PARTICIPANTS
Tom Dicker
Guest Host, Vice President & Portfolio Manager
Steven Hall
Vice President & Portfolio Manager
Mark Brisley: You're listening to On the Money with Dynamic Funds, the podcast series that delivers access, insights, and perspective from some of the industry's most respected active managers and thought leaders. From market commentaries and economic analysis, to personal finance, investing, and beyond. On the Money covers it all because when it comes to your money, we're on it.
Tom Dicker: Welcome to another edition of On The Money. I'm your guest host, Tom Dicker, Vice President and Portfolio Manager at Dynamic Funds. Today I'm with my longtime partner, Steve Hall, Vice President and Portfolio Manager on Dynamic's Equity Income team. Steve has been with Dynamic since 2013, working on small caps, and he is the equity income team's expert on consumer stocks. Steve has 20 years of investing experience covering small caps, U.S. stocks, and consumer stocks. He's one of my favorite people to talk to about investing, period.
Before we get into the opportunities in small caps today, I want people to get an introduction to you, Steve. How did you get interested in investing, or want to have a career in investing?
Steven Hall: Thanks, Tom. Thanks for having me on the podcast. I was hoping that before we got into me answering that question, we could maybe talk a little bit about how we met because we actually met before I joined Dynamic.
Tom: I remember.
Steve: Tom and I met approximately one kilometer below the earth's surface in the middle of Saskatchewan. What I remember most about that trip was this extremely long elevator ride from the surface to the bottom of this mine, and we're excited to see this potash that everyone's been talking about. It's basically this giant, empty field. The mine manager who's giving us this tour announces, "You're probably wondering where all the potash is but this mine has been in operation for over 100 years and all the potash close to the shaft, of course, is the most convenient potash to mine, and it's all been mined. We're going to jump in a golf cart and travel 40 minutes to where the actual potash mining is occurring today."
Tom: Yes, it was so surreal to drive for many kilometers underground.
Steve: Yes. I just remember thinking this must be what Neil Armstrong and Buzz Aldrin must have felt like because it very much felt like being on the moon. It was definitely a very cool thing. Of course, we kept in touch after that and remained friends.
Tom: That's how you met me. You were an investor at that moment, but you have to stop dodging the question. Now, how did you get interested in investing?
Steve: I wish I could give the story that I got birthday money on my 10th birthday, and I invested it in Disney, and caught the investing bug, but the truth is, I didn't get interested in investing until much later, probably my last year of undergrad. I took economics but I was much more interested in macroeconomics. I was interested in how civilizations got better over time, how standards of living improved through productivity, through technology.
What I found most of my economics courses were trying to teach was policy. It was should the government increase interest rates by 25 basis points or 50 basis points? Should it decrease interest rates? Should they increase the money supply? Very policy, very Keynes versus Milton Friedman, which I found just boring. I started shifting my classes and my focus more toward finance. I found that much more interesting.
I think what really sealed the deal for me was I remember the Toronto Star was running a contest. It wasn't called this at the time, but essentially a sports fantasy league for hockey, it was called Hockey Stocks. It was actually done online. How it worked was you got this play money, call it a million dollars, and you could invest it in NHL teams. It wasn't players, it was teams. How you won the contest was you had to collect the most dividends and you got a dividend if your team won a game, you got one dividend. If your team won two games, you got two dividends. If it won three games in a row, you got four dividends. If it won four games in a row, you got eight.
It was actually brilliant because if it had just accumulated linearly, it would have been pretty boring. Of course, if the team lost, you got zero and you went back to square one, and they had to win a game to get one dividend again. The strategy that most of these contestants took was I'm going to find all these hot teams that are on a winning streak and buy those shares. Of course, those are the most expensive shares to buy, right?
Tom: Momentum investing.
