June 16, 2020

VIDEO: Outlook 2020 Recorded Presentation

On June 11, 2020 we moved our annual Client Outlook event online. The agenda for the event was as follows:

• Jim Gilliland – President, CEO & Head of Fixed Income: 2020 Reflection and Outlook
• David Slater – US Equity Analyst: US Small/Mid-Cap Equities
• Stephanie Hickmott – Portfolio Manager: Battling Short Termism
• Q&A

We are pleased to provide the full video and time-stamped transcript for the event below, for those who may have missed it.

This presentation is not intended to provide advice, recommendations or offers to buy or sell any product or service. The information provided is compiled from our own research that we believe to be reasonable and accurate at the time of presentation, but is subject to change without notice. Investment matters are complex and dependent on personal circumstances, please consult your professional advisor. Transcript text edited lightly for clarity.

To download a PDF of the transcript, please click here.

To download the presentation slides, please click here.

---

Jerry Koonar (00:00:07):
Welcome to the Leith Wheeler 2020 Outlook. My name is Jerry Koonar. I’m a portfolio manager in the Calgary office of Leith Wheeler and I have the pleasure of being your host today. Given the unprecedented times we find ourselves in, we are pleased to be virtually delivering this year’s Outlook, and from three locations. I will be hosting from Calgary and I’ll be joined by Stephanie Hickmott from our Toronto office, along with Jim Gilliland and David Slater in our Vancouver office.

In March of this year, when the country went into lockdown, our firm successfully transitioned 100% of our employees to virtual home offices. Today, we are slowly returning to the new normal, with our Vancouver offices slowly starting to reopen. And we have taken the appropriate steps to ensure social distancing remains in place and a safe working environment remains in place for those wishing to return to the office.

(00:01:07): Just a couple of quick technology housekeeping items. You’ll find at the bottom of your screen, there is a Q&A button. If you have a question, click on that button and you’ll get a pop up screen, and in that pop up screen, you can write your question. It’s fully anonymous. Once your question is finished, hit submit and we will receive that question on our end.

Now, if there are time constraints and your question goes unaddressed, I encourage you to directly email your portfolio manager to have your question answered. The second housekeeping item is when we get the presentation started, you’ll see two panels. One will be the presentation speaker and the other will be the presentation. In between there’ll be three squiggly lines. If you toggle your mouse over those squiggly lines, you’ll get one solid vertical line that’ll allow you to either increase the size of the face of the speaker or the size of the presentation.

(00:02:13): So on that note, at this time I’d like to introduce our first speaker, Jim Gilliland. Jim is President and CEO, and Head of Fixed Income at Leith Wheeler. He’ll be reflecting on current market events and what lies ahead for us. Take it away, Jim.

Jim Gilliland: 2020 Reflection and Outlook (00:02:30): 

Great. Thank you, Jerry. I just wanted to start off by thanking you for joining us today. This is a different event than we’ve done in the past. And also thank you for your trust as your investment advisor. The last several months have really been unprecedented in terms of the volatility with significant changes, not just in financial markets, but in terms of our work habits.

As Jerry mentioned, we’ve successfully transitioned to work from home using our business continuity plan. You can rest assured that with the investments we’ve made in technology, in business processes, in systems, that we’re able to seamlessly transition to working out of the office. 

(00:03:14): So just picking up on the financial markets piece of it, I mentioned the last several months we’ve seen unprecedented volatility. It’s not the first time that we’ve seen a market correction or concerns around a recession. In fact, if you look over the last hundred years, pretty much every five or 10 years, we see something similar to what we’ve seen in this first quarter.

And probably the two that are most familiar to you are the ones that have occurred over the last 20 years. The dot com collapse, where you had technology and telecom companies that were valued at incredibly high levels, and a significant amount of debt deleveraging from the telecom companies in the early 2000s. And 2008-9, which was the Great Financial Crisis, where you saw excess buildup of mortgage debt…

(00:04:01): ...and you saw financial services companies that were forced into deleveraging. So those tended to be the framing that people use to look towards a path forward for us. And the Mark Twain quote is, “History may not repeat itself, but it rhymes a lot.” Now that being said, when we look at this most recent time period, there are some key differences and probably the most important difference is the cause. So when you think of those last two corrections and recessions we talked about, they were because of financial exuberance, where you saw excess debt getting built up. And that [debt] then is forced to get liquidated over time. the time process that it takes to liquidate that debt is why these recessions take so long.

This is a little bit different. This isn’t driven by debt deleveraging. This is driven by a public policy decision to halt economic activity. And because of that, it’s much more akin to a light switch, where suddenly everything stopped for a time period. And we’re now at the point where you’re starting to see the dimmer switch slowly resume economic activity.

