April 2024 Conference Call with Michael O'Callaghan
Michael and I discuss the Canadian economy, how we are positioned to take advantage of opportunities that we see in North America and other questions.
Intro (00:00)
All participants, please stand by. Your conference is ready to begin. Good afternoon, ladies and gentlemen. Welcome to the April conference call with Derek Hebb from CIBC Wood Gundy. And I would like to turn the meeting over to Derek Hebb. Please go ahead, Mr. Derek.
Derek Hebb (00:14)
Thank you, Filmar. Today, we're joined by Michael O’Callaghan, Director of CIBC Private Wealth Management's Investment Strategy Group. Michael joined CIBC in 2011 and is responsible for providing market commentary, portfolio strategies and investment recommendations to CIBC Wood Gundy Investment Advisors and their clients. Prior to joining CIBC, Michael was in a similar position at another Canadian investment dealer. Michael is a graduate of the Richard Ivy School of Business's MBA program, and he is a CFA charter holder. He has more than 15 years of experience in the financial services industry. Michael, thank you for joining us this afternoon.
Michael O'Callaghan (00:56)
Thanks. It's great to be here.
Derek Hebb (00:58)
Great to have you on the call. Can you just start by talking about the Canadian economy? How are we doing?
Michael O'Callaghan (01:06)
Well, it's a good question. GDP growth is expected to be 2.8% in Canada. This is expectations of our CIBC's economics group. We're doing reasonably well. And in the first quarter, we're expecting, as I said, 2.8% growth, and that's versus 2% in the US. But over the course of 2024, the Canadian economy is expected to grow around 1.0% and 2.3% in the US. So a bit of a lag there. Canadian unemployment is different than the US as well. It rose to about 6.1% in March, up from 5.8 % in the previous month. Now, this is worse than the 3.8% figure in the US. That figure is down from 3.9% in the US in February. So, while we're having a deterioration in the Canadian labour market, as seen in the March numbers, the opposite has happened in the US, as unemployment in the US remains below 5%. Now, that's significant because that's the level below which people say that's the indication of an economy that's firing on all cylinders and is running at full capacity. It's welcome news that the US economy is doing well. That is, if you're in the job market.
Michael O'Callaghan (02:20)
Less than welcome news to see that the Canadian unemployment situation is moving the opposite way. So I'd say so far, so good this year. The thing, though, is that a lot of people are wondering about interest rates and what impact that's going to have on the economy. Now, the expectations are that the Bank of Canada is on track to start cutting interest rates in June because our economy is not performing as robust as the US. But when you look at the expectation of getting inflation down to 2%, our March number of inflation was 2.9%. So, that's above the 2% target that the Bank of Canada has. In the US, after declining in January, inflation increased modestly in February to about 3.2%, and that's given investors reason to question if the Fed is going to delay its decision to start reducing rates. So, with the continued strength of the US labour market and consumer spending versus that in Canada, it probably shouldn't come as a surprise that Fed officials have downplayed the need for immediate rate cuts in Canada. It may be possible that the Bank of Canada begins to cut rates before the Fed does.
Michael O'Callaghan (03:27)
And since Canada's economy and labour market are not performing as well as those in the US, that may be likely. However, with OPEC and Russia agreeing in March to extend the voluntary oil output cuts to the end of the second quarter of this year, higher crude oil prices may persist. That may provide an inflationary catalyst. And whether that contributes enough to delay rate cuts by the Bank of Canada or the Fed, that remains to be seen. But if the Bank of Canada starts to cut rates sooner than the Fed, that could weaken the Canadian dollar versus the US dollar, but that itself could provide a boost for Canadian export. So, so far so good on the Canadian economy, but over the course of the year, it's going to have to deliver.
Derek Hebb (04:09)
Thanks, Michael. Will China be a key catalyst for global economic growth in 2024?