Steve: It was momentum investing, and everyone did it, but not everybody. My strategy was I'm going to wait until a team has won eight or nine games, and everybody's in this stock in this team hoping for that win that's going to pay them 32 or 64 dividends. Then they lose and it plummets. Everyone's just trying to get out and I'm sitting there low-balling them. Literally, they would go down 90% after they lost a game.
Halfway through the season I discovered there was a handful of these value investors like me and we'd accumulated all the shares. You actually defile if you're over 10%. It was very cool, very ahead of its time. I don't know if I won the contest but I certainly caught the bug.
Tom: That's a very Canadian story too, having hockey as the way you get into investing as hockey is the gateway to so many things here in Canada. I really like that. I also like how you identified value investing on your own and identified some of the follies of momentum investing and hype, and how everyone can crowd into a stock or a team when things are going well. What was the first time you actually bought a stock? When did you actually get into real stock investing?
Steve: Yes, around the same time. My last year of university, I took a job working at the mall, in a kiosk selling Fido phones around Christmas time. There was no selling involved. It was literally this massive lineup at the kiosk in the mall and it was you could have phone A or phone B. I literally just took people's money. I thought that I had discovered something that no one else had discovered, and that's that cell phones are this thing and they're going to be very popular.
I was early to this trend and so I went, and I bought shares in Microcell, which was the owner of the Fido brand at the time. Eventually Rogers bought them and they're now part of Rogers. It was also the late '90s. We were in a massive tech bubble. It was a good lesson in what Howard Marks would call first level versus second level thinking. As it turns out, I was very late to this trend and like most first-time investors, I lost my shirt.
Tom: Why don't we talk about that, this whole notion of first level versus second level thinking. I think it's such a great concept. Not everyone may be as familiar with it as we are. What's first and second level thinking?
Steve: It's like I try to explain to people who asked me, for example, a number of years ago. Well, cannabis has become legal now in Canada. Isn't that a thing? Doesn't that just mean all the stocks are going to go up in price once it's legalized? That market doesn't work that way. The market looks forward. It's a discounting mechanism. You have to always ask yourself when you're buying a stock, what expectations are already embedded in this price?
Usually any good news, any positive future event is already going to be discounted in the stock. You're not going to get the benefit of that if you invest. That's what Howard Marks would say; the second level thinking is what is everybody else thinking? What has everybody else already expected? Almost like a spread on a football game. If Tom Brady's playing in the Super Bowl, you know he's the best quarterback, he's the GOAT. It's not whether his team's going to win, it's are they going to win by 15 points or 20 points, because they might still win but only win by 10 and you're going to lose that bet.
Tom: I want to switch gears a little bit and talk about what might be really relevant to some folks that are listening today, which is your area of expertise, consumer. Obviously, the consumer's had a lot of stuff happen since COVID. A lot of stimulus, rates went down, rates have moved up a whole lot. I think the consumer stocks remain a real battleground in Canada and the U.S.. What's going on with the consumer today? What do you bullish on? Where do you see opportunities in consumer?
Steve: I think everybody's been waiting for the consumer to roll over and stop spending, and it's going to lead to this recession. As you know, consumer spending is about two thirds of the economy. So goes the consumer, so goes the economy, is the saying. I think where investors get it wrong is they try to think of the consumer as this rational economic agent that you read about in the economic textbook. I think you got to throw away the economics textbook and you got to pick up a copy of Maslow and his hierarchy of needs and think about that.
What it really comes down to is the employment situation for consumers. Do they have a job? Do they feel safe in their job? I talked to this retail consultant pretty regularly who used to work for the May Department Stores, which is now Macy's. He worked there for many years, and he tells this great story about how they used to try everything to try to forecast consumer spending. What's the next 9 months, 15 months was going to look like. They came up with all these complicated forecasting models with interest rates and with consumer confidence, and inflation, GDP, PMIs, none of it worked.
