Transcript
Hello and welcome to The Download. I'm your host, Dave Richardson. And we are joined today by Rob Cavallo, who's a senior portfolio manager with RBC Global Asset Management. And Rob, your specialty is in the area of technology and life sciences. Is that the best way to describe it? Or how would you even describe your expertise?
Yeah, thanks for having me on, Dave. And I would say that's probably fair. Technology and health care. If you want to call it life sciences, it's fine. But technology and healthcare are probably the two areas I spend the majority of my time on.
Two areas that are obviously in the news and that are very much of interest to investors. Particularly technology, but we should never dismiss what's going on in health care as well, particularly with an election in the US and aging populations, and then all the things that's happening around new drugs, which are also driving their own little boom. Maybe people miss it more than technology, because technology seems to be the focus. But we can tap into your expertise in both areas. And I think the biggest question that I get from advisors who I talk to and when I'm out with investors is around the technology sector. And if we're talking technology, we're often talking about the Magnificent Seven and the impact that that has had on markets, how it's led the markets. How long can this go?
Well, it's a great question. It's the question that we ask ourselves all the time in here as well. What's next? And really, in anything in innovation, that's what we have to think about, whether it's technology and health care. It's always got to be how do we build on this particular development or this particular advancement into the next thing? It's no different with the MAG7. Now, clearly, over the very near-intermediate, maybe even long-term, it's really going to be artificial intelligence, both gen AI and non-gen AI-type product advancements. These are the leaders and probably going to remain the leaders for the time being. Really the view on how you think about the progression of where we are in that value chain and where we are in the development ecosystem is going to be very important for the performance over the next several quarters, several years for this group of stocks. And we're still very positive. One, they have the cash flow today in their core businesses to support this and really entrench themselves even further as we go along into this AI adoption phase. Two, we see a lot of potential down the road for how big opportunities this could be for all of these different companies. Now, that doesn't mean that there's not going to be ebbs and flows between here and there. Coming into this year, we actually thought that 2024 might be a bit of an ebb, and we're looking to that as a potential opportunity to build greater positions in some of these names based on our view in the outer years. We were a bit wrong there, and AI has really powered through up until the last few weeks or month. I guess it's a long-winded answer to say that we're still very positive, but we do see idiosyncrasies between the names. So it's not necessarily the entire group working at the same pace. We do see opportunities to pick and choose within the group. But in general, we're positive on those mega cap stocks today.
So let's start with where we are in the whole development of AI. When I'm listening to US analysts, they use the baseball analogy, telling you what inning you're in. Since it's a Canadian podcast, we're going to go with hockey. So where are we in the hockey game of AI right now?
We're probably still in the first five minutes of the first period, to try to analogize it. But it's very difficult, and it's not a smooth line. So you're not necessarily going from minute 5 to minute 6 to minute 10 to minute 20. Again, there's going to be peaks and troughs, and there's going to be valleys of despair at times. But we're believers in what the opportunity is looking out 5 to 10 years, both on productivity, improvements, new market creation potential. We see lots of opportunity. Now, we've come through this period where there's been excess spending, and some of the market narrative near term or recently is focused on «show me the ROI». Show me the return on this investment from all this capital expenditure dollars that are being put out there. Now, we think that's obviously an important way to think about it, but that's not the only way. Some of these things are still longer term before you're going to see those types of returns. But even in the short term, you're starting to see it. Walmart reported today, and they themselves are saying, we’re starting to see lots of opportunities to deploy gen AI using internal models, using external models, lots of improvement. I believe they said it would take 100 times the employees and 100 times the time to do what they've done in a short period of time. We're starting to see it, but it's going to be baby steps. It's baby steps until you hit the mass adoption phase, which is probably still a little bit of a ways away, but we're tracking where we thought we'd be, and we're very happy with where we are today.
Now, saying that about AI itself and the technology and how it's going to revolutionize the world in so many ways, just like railways, the telephone, the Internet, all these other things that have come before it. If I was to look at, say, the lead AI stock, which I think most people would point to something like NVIDIA and some of the other stocks in the sector, are they also in the first five minutes of the first period, or are they farther along from a valuation standpoint?
