Hello, and welcome to the Download. I'm your host Dave Richardson and, always exciting, we're going to start calling it «Scott’s Stats Friday», because you're the stats guy, Scott. Scott Lysakowski, head of Canadian equity at Phillips, Hager & North Asset Management. Scott, how are you doing?

Great, Dave, how are you doing? Good to be here.

I'm doing better. And we were just laughing because we always have a little pre-conversation before we tape the podcast, and Scott always brings all kinds of stats, so he's worried about getting typecast as the stat guy. But you are kind of the stat guy, Scott?

Yeah, maybe stats and Friday is not a good combo. We got to ease into the weekend. We can't go too numbers heavy on a Friday.

But it's always good stuff and you've got some more great stuff today. Actually, we're going to go back and revisit your first appearance in 2022 as we get towards the end. But what I really wanted to get you on for today— and again, here's an example of how stats work— the last time we had you on and we often come to you to talk about your expertise in Canada, so that means you've got to have a pretty good handle on what's going on in energy commodity markets. And you'd put forward on the last podcast that you thought you might see some near-term weakness in commodity prices, particularly the energy complex. And sure enough, we're sitting here today with oil actually just a touch below $72 a barrel, which is a pretty significant pullback. And per our discussion, we're actually now down in the price of oil on the year. Scott, you speculated this might occur. What's happening? What's driving the price of energy lower? And then if you look at it from the actual stocks and then you translate it into the Canadian market, which has that significant weighting in these kinds of stocks, what does it mean for the Canadian market?

Yes, as a Canadian equity portfolio manager, you have to have an awareness around the commodity markets and where things are going. But I'll say our ability to predict the direction of where commodities are going is not great. So if I was recently predicting a correction in oil, I guess I must have just been lucky. But when we're thinking about the commodity markets, even though you can't predict the future, you have to be able to think in scenarios and the current environment is a bit challenging because you really have to separate the two-time frames. I think I might have talked about this last time; we have this term «parsing the time frames». The dynamics that may play out, in the short or medium term, are quite different than the things that are happening over the longer term. But you have to understand both because the stock market looks forward, but it's sort of adjusting its scenarios on a daily basis. In commodities supplies of oil— though it's a general trend through all the commodities—, in the near term, you have the market thinking about the economic situation. Are we heading into a recession? Are we into an economic slowdown? And we know that commodity demand is highly economically sensitive. So if you do head into a period of economic weakness or recession slowdown, however you want to capture it, demand for commodities will weaken. So I think that drives some of the near-term weakness that we talked about. But over the longer term you have a dynamic playing out— because of the commodity price volatility across all the commodities, whether it's oil, natural gas, copper, etc.—, where the producers of commodities have become much more disciplined in how they reinvest capital. There's been increased demands about sustainability, not only from an environmental perspective, but also from the shareholders who want to get some returns and who want these companies to be more financially stable. So paying down debt is really important. And so, across the board you've seen this underinvestment in new supply, whether you're talking about oil or copper. And that's starting to have some impacts that, while we may see short-term weakness in the commodity price from an economic standpoint, the longer-term structural supply demand is being driven by this lack of investment or underinvestment. So you might see a correction in commodity prices in the near term, but you could make the argument, because of this lack of investment in new supply, that the longer-term prices might be higher than what we've seen in the past. That's a tough thing to express or observe in the market. One of the things we did see— you mentioned the weakness in oil and you follow the oil price and you look at whether it's the spot price or the shape of the curve or the movement of the forward curve—, but an interesting signal is looking at the stocks versus the commodity. And what we've seen— we talked about oil which is now down slightly year to date—, but energy stocks are up significantly and there's a lot of things that are driving that. And even if you look at a shorter-time frame, oil has corrected $10 in the last couple of weeks even but you've seen the oil stocks acting somewhat better. So if you're looking for different signals, does the market believe in this short term weakness or do they think it's something in between? So that's an interesting signal that we've been picking up on lately as well.

Yes, and for those of you who listen to the podcast regularly, you'll recall that we had Scott on about a year ago when the price of oil had spiked up to nearly $130 a barrel. And we were actually having a discussion about why the oil stocks hadn't followed that price higher, that they seem stubbornly stuck, almost assuming a price of oil in the $80 to $90 range, even though the price had spiked up to $130. And this is, I guess, the exact opposite phenomenon. The stocks are looking past where the current price is and saying the price could go lower in the near term, but as we look out over the next six months, you probably see the price stabilizing a little bit higher and that's where we should value these stocks. And just like when it spiked higher, up to $130, stocks were looking through and saying that $130 is not sustainable. We're going to come down from there.