Michael O'Callaghan (04:18)
It's doubtful that China will be a catalyst in 2024. And although the Chinese automobile industry, particularly in electric vehicles, seems to be doing very well and pushing into many countries around the world, other sectors of the Chinese economy seem to be doing all right. However, it looks like the Chinese consumer is beginning to increase spending slightly, but the consumer spending levels in China have not recovered meaningfully since the end of the country's COVID shutdown. In addition, construction, which is real estate, which is a very significant portion of China's economy, has come under pressure because of the collapse of large real estate and construction companies like Evergrande and Country Garden. And the housing market -we call it the homes market in China - is in pretty bad shape as well. There's an enormous oversupply because the country overbuilt massively when it came to new homes. If you consider that it has been estimated that if you look at the surplus of existing newly built homes in China, it would take two years to sell, one can get an idea of the extent of the oversupply. But when you add to that surplus, those homes are currently under construction, this estimate goes up to 5 to 10 years to sell all of these excess homes. So, when you consider that many of the companies that have built these homes are heavily in debt, that many Chinese have a large portion of their life savings invested in real estate, the extent of the problem appears to be very big, because if the average Chinese citizen sees a big portion of their life savings invested in real estate and falling in value, it will reduce their desire to spend money. And as we know, the consumer has to be spending well for an economy to do well.
Derek Hebb (05:54)
Thank you, Michael. How would you compare US and Canadian equity markets in terms of your outlook for each?
Michael O'Callaghan (06:05)
Outlook for each? Well, we did have a decent quarter on the TSX and a pretty good quarter in Canada and the S&P 500 in the US. Valuations had, at the end of the quarter, been roughly in line with their longer term averages. So, everything looked like they were either adequately valued or there was additional room for modest upside. The good thing was that we'd also seen 9 out of 11 GICS sectors on the TSX and 10 out of the 11 GICS sectors in the S&P participating in the increase in the equity indices. That broad-based participation was a sign of a healthy stock market. However, in the US, led by technology stocks, the S&P has now posted three weeks of declines and looks at the continuous trend as the earnings season starts. This could simply be profit-taking after what I would call an amazing start of the year. In Canada, the TSX Composite Index has posted two weeks of declines, but it has fallen by less than the S&P, percentage-wise, as high energy prices and strong commodity prices overall have provided catalysts in some sectors in Canadian markets to offset downside momentum in other sectors.
Michael O'Callaghan (07:15)
Should central banks start lowering rates this year, it might benefit the TSX more than the S&P, since this should benefit interest rate sensitive sectors such as financials, communication services, utilities, and real estate. And these were among the weakest sectors on the TSX in the first quarter of this year. They account for about 39% of the TSX versus about 26% for the S&P. So, rates going down would boost those sectors and therefore boost the TSX more than the S&P. However, with the sell-off in technology stocks currently underway, particularly in the US, and funds seeming to move into energy stocks because of the situation in the Middle East, this does favour the TSX over the S&P presently. So, we really think that Canadian equities are probably the place to put excess funds right now, at this point in time, rather than in US equity.
Derek Hebb (08:07)
Thanks. So, can you talk a bit about your team, your investing approach, and how you're positioned to take advantage of opportunities that you see in the North American equity markets?
Michael O'Callaghan (08:21)
Sure. Our team, the Investment Strategy Group, or the ISE, as we call it, has 10 people. It's run by the Executive Director, and her name is Wincy Wong. Reporting to Wincy are the directors - myself and a gentleman called Andrew O'Brien. And the Senior Managers, we have two of them, and then two other managers report to Andrew and myself. We also have a gentleman called Alan Bishop, who's a director, and he covers fixed income. So, our investing approach is quite simple. We like to be defensive first and then offensive second. And we like to focus on the preservation of capital. It's all important to us. So we're always looking for good risk-adjusted returns for our investors when we make decisions to invest in the portfolios that we manage. Assuming that the North American consumer, which is about 70% of the economy, that's 70% of the economy, continues to see decent employment levels, we believe this should sustain current spending levels. The recent correction in technology stocks has provided alpha in our ISE model portfolios. And since we are underweight technology, once the pullback we're seeing in technology stocks has run its course, we believe that we will be well-positioned to increase our exposure to the technology sector at much more attractive valuations.