What eventually did work and that was their go-to when they would survey consumers, is they would ask them three questions. Do you have a job? Do you think you'll have a job a year from now? If you lost your job, do you think you could get another job that paid just as well? If you were to ask consumers those three questions today, the answer to those questions is yes. It's not that the consumer has a budget every year, and well, inflation is up this much and so I got to cut this much, there's a lot of credit available still. You could have great credit and a lot of income coming in but if you are worried about your job, it's very quick to stop spending, you'll see consumers cut that spending off very quickly.
On the other hand, if you get squeezed, but you still feel good about your job, then you're okay with maybe borrowing a little bit to buy that new car. Getting back to Maslow's, you can very quickly go from, I want to buy a new car, to I'm going to stop spending because I'm worried about how I'm going to feed my family and pay my mortgage.
Tom: It's very interesting that the last recession was obviously during COVID, so different than, say, the 2008 recession, because the consumer ended up better off during the recession. It's just so different. I think it follows that the consumer may be behaving a little bit differently right now because the lessons learned over the last few years weren't necessarily the same ones that were learned in previous recessions.
You maybe just don't have that sensitivity to higher rates, not least of which because you have savings, but also because there's this sense that maybe there'll be money for me if I do lose my job, so I don't need to worry quite as much as they would have in the past. Do you think that's true?
Steve: Definitely one of the trends you're seeing now is a shift in what consumers are spending their money on. You think about during COVID, you couldn't travel, you couldn't go to restaurants. The service economy was hit hard. People were buying barbecues, they were buying exercise equipment, those categories are definitely slowing right now, and I think there's a lot of investors looking at those categories and saying, "Well, look, the consumer slowing, they're getting impacted by inflation," but it was really I think, a lot of pull forward.
You have your barbecue, you have your Peloton, your exercise machine, what people want to do now is they want to go out, they want to travel, they want to go back to restaurants. It's revenge spending and you're seeing a lot of those sectors right now quite healthy. I think it's a mistake to look at certain categories and say, "Well, that's a weak consumer, they're pulling back because they can't afford it, versus they're pulling back because they already have it."
Tom: I think that's a great explanation of the consumer changing pre-COVID versus post-COVID. China's a fair bit behind where we are, when you think about reopening in the U.S. started really, in some cases in 2020, definitely in 2021, and Canada was more 2021, 2022. In China, it's really 2023. How are you thinking about the impact on the stock market and consumer stocks of China's reopening?
Steve: I think one of the big opportunities I'm seeing right now, and where we're investing as a team, is in the apparel space. There's a lot of inventory right now in the system and usually, that's a bad thing for apparel stocks. I think it's a bit different this time, for the reasons you mentioned with China being slow to reopen, having rolling periods of lockdowns for not just the consumer demand, but also for the production of a lot of goods.
Essentially what happened was apparel companies were getting late shipments. They began ordering their seasonal merchandise much earlier, and then eventually those constraints got better, shipping times improved. The inventory that you were hoping to get going into March for spring, you got in December, and you got in January, unexpectedly. The inventories piled up because of a timing issue with shipping. It's not piling up because consumers are not buying the stuff, which is very different.
If you're willing to look past a couple of quarters, as a lot of these apparel companies worked through this inventory or not even worked through it, but just essentially hold it for when it's actually going to be needed. If the consumer remains healthy and demand remains healthy, and we think it will, those margins are going to hold up much better than they typically would hold and when you have high inventory, you need to discount it to get rid of it.
Tom: Right, and that's the big problem with having too much inventory, is the discounting negatively impacts the margins. It's obviously, it goes well beyond just your company, right? Even if your competitors are discounting back and still hurt you because you'll pull sales away from you.
Steve: Yes, and it also actually hurts the brand when you see it on sale. Something we talk a lot about is this idea of a flywheel effect, right? When you're having to discount products, can change the image in the consumer's mind of the quality of this product, and then they might not want to make a repeat purchase, right? You get into this downward spiral, where you're discounting and then your competitors all have to discount, and you can get into a vicious cycle where it can take you much longer to get over that.