I guess it depends. I think you have to break apart the valuation discussion from where you are from an operational fundamental discussion. Now, in actually building out the ecosystem, for sure we're beyond the first five minutes if we're talking about NVIDIA, because the CapEx dollars have already started. They were the very first real winner, and arguably to date, 90% of the wins have gone NVIDIA's way at this point. To say that they're a little bit further along in the build is probably fair beyond that five-minute mark. Maybe a year later in the first period. But it's not a cliff. It's not how we're thinking about it. It's not as if from their perspective, CapEx just goes away and you move to the next part of the value chain. It's just the middle part of the value chain or the latter part of the value chain, creating the applications has not really happened yet. We're still very much in the infrastructure, pics-and-shovels phase, like we like to call it,. Starting to see some signs emerge of moving towards the next phase of how this build-out happens, but we're not quite there yet, and that's something that will still take some time. Valuation? If you're going to say NVIDIA, as an example, is expensive on this year's numbers, it’s hard to argue, but we think that's the wrong way to think about that stock and just growth stocks in particular. If that's the view, it's very difficult to be a growth investor. You have to take a longer-term mindset. What are the range of scenarios? How could this build out? How much bigger could this get? When you think about it in that perspective, it's really not that expensive versus a lot of other stocks in the market, let alone exposed to AI. I could go on a whole tangent about NVIDIA, but that's probably its own podcast. I don't want to bore everyone there, but just a little bit of how we think about the business versus the valuation argument.
We’ve had your colleague Marcello on the podcast before, and one of our conversations — and I've had the same with Stu Kedwell and other guests — is around this concentration in markets, particularly around a small number of stocks in tech, and the similarity to the tech market that we had in the late 90s and coming into 2000, where we saw that tech bubble burst. All the time, I get the question from people, and I read the articles from analysts who say, we're at a similar phase of valuation of these types of companies relative to the broader market. Tech now is making up 35 to 40% of the S&P 500. And we're going to have to go through a similar correction in technology and a similar rightsizing as a part of the S&P 500, similar to what we went through from 2000 to 2002. Marcello generally tries to reassure me that this is not where we're at. From your perspective, why is it just too simple to look at one market and draw a comparison? It's a completely different world now, isn't it?
For sure. I think there's a lot of different areas that you could pull apart there. And again, that's a long time. So I'm going to try to keep this as informative, but as high level as I can in the interest of time. But I say, first of all, you look at NVIDIA. Now, the stock has recovered a little bit, but when it pulled back with the whole Yen carry trade issues and market volatility a week or two ago, it got down towards the mid '90s price level. At that point, you can make the argument that the stock was trading at about 25 times 2025 estimates. Cisco in its heyday was trading in and around 100 times somewhere in that ballpark. I don't have a number in front of me. The valuation picture today for the poster child of the AI buildout versus the dotcom internet buildout, the valuations are not really in the same stratosphere. That’s the first thing. The second thing, there was a very debt- and VC-funded '98 to 2000 cycle. When macro events occurred and we started to see the stocks plummet, taps turned off there. It created a huge funding gap and the house imploded on itself. This time around, the funders of what's happening today are companies like Apple and Amazon and Meta and so forth that have such tremendous free cash flow. You can make the argument it's horrible spending, but it's not something where we see taps turning off because the funding sources just dry up. We see a very different fundamental picture, '98 to 2000 period versus today. I think the Internet also, in my view, was maybe a little bit more revolutionary, where you were going from zero to hero. That took a decade to create the ecosystem to support and to gain the trust of main street America to actually buy these products and give their credit card info to their Internet site and so forth. Whereas, yes, gen AI and AI could become revolutionary, but I also think it's a little bit more incremental as opposed to a vast sea change of what's needed for this to become meaningful in a relevant time frame. So very different. But I also have the view that you can't have the horse blinders on and be ignorant and say that it's just different. But we think there's a huge difference in the fundamental setup. So we're looking for warning signs, but we think it's different and easy to compare to the Y2K, but it's just a different animal in itself.
Yeah, and the other thing that Marcello talked about — and I'm sure you'd have a point of view on as well — is the whole idea that these companies are just further along in their life cycle than those dotcom companies. So there's a little bit more stability in terms of where they go. And as well, you go back through history, and it took a while for some of those stocks to come back, but typically, it's a single company inside a particular space that dominates. When we look at tech, you want to be in those top companies over the long haul. But to buy those top companies, you have to pay a premium. If we're looking in this build out of AI, NVIDIA is the dominant player. But there's likely going to be some dominant players in the other spaces and different spinoff businesses that come out of the development of AI. Or am I completely off base there?