Michael O'Callaghan (09:33)
We believe that's a good opportunity. Also, we have decent exposure to the energy sector as well. So, as energy prices continue to move up or stay strong, at least, we're positioned to benefit from that as well. So, at present, our defensive positioning across our portfolios continues. And if the markets continue to move lower from here, we believe the defensive stocks should do well versus the rest of the market, and our portfolios, we believe, should reflect this because of the portfolio's defensive positioning. So, in a nutshell, that's who we are and how we do what we do. We believe there is good opportunity probably in the back half of this year. The markets may take a bit of a pause in this second quarter that we're in, but we're cautiously optimistic on equities going forward.
Derek Hebb (10:19)
Thanks, Michael. These are all timely topics, so it's great to discuss them with you as we look ahead to the rest of 2024. In the interest of time, this will conclude today's call. If anyone has questions about the information that Michael discussed, please contact me. Thanks to everyone for listening in, and Michael, thank you again for joining us on this month's call.
Michael O'Callaghan (10:42)
You're welcome. Thank you.
Derek Hebb (10:43)
Take care.
Disclaimers
This information, including any opinion, is based on various sources believed to be reliable, but its accuracy cannot be guaranteed and is subject to change. CIBC and CIBC World Markets Inc., their affiliates, directors, officers and employees may buy, sell, or hold a position in securities of a company mentioned herein, its affiliates or subsidiaries, and may also perform financial advisory services, investment banking or other services for, or have lending or other credit relationships with the same. CIBC World Markets Inc. and its representatives will receive sales commissions and/or a spread between bid and ask prices if you purchase, sell or hold the securities referred to above. © CIBC World Markets Inc. 2024.
Michael O’Callaghan is a Director of CIBC Private Wealth Management’s Investment Strategy Group. The views of Michael O’Callaghan do not necessarily reflect those of CIBC World Markets Inc.
Clients are advised to seek advice regarding their particular circumstances from their personal tax and legal advisors.
“CIBC Private Wealth” consists of services provided by CIBC and certain of its subsidiaries through CIBC Private Banking; CIBC Private Investment Counsel, a division of CIBC Asset Management Inc. (“CAM”); CIBC Trust Corporation; and CIBC Wood Gundy, a division of CIBC World Markets Inc. (“WMI”). CIBC Private Banking provides solutions from CIBC Investor Services Inc. (“ISI”), CAM and credit products. CIBC Private Wealth services are available to qualified individuals. Insurance services are only available through CIBC Wood Gundy Financial Services Inc. In Quebec, insurance services are only available through CIBC Wood Gundy Financial Services (Quebec) Inc. The CIBC logo and “CIBC Private Wealth” are trademarks of CIBC, used under license. “Wood Gundy” is a registered trademark of CIBC World Markets Inc.
If you are currently a CIBC Wood Gundy client, please contact your Investment Advisor.
The Hebb Advisory Group’s February 2024 Conference Call
A conversation with Murdo MacLean, Client Investment Manager with Walter Scott & Partners.
[00:00:00.330] - Intro
Good morning, ladies and gentlemen. Welcome to the February conference call with Derek Hebb from CIBC Wood Gundy. I would now like to turn the meeting over to Mr. Derek Hebb, Investment Advisor. Please go ahead, Mr. Hebb.
[00:00:15.900] - Derek Hebb
Thank you, Amancha. Today we're joined by Murdo MacLean, Client Investment Manager with Walter Scott and Partners in Edinburgh, Scotland. Murdo, who I last interviewed in November 2022, joined Walter Scott in 2006 and spent twelve years on the research team focused on Japanese and US equities. He joined the Client Service team in January 2019. Prior to Walter Scott, Murdo lived and worked in Japan for six years. He holds a BA (Hons) in Japanese and Marketing from the University of Stirling and level one Japanese language proficiency test. Murdo, thank you for joining us this morning.
[00:00:57.490] - Murdo MacLean
My pleasure, Derek, nice to see you. Nice to speak to you again.
[00:01:00.500] - Derek Hebb
It's great to have you on the call. Just to get us started, Murdo, can you just highlight some of the key company characteristics that must be present for a stock to be considered for your portfolio?