You need to clear inventory, need to rebuild your brand. Nike would call it getting into a pull market, where you're waiting for the consumer to pull demand back from you rather than you're pushing all this excess inventory on them.
Tom: That's just not where you want to be investing in the apparel space. Why don't we get into it on the flywheels because this is something you and I have spent lots of time talking about over the years. I think the first one we ever did was on Nike, or rather I should say that you did, and you brought to the team. Then, we tried to apply it in a lot of other places because it's such a great way to think about the business model. I always say when I'm talking about flywheels for Nike, it starts with great sneakers. Can you take us through how does a flywheel work?
Steve: Sure, every consumer company, whether they know it or not, is in a flywheel. It's a term that was first coined by Jim Collins in his book Good to Great, and it's essentially how the various drivers of a business reinforce each other in either a positive or negative way. The example with Nike is, well, Nike makes the best products, which attracts the best athletes because the best athletes want to wear the best products. Nike pays these athletes to endorse the shoes.
All the kids out there, they want to emulate their heroes, who are the best athletes. They don't want to wear what the number three guy or number four guys wearing, they want to wear what number one is wearing. Then Nike gets the best market share, they get the most sales, the most profits, they have more money to reinvest in R&D in the marketing to make the best product which then attracts the best athletes. It's this virtuous circle that's just very difficult to compete with.
Tom: Right. I always really liked that. With Nike, it's very easy for people to see. I think it's tougher for an industrial company or financial services company to understand how that works, but everyone's bought a pair of running shoes. It's a nice easy way to get your head around how a flywheel works. Then once you open your mind to this idea that when a business is doing well, it's because there is a flywheel that lets you take that mental model out there into the world, which is why I always thought that was so brilliant because it helps you go from idea to idea saying, well, what's the flywheel here? If you can't figure it out, that's a problem. Either there isn't one, or it's too difficult for you.
Steve: Yes, or is it spinning faster? Or, God forbid is it going in the wrong direction? I think a paradox of thinking about the flywheel, and we always think pretty long term with our investing is quite often when that flywheel is in effect, and the moat is growing, sometimes your margins are not going higher, they're actually flat, or they're going down. That's sometimes a hard thing for shorter-term investors to get their head around.
Tom: Because you're investing in the moat.
Steve: You're investing in the moat. Those investments are going to pay off years and years down the road, and so it seems like the story with Nike, it's always, well, one of these margins is going to go higher but they're constantly taking those excess profits and reinvesting it back in the business. Forsaking short-term margins for long-term share gains, category growth. It's been a great stock over the long run.
I'm reminded even just last week, with Home Depot, they announced they're going to spend an extra $1 billion to pay their employees more, to retain talent, to just get better employees. Stock market didn't like it, stock was down 5% or 6% that day because 2023 earnings might not grow as fast, but they're expanding their moat. They're becoming a better company, they're going to crush their competitors because they've got the best workers, which is going to have the best customer service. That's their flywheel. Right?
Tom: Right. Great retention, having all of those employees that are customer-facing, being that much happier. Everyone who's been to a Home Depot versus their competitors, you know the difference. They have more people on the floor doing customer-facing things, and they're generally higher quality, more knowledgeable, willing to take the time with you. Whereas you go into some of their competitors, you're lucky if you can even track someone down.
Steve: Yes, they're hiring the kids from high school versus Home Depot's hiring someone who was actually [crosstalk] wrongfully in the construction business or actually maybe had their own business at some point.
Tom: We talked a bit about consumers, a bit about apparel. The other big area you cover is small caps. Why don't we talk a little bit about what's the opportunity in small and mid-caps right now?
Steve: It's interesting I was reading Warren Buffett's letter to shareholders that he puts out every year around this time, and he specifically spent some time in his letter to talk about two investments that he made back in the mid-'90s. One was Coca-Cola and the other was American Express. He talked about how those stocks are essentially up 10 to 15 times what he paid for them. I think dividends that he's getting from Coke now is the equivalent of half his market value of his investment. It's grown that much.
