe been some supply discussions on the memory side coming from China. So we have to always think that a share price embeds a set of assumptions. And if we get a small change in the assumptions or a change in probability around one of the assumptions, the stock market tries to recalculate the odds. You've pointed out in some of your work, at the margin some of these stocks are involved in leveraged vehicles. So, that process of recalibration can be quite abrupt to say it politely. So we've seen that. And then the last thing, while some big stocks have seen corrections, there's been this big rotation. And other stocks have come on and carried the ball. While we've seen some weakness in the NASDAQ some weakness in the semiconductors, in the equal-weighted market, the average stock has done better. So those have been 3 things that require contemplation. And it's always a matter of saying, these 2 businesses operate in generally the same environment, why has one done so well and the other done so poorly? And is there an opportunity? Things like that.

And it’s a different market in a lot of ways than we've seen. You look at modern technology. You look at access to markets, the ease of access, how technology allows me to be much more active, different investment tools which allow me to take leveraged positions for very short-term periods of time. And it just seems like we've been waiting, or you generally have at some point a correction across the markets. You have a 10% pullback or a 20% pullback. And it seems like over the last 5 years since COVID we've seen, like you say, these big rotations and these massive corrections or bear markets take place in little parts of the market. As you mentioned, I did a video internally yesterday. Just looking at this year, you saw this wave of additional money rolling into gold and mania around gold. And gold's now down 30%. You had Korea, which was leading the world and over the last 2 weeks, the Korean markets dropped 30%. And then you mentioned semiconductors and storage stocks. And so, you've got all these little areas that have had these massive run-ups and then 30% pullbacks just in the last couple of weeks. Or just in the first 6 months of this year, we've got all these examples. These are massive moves. You talked about one stock, Netflix, which is something that everyone's familiar with. A generally pretty stable business model in a lot of ways. And all of a sudden, boom, the stock's down 40% from the high. So these are massive moves. I don't really recall seeing these rotations through these different sectors and the magnitude of these moves. So you got lots of different people investing, in different ways, lots of leverage, with still more money on the sidelines than we've ever seen. I guess that's just a rambling way of saying your job's really hard, Stu.

Well, yeah, that's always interesting because momentum definitely plays a role in today's market, but what we always try and think about is understanding what creates the momentum. Even in something like Netflix. We've talked about the 4 ways that a share price goes up or price changes. First, the revenue grows above, in line, or below expectations. A business collects this revenue, they have a bunch of costs, they get their profits. That's their margin. Margins change a lot more than revenue. Then we have these profits, and we multiply those profits by some number to get to the valuation. The last thing is companies put capital to work and sometimes they put capital to work successfully and sometimes when they do it, they tip their hand ever so slightly about maybe a concern they have in their business. So a company goes off and does something and you're, why are they doing that? I wouldn't think they needed to do that. And we've talked a lot about management trying to grow the business over time. And sometimes they're saying, look, we think this is a great opportunity. Sometimes they're saying, look, there's a bit of a blind spot. There's this issue in our business that we need to protect for. And when a company uses capital in that manner, investors are going, I didn't know you needed to protect for that. So then that becomes a bit of a surprise. So you think of a business like Netflix where you had all this enthusiasm about subscriber growth and they're going to add in advertising. And at the same time, they were the only game in town and now there's Hulu and Peacock and Paramount and Crave for Canadians. So that became a little bit more competitive. The advertising business, it's doing all right, but maybe it didn't quite live up to some of its expectations. And then they got involved in trying to buy some studios. Without the distribution engine, do you need to own more? So it just changes the conversation for a period of time, even though we're all watching Netflix the same degree that we were. So we've had these rolling periods of momentum in different areas of the stock market. No one wants to be a momentum investor just because. That leaves you vulnerable to some type of change. But what creates the momentum is revenue growth, margin expansion, valuation expansion, successful use of capital. So when we have the wind at our back and there's momentum, we need to understand those 4 variables as best we can because we know that if one of those changes even at a small amount, momentum could shift. A great thing to look at. Momentum is what they call a factor. It's a factor in performance. And you can look at how much performance comes from moment, value, quality, this type of thing. And if you look at the quality basket— those would be a list of companies that you and I would say they stand the test of time, good balance sheets, etc.— since interest rates bottomed, quality has underperformed the index by around 250 to 300 basis points— 2.5 to 3% a year. It doesn't mean those are bad companies. It just means that when interest rates were very low, the price that we paid for that quality was very high. And when interest rates started to rise, they couldn't grow their way out of the interest rate challenge. So the quality basket doesn't seem to change very often. Those are the test-of-time companies. The momentum basket changes frequently because what has momentum is always shifting, just as we've discussed. So there's times when there's a strong overlap between the quality and momentum basket, and then there's times when there's no overlap. For a long-term investor, I own these businesses, I think they're going to do the trick. Do I want to sell them and pay tax and all sorts of things? But the stock market is obsessed with that calculation of revenue margin expansion, valuation expansion. We've talked about this before, a big change over my investing career is understanding what a business is worth versus understanding how a business might trade. And we always need to understand what we think it's worth. But we have to understand too that those three variables— revenue, margin, valuation— are multiplicative, not additive. So a small change in one causes maybe a slightly larger change in the other, and a bigger change in the other, and you add those three things together and you get a larger share price change than from a just a small change at the top of the pie.