[00:01:16.150] - Murdo MacLean
Absolutely. You know, so we do, given that we really aim to invest in businesses for the very long term, in our sort of parlance, that means as long as, frankly, the original investment rationale sort of stays valid. We do ask quite a lot of companies, or to put it another way, we set the bar very high. But I think if I was to sort of select several key characteristics, the first would be a reasonably long and successful track record of delivering profitable growth. So, the big major issue with a lot of companies that have IPO'd recently is that they just lack the long term track record, which we can then analyze and use that to kind of infer things about the future. So, businesses that have been around since before the Global Financial Crisis are far more likely to get our interest. Given that they have that track record, we can analyze how they've fared in a higher interest rate environment like we are now. So that is definitely very important. And as a starting point within that, the spreadsheet analysis is designed to highlight aspects of their profitability. We want businesses that are typically the most profitable in their sector or in their industry.
[00:02:39.930] - Murdo MacLean
And that's typically measured by obvious things like gross profit margin, operating margin, as well as the consistency of those margins, rather than just how they've done in the last twelve months or so. And then digging in more deeply into other metrics, such as the cash return on capital employed, a sort of return on capital type measure, and also the return on equity of a business. When we consider sort of last 15 years or so, the sectors that have averaged the highest return on equity have also actually delivered the best returns. So, we do think that there is a relationship between profitability and how a share price or stock will perform over the long term. I think also crucially, because in order to own a business for the long term, you will need to expect that there will be bumps in the road for the economy or for the company itself. And therefore, in order to sleep well at night, even through those more tricky patches, we very much want companies to possess a strong balance sheet, and we use that or measure that in a variety of ways. But typically, we would not expect the balance sheet to be utilized to fund the growth of the company itself.
[00:04:04.620] - Murdo MacLean
We would prefer that to be generated through internally generated cash flow with the balance sheet there as a sort of buffer that can be used for acquisitions of companies or other sort of things such as that. But the core funding streams will come from the business itself. And so those are the sort of major sort of financial characteristics that we require before we then move on to analyze the business in more qualitative terms. In other words, performing a sort of swot analysis, or as we would call it, the seven sisters, where you're looking at the industry, the market nature, the size of the market, the participants, the market share, who are the management team, and all those sort of things. So, I think those are the major ones that we would look at.
[00:04:56.350] - Derek Hebb
Thanks, Murdo. The dramatic rise in interest rates will impact some companies more than others. How do you expect companies in your portfolio to emerge from this environment?
[00:05:11.090] - Murdo MacLean
Absolutely, I would agree with you. That is, indeed, why we require businesses to have a strong balance sheet. Many businesses entered this recent sort of tightening cycle with quite a lot of debt on their balance sheets. And the market is supposed to take comfort from the fact that those borrowings were done or were fixed for a certain amount of time in a low interest rate environment. And therefore, the immediate impact of the tightening is not going to affect those companies, but at some point, they're going to refinance at a higher cost of capital. And I think that connects with the fact that between 20% and 30% of corporate America is classified as being a zombie company. So, in other words, it's not the repayment of the debt that's the problem. It's the actual repayment of the interest payments on that debt that they're failing to meet. And so that's a very large number of companies out there that are basically on life support. And if you were to see any sort of change in the circumstances or a persistently high level of interest rate, you can imagine what might happen to those businesses. So we feel, again, when we talk about the reasons for not owning banks in our particular portfolio, we would suggest that the very strongest businesses in the world have plentiful cash to meet all their investment requirements, and therefore, they tend not to have that much debt.
[00:06:47.320] - Murdo MacLean
So, the question is then, to whom are banks lending? Well, it tends to be companies that need that extra little bit of cash to keep the lights on, and we would not consider those to be the strongest of companies. So, I think in this environment, the longer rates stay high, and I think the chances of them going back to nigh on zero are very low. This will really be an environment that will test companies' financial strengths and will probably limit their appetite for further borrowings, which will then magnify whether or not they have enough cash coming in through their operations to fund their business. And so when we look at the companies that we invest in, we would expect them to take advantage of an environment like this, to lean into investment for the future of their business, to acquire the weaker, who, frankly, might need to be bailed out. And that is the sort of behaviour that we've seen time and time again, and which tends to increase the lead or advantage that businesses that we would typically own have over their competition. So, we sort of relish, although we admit that it is a more difficult environment for all companies right now, we kind of relish seeing how these businesses that are selected for financial characteristics that you might suggest are really almost too strong for most environments.