These are two large almost mega-cap stocks today, but if you go back to when Buffett was buying these companies, and I did, they were both about a $15 billion market cap. They were much closer to being mid-cap stocks back then than they were to large-cap. The obvious opportunity is just good companies that are mid-caps do eventually grow into large-cap companies. I do think also there's a bit of a misperception, at least in Canada, that somehow small or mid-sized companies mean small or mid-sized returns.
If you own a large-cap fund in Canada, I hate to break it to you, but those stocks are much more closer to being mid-caps than they are to being large-caps. There's 235 stocks in the Toronto composite index. 200 of those are under a $12 billion market cap, U.S., which would qualify them as mid-caps. They would be much more of a better fit in the S&P 400, which is the mid-cap index. The average market cap of an S&P 500 company is $450 billion. I think the average is 30-something billion in Canada. If you're already comfortable with mainstream Canada, there's no reason why you shouldn't be comfortable with U.S. mid-caps.
Tom: That's very interesting. What do you think the advantages are that you have when you've got this whole team of people that are looking at small and mid-cap securities versus trying to do it on your own?
Steve: One of the biggest opportunities in the small and mid-cap space is they're just not that well covered. There's 60 analysts that cover Amazon. It's going to be very difficult to get much of an advantage, at least in the short term on a company like that, versus a lot of mid-cap names have three or four analysts that cover it, and to be frank, they're not always the best analysts. They're usually the junior analyst that has just been promoted, and so they give them the small stocks. Or they're being covered because the brokerage firm underwrote the IPO and they have to cover it.
Tom: Right. Some banking relationships.
Steve: Yes, so it's not always the best research. Obviously having the expertise of the equity income team with expertise in every sector going a mile wide, also going a mile deep, allows us to uncover a lot of great opportunities in the mid-cap space and the small-cap space.
Tom: One of the reasons people like small-caps and mid-caps is in a world where the large caps are so big as you just outlined, they're often having a harder time growing, and they need to go out and do M&A. Do you see opportunities for that, especially given rates have moved up a little bit?
Steve: Yes. One of my favorite statistics is there's enough cash on the balance sheets of the S&P 500 to pay a 40% premium on every S&P 400 company and take it private. That's how much cash there is, and that's just the public companies. I'm not even talking about private equity.
Tom: Which have many trillions of dollars of--
Steve: And continue to raise money in this environment. Blackstone just raised an Opportunities Fund, KKR has raised a fund for mid-caps specifically, I read. I read an article in Barron's last month with one of the partners at Thomas Bravo, which is a tech private equity fund, specifically targeting small and mid-cap software companies that have become much more affordable in their opinion. As you said, large caps need to grow. Every large cap is faced with a, well, do I build it myself or do I buy it, decision?
We know that building things today is just very difficult. We could talk about a physical plant or a factory, but building a sales team is also very difficult. It's just hard to get people and materials, we're in a very supply-constrained world. I think if I'm a large-cap company, and I want to grow, I think looking at the small and mid-cap public companies as targets makes a lot of sense.
Tom: I think it's so true, this idea that an inflationary environment, well, it does increase your funding costs, obviously, so if you need to fund things with debt, it's more expensive. However, it also increases replacement cost of everything. It doesn't matter if it's cement or steel, or land, or people, intellectual property, everything's gone up dramatically in price over the last few years since COVID. Those things that you have already gotten much more expensive as a result of inflation.
The stock market, of course, is impatient and doesn't necessarily always appreciate that on day one. They don't always necessarily appreciate that. While interest rates have gone up, the price of, for instance, what I cover public REIT may go down right now, but their price to replace that piece of real estate might be dramatically higher because rebuilding it is so much more costly. I think that makes perfect sense also in the small and mid-cap space. It's probably true of everything from software, to an industrial, to a financial services company.