But as an investor, what do you think is the best way to manage through this? I obviously want to have these quality stocks. I want to own great companies and I want to own them over long periods of time— that's going to drive success— but then, I can't ignore what's happening in the areas that have momentum. I just look at this stock appreciation. It's not necessarily driven by some kind of mania. It's driven by an understanding that these stocks and these companies are moving because they're seeing massive revenue growth. They happen to be in a period where for whatever reason, the margins are at unprecedented levels. And how do I balance out? Because I think I've got to have some of that momentum. Do I need to have those, these great growth companies that might be hot in a particular period along with that quality? How do you balance that all out as an investor?

Well, it's a great question. You start with, is this a business I want to own? Every business, no matter how good the growth is, goes through some cyclicality. So you can do a scenario that says they're hitting it right on the screws. They're firing on all cylinders, revenue is surging, margins are wide. That's one scenario. Then you have a more normal scenario. And then occasionally companies go through depressed periods of time where it's still good business, but, maybe the margins compress a little bit, the revenue doesn't quite live up to expectations. So generally speaking— and it's more complicated than that— but you have 3 fundamental scenarios. And then you have valuation, and you can look back and you can say, this is where interest rates are, this is where the company has traded before. So I might have a low valuation, an average one, and an above average one. Now, the most important thing is, if you've done the good company part before you even do this analysis and you leave it for long enough, it will compound out of whatever challenge they might have. So then you have these 9 boxes. And if every one of the stocks in the portfolio is at a high valuation based on stunning results, you have to sit and wonder, how could that change? So in those stocks, then you might ramp your use of technical and quantitative analysis because you know that they are susceptible to a small change in perceptions. Conversely, when you have a good quality business and you're paying a low price for maybe currently underwhelming earnings, you don't have to pay as much attention to technical and quantitative because you know this is a good business, a good management team, the chances of them fixing this business on my behalf are very high, and there I'm just waiting. So for every business, it's going back to those four components. Even the most expensive stock has a pathway to success. It's just that the odds might be a little bit lower because we can go back through time and we can say, what would it take for this company to be successful from this price? And it would say, well, it had to grow at 30% forever. And then we can go look in our database and say, has anyone else ever grown 30% forever? And compounding, just like the story of would you rather have a penny every day that doubles for 30 days or however much money now? Those last doublings are very significant. It's the same thing when you're banking in 30% revenue growth forever. Something with a lot of revenue to grow at 30% forever in 10 years, sometimes it needs to be the size of the whole economy. And you're, well, I don't know about that. So it's just really understanding the assumptions that you are accepting in the current ownership of that security.