[00:08:18.500] - Murdo MacLean
We really look forward to seeing how that then comes to bear over the next several years.
[00:08:26.930] - Derek Hebb
Thank you. Murdo, can you just highlight any recent changes to the portfolio and what drove those decisions?
[00:08:37.270] - Murdo MacLean
Yeah, absolutely. So, recent changes to the portfolio, really considering the sort of last three or four months then, in the global fund, we sold a position in a company called Illumina, a US medical company that was brought into the portfolio in early 2020. This business is a world leader in gene sequencing technology, selling hardware and consumables to researchers and pharmaceutical companies to better help them understand how their drugs may or may not work for a certain patient population based upon their genetic makeup. Longer term, we believe that that is a very attractive area. But the reasons that caused us to sell that business, very briefly, were that in 2021, they sought to acquire 100% of a company called Grail, which is a business that they were, in fact, involved in starting up. They had an equity stake, but they wanted to fully consolidate this business because it was potentially a pioneer in early cancer screening technology. So, very exciting. The regulator made noises to the effect that they would prefer them not to consolidate that company until they had a chance to run the rule over the acquisition, to make sure it was fair. But Illumina decided to go ahead anyway.
[00:10:01.250] - Murdo MacLean
Fast forward a couple of years. Some of the management team actually lost their jobs as a result of the protracted regulatory review. Investors became somewhat disgruntled by this. And then, to cap it all off at the end of last year, their guidance for the year ahead actually reflected quite a weak industry outlook for the business. It just really felt as though, although the long-term picture is likely to be attractive, the strategic decisions taken by the board, and indeed the near-term sort of financial outlook, looking as weak as it did, we felt that it would be prudent to step away and in fact, invest those proceeds where we have greater conviction. And the business in which we have greater conviction, which we've added in the last couple of weeks, is also a US company by chance, by the name of Mettler-Toledo. The name is a clue to where it's from, obviously, in Ohio. But Mettler was, in fact, established back in 1945 in Switzerland, and subsequently merged with a company called Toledo in the 80s. The key attraction here is that this is the leader in manufacturing a wide range of precision weighting and analytical equipment for use in medical laboratories, industrial settings, and indeed, food retailing applications.
[00:11:29.170] - Murdo MacLean
And they make a whole range of things, from laboratory balances and weights, pipettes, titrators, thermal analysis tools, even right down to the scales that weigh your luggage at the airports sometimes. You can see their name on that. So a very broad, diversified company. In fact, although it's a US company, 60% of its revenues are actually generated outside of the US, including a reasonably healthy emerging market business. And indeed, their dominance is probably best exemplified by saying that 75% of the products that they sell are in markets where they'll hold the number one position. So we really like the position that it's in geographically, as well as being broadly diversified. And then its financial track record is also a real testament to the strength. From 1998 right up to the present day, the company has only had one year where profits declined, and that was in 2009, during the financial crisis. And even then, it was only down by around 10%, which is very impressive and speaks to the sort of sustainability and the consistency of their growth. So, this is a very profitable business with a great balance sheet, and with revenues of around $4 billion, and a market capitalization of only $25 billion.
[00:12:50.970] - Murdo MacLean
We really do believe that there's significant runway for growth with this business and the weakness in the share price last year just offered that additional incentive to bring that into the global portfolio in the last couple of weeks.
[00:13:04.330] - Derek Hebb
That's great. We hear a lot these days, certainly in the news, about artificial intelligence. How does Walter Scott prefer to play the AI theme?