No, 100%. There's going to be new winners that will emerge, just as there's new winners that emerge in every major tech or just broadly macro or investment themes. There's going to be new winners. But we look at the mega cap tech today — and even circling back to the last question — the difference is you look at Amazon in '97, '98, '99, they were trying to build their first business. Whereas these companies now already have massive and massively profitable and growing core businesses that are used to fund what could be the next S Curve, the next growth venture for them. So it's very different. And for sure, you're going to pay a premium for these stocks today because of these features, because of just their market dominance. But again, not to say that other companies will not emerge down the road. And then the final thing you mentioned, tech, unlike a lot of markets, is winner-take-all, winner-take-most. Now, popular investment theme is mean reversion. So stock A outperform stock B by X amount. That has to revert because that's just what has happened historically forever. Tech is different. If you miss a product cycle — look at Intel — or a couple of product cycles, and you can be left in the dust for an indefinite period of time. Things do not have to revert in innovative sectors. We think that's a point that gets missed a lot in the market, and it gets missed a lot with non-growth investors. I say all this with the hopeful, the humility to understand that things don't always last forever. Things change. But mean propulsion, like we like to say, or winner-take-all is something we keep very front of mind in these sectors that we look at and spend our time on.
We'll get to health care in a minute because we don't want to miss that piece. But when you're building a portfolio in technology, are you trying to spread your money out so that you've got a little piece of everything and make sure that you at least get some of each of these big winners? Or are you doing more? Are you trying to concentrate, identify the winner, load up on who you think is the winner and hope that you get it right? What's the philosophy of how you build a portfolio of these stocks, not just across the AI, but across all of technology?
I would say that broadly, we're more diversified than concentrated. It's just how we think about even within our group, more broadly, even beyond just the stuff that Martello and I manage for RBC. But I say it's a combination in the sense that we want to have some bigger active bets where we have high comfort, and the visibility is improving and just the range of outcomes. Everything in our favor, we try to add a bit more active weight there to benefit where we have that conviction. But again, this is a sector where maybe there's five companies in a basket, and if you're wrong and you pick the wrong one, you could leave so much performance on the table that we feel that until our visibility improves and the range of outcomes becomes something more favorable, we like to spread some of that risk. One, we keep more chips on the table to let the market dictate where we should go as opposed to using our ego to do that. But secondly, having more diversification also keeps you more in the flow of the information of what's happening. There are so many stocks out there. It could be very easy to miss something. Having something on the table keeps it front of mind and allows you to keep iterating through and allowing the things to play out and then understanding where to then concentrate a bit more of your bets as winners start to truly emerge.
I was just reading an article from the New York Times last night. It's on a book that's just been released by a statistician, but he's also a poker player. His name is Nate Silver. You might know him from 538.com for anyone who's listening. He does a lot of predictions on the US election. There's sports forecasting on the website. It's an interesting space that he holds. And the book talks about risk-takers versus non-risk-takers and different occupations or worlds where people are particularly comfortable taking risk versus not comfortable taking risk. And one of the areas that he highlights, he hangs out with a lot of people who are in venture capital. And the idea of venture capital in tech is you're in very early and you're spreading bets out in the hopes that you get one winner out of 20. But that winner is a massive winner with upside. But these are people who have an almost unlimited ability to manage and understand the risk they're taking versus someone who's investing in a mutual fund or ETF who wants exposure to a particular sector, but wants that risk managed much more in a way that aligns with their comfort with risk and what they're going to put in as part of a broader portfolio, which even further manages risk. I guess that would be more the way that you're thinking about managing a portfolio to get the right level of risk, still have the chance to get the winners and get the upside, but so that it fits in with a broader portfolio and allows an investor who doesn't have an unlimited risk capacity to get exposure to this sector that's going to be so important for them to get growth in their portfolio over the long haul.
Absolutely. And when I'm thinking about health care, for instance, it's an area where there can be stocks that go 10X, and there could be stocks that go essentially to zero. So you have to really understand what's at stake in any of these investments. And I’d say, that’s smaller and mid-cap companies, not large-cap health care. Large-cap health care is much more defensive, predictable, strong cash flow businesses. So what I would try to do is populate most of the portfolio there, try to find where the idiosyncrasies are between those names and where you could add some relative value within that, and then think about basket approach for things like biotech, for instance. At any one time, we might own four or five small mid-cap of techs that have huge upside potential. Obviously, there’s downside risk to it. But think of it from a basket. So that basket is going to add value. I'm very confident the basket adding value historically has over time. But we minimize the risk of any one stock hurting the portfolio. So that's the way we try to think about it. We're not going to go out and try to hit a home run. With every single investment, that's not what we're trying to do. That's not who our unit holder is. But we're trying to give them a strong, consistent performance with that ability to add better than competitor upside, let's say, strategically with the way we lay our bets down.