We've talked a lot about whenever we get into some of these strong momentum plays. So as you said, in your 9 boxes, one would be «high to low» and the other would be «low to high». You get high up in the top far upper right-hand box. You look at those companies and as you say, what they have to do to continue along that course, sometimes just defies gravity. They've got to thread the needle so perfectly that there's no way that it can happen. Although, they can still be great companies and still continue to have fantastic results. But can the stock continue to appreciate at the same levels? And then you get down in that bottom left-hand corner, and as you say, there could be some good companies that are struggling for whatever reason, although some might be signaling that they may never get out of this. Because that's the flip side of it. Some companies die along the way. But the really good companies in there will eventually figure things out. And then again, it's not about threading a needle. They just need a little bit of a shift in the storyline around that company, and it's going to start to move, and it's doing it off a low valuation. So again, the ride out of that is going to be smoother. So, in your portfolio, Stu, are you going to have a mix of all of these companies?

Yeah, you always have a mix of all of them. And you're harvesting and adding and you're out in the field each day trying to till the soil and fix things. It's a very humbling experience. Prem Watsa wrote in one of his letters, the difference between being early and wrong is indistinguishable in the short term. There are the fundamentals, there's the human behavior, that part is the constant maneuvering inside of the portfolio.

We've talked about this on previous episodes.

I'm sorry, I shouldn't say the constant maneuvering. I should say the constant thought about maneuvering. You don't come to work to change your portfolio. You are always evaluating it.

But you're evaluating every position every day because every day you hold something, or every moment that you hold something, you're making a decision to buy that versus sell it.

That's right. Tom Gaynor at Markel, who was another insurance company, he had a great line which was, our morning meeting is every minute of every day.

Every minute of every day. I was just going to go into the idea that if you love this wisdom— the investment stew, as we call it, on Stu’s day— please subscribe. Follow us wherever you get your podcasts and subscribe to the YouTube channel. We always say that we're much more popular in audio than video, but we're aging gracefully and hopefully we'll grow into our role on television. But you can go back and listen to Stu's wisdom over a number of years as we continue to build on this idea and build a framework for you as an investor to think about how you want to pull together a portfolio and avoid some of these pitfalls that can come by chasing momentum. We've just seen another example over the first 6 months of the year. But another example over the last couple of weeks where you can just see how quickly the air can come out of a balloon. And if you're on that balloon, it's a pretty bumpy ride down until it finds ground. And then you hope ground isn't actually ground because then you got a real big problem. But Stu, the one thing that's been a constant for me as I'm watching markets evolve and I'm watching all of these different ways that investors approach markets and different vehicles, different tools, it just constantly seems to me that a lot of investors are just not conscious of risk management at all. In other words, when you're riding these waves, you're rewarded for taking on as much risk as you can. You're ultimately punished, but on the way, I think people just disregard the risk factor. And again, it becomes much more speculating and gambling. I think Warren Buffett had made a comment about that over the last couple of weeks. The gambling element and just riding the wave, not really worrying about what's on the other side, and there usually is something on the other side as we've been discussing.

The market is what the market is. I just try and keep to that investment process that we just discussed. Anytime you look at a stock and it could be at a level that might have a levered ETF that purchased it— who knows why it's owned at what level?— you just have to ask yourself, so the assumptions that are embedded in that share price today, am I willing to underwrite those assumptions? Do I agree with them? And if that's the case, and then there's volatility and you think your assumptions still hold, then you ride through it. We're in an environment where there is a lot of access to these products. Through X— I still call it Twitter— the town square is very vocal. News travels fast. So we just have to take the world for what it is.

But also remembering, as you say, the long nose of the stock market. Because it's not what's happening today. The market is trying to understand what's going to be happening a year from now or thereabouts. And it's trying to sniff out, like you say, with your long nose analogy, long nose trying to sniff out what's happening down the road. Today is a snapshot and the market is going to move off where things are going, not where they are.

You got it.