Yeah, that's one of the bases when you look back or study history of oil stocks in the energy sector and how they behave at the tops and bottoms of the cycle, they don't typically discount the current environment in perpetuity. They definitely will go up and down with the commodity. But just like when we saw on the very short-term basis during the pandemic, oil actually went negative, obviously the stocks don't assume negative oil prices forever, but they look through that and it's what they're looking through too. I think we had talked about this earlier in the year, but typically, before that big spike, we had prices in the $80 range. And that was typically a period or a price signal that producers would add new production and we didn't see that. So that goes back to that underinvestment in capital and bringing on new supply. A lot of times we're looking at how the companies act and what their intentions are, and so for the last couple of years, the big oil producers have been very disciplined on capital; they're returning shares or cash flow to shareholders, whether it's paying down debt, increasing dividends, paying special dividends, and being very disciplined— not adding new supply. But what we're seeing— so this is more Canadian specific, but a couple of the major oil companies have just put out their guidance for next year— is an uptick in their capital spending. Balance sheets are very good. You're not seeing the undisciplined behavior, but you are seeing an incremental investment in bringing on some new supply. It's not going to be the production growth in Canada that we witnessed over the last decade. It's going to be in the 2, 3 or 5%, but it is increasing supply. So that's an interesting data point, an interesting signal that we pick up on and say, okay, they have been disciplined, they're not losing that discipline, but they are starting to spend money. Obviously, part of that increased level of spending is going to go towards inflation. Inflation is everywhere. It's in the cost structure of commodity companies. Some of that increase in their capital spending is driven by inflation. You have to spend more just to keep things flat. But they are actually adding a little bit of growth as well, which is something we probably haven't seen in several years, particularly out of the Canadian companies. So it is an interesting data point that we're looking at, on the margin.

At $72 a barrel. Scott, we've talked about some of these companies, with the cash flow that they're generating, with that elevated oil price, the extent to which they can buy back shares they can return, pay dividends out to their shareholders, reinvest in a transformation and being alternative energy or net zero, and getting to the next wave beyond oil as energy companies. Is $72 a barrel still a level that produces sufficient cash flow for them? Has inflation changed that price and moved it higher?

Well, $70 is still a reasonable price in terms of cash flow generation. Certainly not as much cash flow is being generated at $70 than it was at $100. That's obvious. I would say that the cost structure— and I'm speaking mostly of the big Canadian producers— would be around the $30 or $40 range, maintaining existing production. And I think a lot of companies have moved to more of a variable-type dividend or at least a variable model that, once they achieve those debt targets, then they can return more cash to shareholders. They're using it on a percentage basis and it's been going up. It'd be interesting to see how the market reacts to those variable return of capital to shareholders on the way down. But I would say on average, $70 is probably okay for them. It probably doesn't fund their entire energy transition. I think we did some analysis and I think we shared it with the group. I won't go completely through it, but the industry probably needs to be in the $80 range to keep their production flat, handle inflation and meet their net-zero goals. It was interesting that in some of these budget releases and forward guidance, the big capital spending for energy transition or emission reduction at zero objectives is not quite in the numbers just yet. So, we're still working on the framework and the details of how that's going to get spent and evolve over time. So that's something that we're watching very closely. So that increase in capital spending is not going towards emission reductions. They are always working to reduce emissions, but not a significant amount is going towards that. So still some work to be done. I'd say you'll need more than the $70 if these companies are really going to do all things, that is, return capital to shareholders and reduce their emissions. But we're right around that level where they would be sustainable longer term.

Great. Well, that's a terrific update on oil and we'll get back to you next time and check in and see where we go from here. But we were just refreshing. If you go back to that podcast in the first week of January of this year, we had Scott on, and Scott was talking about statistics around the market, both the TSX and S&P 500, and what he was highlighting out of the calendar year 2021 was what a remarkable year it was. Not just in terms of the strength of the returns, but particularly around the lack of volatility in the markets, that it was arguably the most— or historically, within the top two or three years— in terms of how little volatility there was, day to day, month to month, how small any kind of pullback in the market was throughout the year. And then, what that would do is that typically that’s followed by a year that looks different; a whole regression to the mean. If you have a remarkable year in terms of stability and strong returns, it's often followed by a year that is more volatile and not as strong. And now we can look back in the middle of December of 2022 and see the difference between last year and this year. What are the numbers as we look at this year, Scott?