I think it was David Lambert, who's been on this podcast several times — for myself and the listeners — who opened our minds to the idea that people get very excited about tech. It's very high profile. Again, we see the winners. We've seen the winners over the last decade. But it's not the only place where you're seeing this enormous value being generated in terms of the market capitalization. It's in areas where there's incredible innovation. And there's incredible innovation in a lot of places. It might be a LVMH, Louis Vuitton, who is somehow over decades able to charge a massive premium for what you might view as an everyday item that you can get for a very low price. And the innovation it takes to be able to maintain that pricing power is similar to what a chipmaker might make as they're evolving their chip over time and making it more and more powerful. And one of the areas where you've seen that a lot of is in health care and pharmaceuticals. We've talked to Marcello about this as well. But I'm interested to get your view on where we go with these GLP-1s, Ozempic and Wegovi, because it's been an enormous area of growth. And then are there any other areas that investors should be thinking about as really important emerging areas in that space?
Yeah, I'd say within the obesity trade — knock on wood — we're pretty early with Eli Lilly. It's been a name that we've liked for a very long time. The story has evolved. It wasn't always about obesity, but yeah, look, if we're talking what part of the first period we're in, this is maybe even earlier than where we are in AI. These drugs are really just starting to emerge. The issue has been supply shortages. The demand has been extraordinary. It's just the supply from both Eli Lilly and Novo Nordisk just hasn't been there. It's just building. It's something that's going to take some time to catch up. We're very early. This is going to be the biggest drug category ever. The range of indications that it's going to be able to treat, it just keeps growing. So it's not just obesity. You're seeing the cardiovascular benefits. You're seeing benefits in sleep apnea. There's possible neuropsychology benefits you might see in areas like Alzheimer's as more data emerges. These are massive categories. Eli Lilly and Novo Nordisk are the leaders today. I think it's going to be very difficult to disrupt them unless something truly innovative comes about. Neither of these companies are sitting on their laurels. Both are well-advanced in their pipeline. We're very positive there. The second derivative of that is what's the impact to the rest of health care? If there's a less obese and healthier population, what does that mean for general surgeries? What does it mean for knee replacements? What does it mean for other drugs that treat various types of cancer that are associated with obesity? These are the things that we're thinking about. The market likes to shoot first, ask questions last. You saw a lot of these stocks get hit a year or so ago. We saw the first set of strong health outcome studies from Novo Nordisk emerge. A lot of these stocks have now recovered, but that's where we're spending a lot of our time for. How does this reshape the whole health care landscape? Beyond obesity, this is a blank term: personalized medicine. It's not new. It's something that's been going on for many years. This is how patients are going to be treated, whether it's oncology, you don't just treat prostate cancer or breast cancer. You're going to the very specific gene that you're targeting and drugs that are specific for that treatment. I've talked in the past about something called antibody drug conjugates. Historically, you would use chemotherapy. Just carpet bomb the entire body, kill everything we can. Technology today would use this antibody drug conjugates. These are called ADCs. They're basically like a missile guided system, and we're going to deliver that chemotherapy directly to where it needs to go rather than having to carpet bomb the entire body. That's just one example. Whether you want to talk about gene editing, some advancements in gene therapy, there's a lot to be excited about on the biotech front. I still think biotech is the area you want to invest. If you want to be invested somewhere for the next 20 years, it's in the biotechnology sector. But it's going to be lots of winners and lots of losers, and hopefully we can help add value there for clients. Lots of areas in like non-therapeutics as well, I'm happy to go into, but maybe I'll pause there just to see if that makes sense.
Yeah. Why do you think that biotech has lagged other techs so much over the last decade?
Yeah, I'd say it’s fits and starts. So one, I'd say interest rate environment played a little bit into it the last couple of years. Take away the large cap biotechs, which are a little bit different, but small and mid-cap, they tend to be very interest rate sensitive just because the duration of their cash flows are well out into the future. Interest rates factor into how you think about valuations there. I think, honestly, people get scared about the blowups that you see in biotech, and these things happen in waves. We went through a wave where there's things that didn't work. We're now going through a wave where we've had a lot of really big drugs do well this year in terms of data readouts. I think that's another thing. Thirdly, I would say that tech has just been so good. Why do you need to invest elsewhere has been an attitude as well. That won't last forever. That's why we think it's a good balance to have health care and technology because you can rotate back and forth based on where you are in the macro and where you are in the various innovation cycles within both of those sectors.