So, a great summary of what's been going on, by the way. I think that was a great learning opportunity for people who listen to that. When we have Eric Lascelles on, we encourage people to slow down the speed. I think that's one where you can slow down the speed of your audio to make sure that you're capturing everything that Stu was saying there. I did want to go into one specific area, as we haven’t been on over the last couple of weeks. The bank earnings came out of the US earlier this week. And it always portends what might be happening in Canada, but also gives you an indication of what's going on in the economy. Where are they making money? What are the areas of the business? These are broad, diverse businesses that have lots of different profit pools. And there was a pretty distinct area that was driving more of the bottom line than you'd normally see across the US banks. What are your thoughts on that and how that plays out across that sector as we move forward?

There are 3 things to take away. The first is what you mentioned: capital markets activity was very strong. And when you think about the last 3 months with the war in Iran, what's gone on with some of the semiconductors and AI stocks and interest rates and currencies. SpaceX. This was a tremendous period of time for trading businesses. When you think about the IPO of SpaceX and the amount of volume that traded in that first couple of days. Trading desk, I think of it like a hamster wheel. And in the quarter, the hamsters were busy. Those wheels were turning. Of the business, you might say, well, I'm not sure that that will sustain itself at these high levels. We'll see. The net interest margin, what had been a big part of bank earnings, those started to subside, the increases in them. But then interestingly, in a number of the US banks, loan growth picked up, which has been relatively dormant. And so when you think about it, a bank has different pistons that fire at different times. And so the loan growth was a bit better in some banks than expected. Those were the 3 things that stuck out in my mind. All 3 would certainly help the Canadian banks, although those share prices too have done extremely well. I think there's a good argument whether or not they reflect a degree of the strength.

Yeah. For those who've listened regularly, go back to when interest rates were peaking and we were going to start to see some cuts in the Fed rate, Bank of Canada rate. And just the basics of how a bank would have made money back in the caveman days as a traditional business. You take the money in on deposit, you pay a rate on that, and then you lend it out and you charge a rate on that. And you steepen the yield curve. And you'd pointed out a couple of years ago the opportunity that you were going to see in banks. And we've really seen it, not just in the US, we've seen it in Canada, we've seen it all around the world that the financial sector has done very well for people. And then, diverse businesses. There's fee-based businesses, capital market businesses, that tend to do fairly well during strong markets, and volatile markets helps as well. Is this something we're going to continue to see happen, or have we passed this incredible golden age for bank stocks?

I don't know if we've passed it. I would just say that when you look at the amount of announcements in Western Canada and the amount of activity in the United States, long growth would be another leg to that stool. The question is, when valuation rises, it pulls forward some of that excitement to some degree. Capital markets are quite robust. These trading numbers were up in equities 50, 60, 70%. And there's no question when there's volatility and there's lots of new issuance, you make a lot of money in trading. You wouldn't expect the same type of growth going forward again. We've talked about net interest margin not necessarily contracting, but just leveling off. That was a source of growth. So loan growth will be interesting. Wealth has also been very strong. Can that continue? So like everything, you need to go look at the assumptions that drive the forecasts. Banks have been very good at growing earnings over the long haul. So even when they tend to get a little bit elevated from a valuation standpoint, they can grow through it. But we also have to acknowledge that if credit spreads were to widen, that would likely suppress some of the trading activity. There are always some cyclical elements that we need to pay careful attention to.

Stu, that was a fantastic investment stew. I've been closely following the World Cup. I think Messi has proven to be the GOAT. By the way, my wife did not know what that term meant. She goes, why are they calling that guy a GOAT? I had to explain. I had some fun with that.

I always struggle with the OG, the original.

Being an OG, I struggle with that in particular. But I just want to say very clearly, you are the Messi of this podcast.

I think I might be an actual goat.

Well, again, that was just a tremendous summary of what's been going on. I know it's hard— it's just funny, we get so busy, the both of us— to try and connect. And I know your role is particularly challenging, but hopefully we'll be able to stay consistent over the next few weeks and keep people up to date on what is just a fascinating market as you've covered. And again, keep enjoying your summer, Stu, and we'll talk to you soon.

100%. Thanks, Dave.