Steve: Yes. It's really interesting because I feel the last call it 10 to 12 years since the great financial crisis, asset light was the way everybody wanted to go. If you had too many assets, that was a bad thing. We might be at a point where that starts to reverse. Nobody wanted any assets and there's not enough of them now. These terrible asset-heavy companies that were ignored or dissed, are now probably becoming extremely valuable.
Tom: Steve, that was a great conversation. Before we go, could you give the listeners your number one non-investing book that would help them become better investor?
Steve: Without a doubt. I would say my favorite non-investing book, and I try to read it at least once a year, it's called Thinking and Systems. It's by Donella Meadows. She wasn't the person who came up with systems thinking, but she learned from one of the great, a guy named Jay Forrester who was a professor at MIT, and she was a student, and then she went on to teach systems thinking at Dartmouth. It's a short book. It's a pleasure to read what is systems thinking. It's essentially anything that's a collection of pieces that has interconnections and has a goal, is a system, human body is a system, a company is a system, there's an ecosystem.
It's essentially a way to try to understand a complex world. One of the big insights I got from that book is, so think of a bathtub. A bathtub full of water it's stock of water. There's flow from the taps, the faucets bring water in. Then there's a drain where the water flows out. Donna goes on to talk about how everything that we pay attention to in the world is the flows. It's the changes. It's what makes the news. It's the profits and the sales of a company. These are all the flows. What you should really be paying attention to is the stocks, because that's where the big changes happen. That's where those structural regime changes happen when you have changes to stocks.
She started off as an environmentalist. She wrote a book called Limits to Growth in the '70s. She had very much an environmental angle to it, but I use it for investing as a framework. I said an example of flows would be income statements. An example of stocks would be balance sheets. I just don't think investors look at balance sheets enough. It doesn't matter until it matters. Another thing from the book is that a lot of the solutions that we come up with to complex problems usually don't work. In fact, it usually makes the problem worse.
When you understand these problems as big systems with moving parts with its own goals and its own agendas, you start to think of policies that are a little bit more effective. I love systems thinking. I wish I learned this in school. I wish they taught it in elementary school. I wish they taught it in high school. I wish more people read this book. That's my recommendation. Tom, I got to ask you, what's a non-investment book that you would recommend for our listeners?
Tom: In fairness, most of them would be books that you had me read because [laughs] you're really great at identifying these books and in fact, I have a very large shelf just dedicated to Steve Hall book recommendations that are yet to read. I will get to them one day. Maybe I'll be retired. My recommendation, I'm going to recommend one from another colleague of ours, Jennifer Stevenson, who recommended the book, How the World Really Works by Vaclav Schmill. It's another book that's really about the environment and about energy.
When you go to the gas pump and you think about what the impact of that is on the environment, about transportation's energy usage, if you think that is where your energy impact stops, the system is so much more complicated than that and everyone gets that, well, there's some energy that gets used in construction and there's must be some energy that gets used to ship things to me or to make some food, but it's really mind-blowing how much energy is used in places that aren't your gas tank.
I think when you understand that it opens your mind to this idea of, holy moly, this, energy transition problem is way bigger than everyone driving a Tesla. It's way bigger than that. Energy and fossil fuels are way more integral, I think than I appreciate, certainly, than the mainstream media appreciate. I would highly recommend that for everyone.
Steve: Yes. His example of the tomato, and the two teaspoons or tablespoons of diesel that would be required to bring you that tomato to your kitchen table was for me bit mind blowing.
Tom: Yes, absolutely. That was it for me, too. It's that moment of there's a lot more fossil fuels in this house than I appreciate. [music] Well, thank you again, Steve. I really appreciate you taking the time with us today. That was a great conversation, and I can't wait till next time.
Steve: Always fun talking with you, Tom. Thanks very much.
Mark Brisley: You've been listening to another edition of On the Money With Dynamic Funds. For more information on Dynamic and our complete lineup of actively managed funds, contact your financial advisor or visit our website at dynamic.ca. Thanks for joining us.
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