Yeah, it's just that everything else gets crowded out by US tech, it seems. I mean, there's a little bit here and there, but that's been such a strong trade that people almost forget about everything else, which is one of the reasons why we love to do this podcast, and we like to bring on lots of different guests with lots of different perspectives to share about some of the other exciting areas where you should be thinking about for your portfolio. And it's not to completely dismiss tech, but you can find more reasonable valuations with the same opportunity long term. And I love the fact that you didn't say, hey, over the next two years, I love biotech. It's like over the next 20, because that's the kind of time frame I need to think about as an investor, especially someone who's not dealing with it every day like you are, somebody like me and a lot of our listeners who will listen to you on this podcast but go on with the rest of our lives. You're in it every day. You've got to have a mindset around these types of areas. And you can get big wins, but it takes patience and discipline and time.
Absolutely. I think that's correct. And then also just understanding the risks of where your downside might be and how to balance out and manage so that you don't get forced out of a position or get discouraged. It's very easy because the moves could be big on both sides. It's understanding how to manage that risk and give yourself peace of mind to stay fully invested.
This is probably an overhang from spending the last three weeks cheering for Canada to win medals at the Olympics, but if you compare Canadian companies to Amazon, NVIDIA, Apple, we don't really have a comparable. Are Canadian industries in a better position in terms of biotech?
So there's very early stage innovation that's good and that's very promising in Canada. There are great universities, great early venture type support. But the US is a different beast, and there's not many countries globally that have the biotech ecosystem, from funding to human resources, to really compete. It's challenging. I think Canada could do better, but the US is the best in biotech development for a reason. But that doesn't mean Canada doesn't have their own rightful spot within the global landscape.
And is the US election something that you're looking at in this space a lot? Is there a big difference between one party over the other in terms of the development of these companies?
So I would say historically, health care tends to be one of the higher on the platform type issues. This time around, it is a little bit lower. So the broader risk is a little bit lower than you would see in most presidential cycles. There are various issues for different subgroups. For instance, if the Democrats were to win, that might be a little bit more negative for Medicare, which is insurance coverage for seniors. And it might be better for Medicaid, which is insurance companies for less fortunate people. And then vice versa if it's the Republican side. So, little intricacies like that, but generally speaking, thankfully, a little bit less relevant this time around because every four years tends to be a tough time for health care because of the rhetoric on the campaign trail.
Okay, let's just finish off. Rob, thank you so much for being here because this has just been amazing. What's always great about talking to investment managers when you get into their space, the breadth of knowledge across so many things that are going on, to be on top of all this stuff. I just can't imagine as an individual investor, there's no way that I could track all this stuff myself. There's no possible way. So it's always amazing to see just the depth of knowledge and breadth of knowledge in the space. I asked Marcello the last time I had him on, and he gave me a really surprising answer. We talked about AI. We talked about what's going on in obesity drugs and diabetes and cancer. Is there any area of technology, either on the health sciences or technology sector that you think people aren't talking about enough? Or is it even too early in the hockey game. They barely dropped the puck? Something that we should be thinking about for down the road that you're not seeing people talk about out in markets?
If I were to take a step back into the healthcare side, I touched on it when I said personalized medicine, but the driver behind it is just the low cost and speed of how we're able to sequence the genome. AI is just going to magnify what that effect is going to be. I don't think it gets enough airtime how things have advanced in terms of early-stage drug discovery that we're not really seeing necessarily play out yet from time to market for a drug or the cost. But we're on the cusp there. The actual pace and cost to develop drugs, I think, is on the upswing from a positive standpoint. That's something that might get a bit more airtime, although it's hard to say. It's not necessarily a pop culture term, so it's hard to say, but that's something I'm excited about.
Yeah, I guess one of the earlier applications of the AI that we had at the time was getting computers to read through medical books. If you plug in different symptoms, it spits out, well, the patient has this. Or look at this, prescribe this. It's not surprising that that could evolve to the stage, with multiple times the speed and power and learned ability in medicine, to start to drive innovation more.
It's things like where you might start off with 20 molecules that you're thinking about for a specific drug that you want to develop. You might get down to the 5 that you want to focus on really quickly. And that's where you're going to see the initial AI help within the health care system as it relates to drug discovery. Just that ability to really hone in where you need to spend your time from a drug discovery perspective.
Wow. Amazing. It's an exciting world coming. By the way, you beat Marcello on that answer. Marcello said nuclear energy, and I don't think anyone was too excited about that. Although it's been pretty good.
I don't think he's wrong there. I guess I'm trying to be a bit more positive for humankind.
No, both are interesting. It was a really fascinating answer that we've dug in deeper on, and I'm sure this is one we'll come back to as we get you on in the future. Rob, thanks a lot for joining us today. Just a fascinating walk through the area that you specialize in. So I really appreciate your time.
Thank you for having me.