Yes, I’m obviously fascinated by the stock market and I love all this, especially when you can look back over long periods of history. These are things that we rely on. I don't have the ability to predict the future, so I need to study history. As the saying goes: history doesn't repeat, but it often rhymes. So, yes, you're right. The entry year, last year, volatility was quite low. I think our biggest entry-year drawdown in 2021 was 6%. The long-term average is 15%. And that's a good thing to keep in mind that when markets are tough and volatile, people get really caught up in the here-and-now. You have to remember, volatility is normal. One of our personal favorites is that volatility creates opportunities. So that's what we look for actually, that volatility, because it creates a buying opportunity to get great companies at good prices. So, yes, last year was a very low year for volatility and this year we're making up for it. As I said, last year, 6% was the biggest entry year draw down. The long-term average is 15%. While the TSX is only down 6%, year to date, the biggest entry-year drawdown was about 18%. So that's greater than the long-term average, certainly a lot greater than what we saw last year. It's also the 16th worse, going back to 1980. Not the worst, but one of the worst. And so that's an interesting outcome. If you want to make yourselves feel better as Canadian investors, the S&P 500 is down, year to date— 17% or something like that, just looking at my Bloomberg screen. But its entry-year drawdown is a lot higher. I think it had a 25% drawdown. That's the 11th worst. That's going back to the 50s. So the drawdowns have been big, and we've been somewhat shielded north of the border. So, again, when you have these significant events, what happens going forward— it's a smaller sample set in Canada, but I'd say on average—, the returns are in the 10 or 11%, which is slightly above the long-term average. I think the long-term average return for the TSX is about 7%, and the following year's drawdown reverts more to that average, and you get slightly below that in the 10 to 15% range. So hopefully that sets us up next year for a decent return opportunity and maybe a slightly less volatile year. And just to touch on another point of volatility— and I don't know if this is comforting for people or not—, but the percentage of trading days on the TSX of either up or down greater than 1%, has been extremely high. The long-term average is about 35%. So a third of the time, you'll get these big up or down days. This year, it's 60%. If people have been thinking that this feels like a more volatile year, it's because it has. And again, if we want to feel slightly better about ourselves here in Canada, we can compare that to the US where they've had 87% of the trading days, so far this year, either up or down more than 1%. So it's been a bumpy ride intra year, but it's also been a bumpy ride, day to day. So I don't want to leave everybody on a sour note. The one thing to keep in mind is that December— now, this is getting very short-term focus, but I got to give some good news here as we’re heading into the holidays—, if you look back to the average monthly performance going back to 1950, December is the best month of the year. I think the long-term average is up 1.9%, and it's a positive return over 80% of the time. So hopefully that means that we get the Santa Claus rally coming our way and we can wrap up a volatile year on a strong note.

Yes, those stats are remarkable. Again, I love the comment you made because for those people who are regular listeners to this podcast, one of the things that we're trying to highlight as we talk to investment professionals like yourself is this whole idea of where do we find opportunity? And a lot of times, those opportunities are generated by that volatility or generated by pullbacks in markets that, if you can keep the emotion out of it, you do the math and look at it like a professional does. That volatility and those pullbacks create opportunities for you. Hopefully, as you're listening to this, whether you're an investor yourself or you're someone who advises other investors like a lot of the listeners to this particular podcast, you stay unemotional and you look to see where opportunities are generated by an unusual year of volatility or where risk could be created by a year that is a little calmer or a stronger year than before. And so, all of the guests that we have on come from that contrarian mindset. They start to get interested when you see that volatility or downturn and they start to get a little skeptical when things move ahead a little bit too fast. And Scott, I know you've had a terrific year this year in terms of the portfolios that you look at, on a relative basis, of course, because you're always looking for those opportunities. And then again, Canada, where you really ply your trade, has had a relatively good year versus the US in particular.

Yeah, volatility creates opportunity. I got to write it on a sticky note and put it on my computer screen just to remind myself.

Yeah, because even professionals as well can get caught up in that. I need to go back to basics, but I know how disciplined you are overall. So, Scott, fantastic stuff. It's great to pull the actual numbers out because if you're watching the markets day-to-day as we do, and as many of the people who would listen to this podcast do, it has been remarkable just to see the daily moves. Actually, it's very good for listenership on a podcast. If you're hosting an investment podcast, you pick up more listeners with those kinds of moves, and just day-to-day, those big swings, particularly in the US as you highlight. And to go back and actually look at the numbers and go, wow, I wasn't just dreaming this. This is what was actually happening through the year. So hopefully, again, all of this leads us and sets us up for a less volatile and perhaps a somewhat better year. We've had our drama for this year. That's good. Maybe 2023, a little calmer, right?

That's right. I think it feels like a long year and the volatility has certainly added to that. So we're looking to turn the page on this year and hopefully we’ll get a little bit of a mean reversion, at least on the volatility front as we head into next year.

Great. Well, Scott, thanks for all your appearances. This year we're going to get you back in early 2023 to look forward and see if we can get some ideas of what's going to happen in the new year. But happy holidays to you and your family. And again, thanks for always being there.

Great. Thanks Dave. Have a great holiday. We'll see you in the new year.