[00:13:18.350] - Murdo MacLean
Yeah, so clearly AI seemed to be the sort of story of 2023 alongside the Magnificent Seven. I think we always are a little bit circumspect when we see these sort of big periods of hype around a company or a technology. I don't want to pour cold water over AI because it's clearly going to be a very important tool for a great many industries and businesses around the world. But what is certainly true also is that all of the good news is not going to arrive in the next six to twelve months. And so I think we feel that it's important that you do have exposure longer term to this space, but that you don't get carried away and invest in companies that are seen to be or touted as being the sort of leaders in AI, necessarily. Until such time as that came along, there wasn't much to look at them for. So, the way that we have access are through companies that already have a long track record of success in multiple other verticals, and that AI is likely to further augment that position. So companies operating in the cloud, for example, like Microsoft or Alphabet, operating in search, again, like Microsoft and Alphabet, where you will see AI being used to better refine online search and so on; advertising as well.
[00:14:52.030] - Murdo MacLean
Adobe is an excellent example of a company which sells software for content creators online. And their recent commercials showing their Firefly product illustrates how they can use generative AI to really enhance the content creation tools that they have across their suite. So that's a major beneficiary right there. And then, of course, there's going to be huge investment required to deliver on these massive expectations here. And so that really means high powered AI chips. And so across our portfolio, we have companies such as Shin Etsu Chemical that manufactures the silicon wafers that go into chips, companies like ASML that supply key tools to design the chips, and of course, Taiwan Semiconductor Manufacturing Company that assembles the chips. And although we don't own Nvidia, it must be kept in mind that all of Nvidia's AI chips are manufactured by Taiwan Semiconductor. So, right across the value chain, there is significant exposure to AI, even though it might not be leaping off the page at investors. Valuation is very important here. A lot of excitement and a lot of it's justified, but it still won't be a good investment if you overpay. And so Taiwan Semiconductor is a really good example of a business that stands to benefit massively.
[00:16:31.970] - Murdo MacLean
They are going to turn a two and a half billion dollar AI-related business into a $10 billion business over the next five years. And their valuation is still trading in the sort of mid to high teens price to earnings ratio, which is significantly cheaper than some of these so-called AI darlings that we see. So, I think it's very important that you look for the long-term beneficiaries. You don't overpay. And you also have the benefit of other revenue streams coming into those businesses, so that if AI takes a little bit longer to materialize, you still have a very credible and strong business underneath that which will see you through.
[00:17:13.770] - Derek Hebb
Thanks, Murdo. As an investor in the Walter Scott portfolio for my own family for almost 20 years, I can attest to the benefits of your disciplined approach. It gives us access to investing in some of the world's best managed companies. And I think it's the consistency of your investment process that has been a key factor in your success.
[00:17:40.050] - Derek Hebb
In the interest of time, this will conclude today's call. If anyone has questions about the information that Murdo discussed, please contact me. Thanks to everyone for listening in, and Murdo, thank you again for joining us on this month's call.
[00:17:54.070] - Murdo MacLean
Thanks so much, Derek. It's always a pleasure. Take care.
[00:17:57.230] - Derek Hebb
Likewise. Take care.
Disclaimers
This information, including any opinion, is based on various sources believed to be reliable, but its accuracy cannot be guaranteed and is subject to change. CIBC and CIBC World Markets Inc., their affiliates, directors, officers and employees may buy, sell, or hold a position in securities of a company mentioned herein, its affiliates or subsidiaries, and may also perform financial advisory services, investment banking or other services for, or have lending or other credit relationships with the same. CIBC World Markets Inc. and its representatives will receive sales commissions and/or a spread between bid and ask prices if you purchase, sell or hold the securities referred to above. © CIBC World Markets Inc. 2024.
Clients are advised to seek advice regarding their particular circumstances from their personal tax and legal advisors.
CIBC Private Wealth consists of services provided by CIBC and certain of its subsidiaries, including CIBC Wood Gundy, a division of CIBC World Markets Inc. The CIBC logo and “CIBC Private Wealth” are trademarks of CIBC, used under license. “Wood Gundy” is a registered trademark of CIBC World Markets Inc.
If you are currently a CIBC Wood Gundy client, please contact your Investment Advisor.