(00:05:11): When we look at the impact that had on financial markets in the first quarter of that time period between third week of February and third week of March, we saw the most significant decline in equity markets, that quickly. So basically a 35% decline in stock markets in the course of about a month. 

It wasn’t just equity markets. We also saw pretty severe stress in credit markets. It became very challenging to buy or sell corporate bonds for a time period in the latter part of March. And since that time, you’ve seen a significant amount of central bank intervention, which has helped support the market. And in fact, if you look at the most recent performance. A significant amount of that has been regained, albeit a little choppier day to day.

But you see that over the course of the last six weeks, a significant amount has come back. And that can seem like a little bit of a disconnect when you’re looking forward. The reason being, we’re in the midst of what is considered a pretty significant recession. What some people are even calling a depression, yet at the same time financial markets have moved back up to their highs.

(00:06:21): And so does that really make sense? Does that disconnect make sense? And I think to really explore that question, what you need to do is look at the actual economic impact. And probably the best way of understanding the impact that the coronavirus or COVID-19 has had on the economy is through the jobless rate. And what this chart here shows is the unemployment rate in the United States.

Coming into early 2020, we were at a record low in terms of unemployment. So that scale on the left-hand side of 4% means that for every hundred individuals that are looking for work, 96 of them were able to find jobs and only four were actively looking for work. That is an all-time record of the last 50, 60 years in terms of the low level of unemployment.

(00:07:11): In the course of just two months, March and April, we saw that unemployment rate increase to close to 15%. That is by far the most that we’ve seen since the Great Depression. And because of that, you have a lot of headlines that are talking about, is this the next depression? How are we going to be able to redeploy all of those jobless individuals?

It’s important to dig into the data a little bit. In March and April, you saw about a 20 million decline in terms of jobs. Now, what doesn’t get well recognized or necessarily reported is that of that 20 million unemployed that were looking for work, 18 million of them were classified as temporarily laid off.

(00:08:00): So those are individuals that were at home, who had jobs, but were being furloughed from their jobs and were expecting to return to work over time. The other aspect is that you can dig in a little bit is in terms of the industries, and try to understand what were the industries that were most affected.

On the right hand side, you can see that leisure and hospitality and retail trade were two areas that had the greatest impact in terms of job declines. And that makes sense. If you’re forcing restaurants, hotels, retailers to close their doors, then the individuals that work at those companies are going to be furloughed.

There are also areas that you might not expect, where we saw significant job declines in March-April. One of those is education/health services, and that’s primarily hospitals. And you would think in the midst of a pandemic, why would people be being laid off from hospitals? And it’s because of the furloughing of elective surgeries.

So as hospitals retracted to focus purely on COVID-19 cases, it meant that a lot of elective surgeries were delayed. And so that’s an area similar to manufacturing, that we think will come back pretty quickly. So there is a portion of those jobs that are truly furloughed, that over the next three to six months we do expect to get called back and to be employed again.

(00:09:23): When you go back to that retail trade and to that leisure and hospitality, it’s probably going to take longer. In Vancouver, we just recently started reopening restaurants, but they’re at half capacity so you’re not going to need as many employees as you did prior to it. So it’s probably going to be more of a long, drawn-out recovery when it comes to joblessness.

So is this the Great Depression? I said that it’s the highest unemployment rate since the great depression. Our view is that it isn’t, and it’s because of the role that government plays in the economy now, relative to the time period in the late ‘20s. So for every hundred dollars of economic activity, $12 were generated or spent by the government in the late 1920s.

(00:10:12): Currently, it’s around $40. And the reason is, there are far more support programs than there were previously. So think of unemployment insurance, of social security, of banking insurance, of depositor insurance. Medicare, Medicaid were both introduced in the 1960s. All of those programs were developed after [the Depression].

And the reason that’s so important is it allows the government to smooth the impact of some of these declines in joblessness and to spread it out over time. So that it isn’t felt as severely as it was in the Great Depression. So if we look instead at maybe not necessarily the Great Depression, but let’s say a regular recession, like we saw in 2000 or 2008-09. What are the similarities to that?

(00:11:04): Well, one thing that is clearly the same is the panic that we saw in credit markets – that time period in March that I mentioned, where credit markets became very challenging to trade. It’s an over-the-counter market and counterparties were reluctant to put pricing on corporate bonds.

In my last 30 years managing institutional money, that’s probably one of the toughest environments that I’ve seen since 2008-09. And really it got solved or got improved through central bank action. And similar to 2008-9, you saw central banks lower interest rates pretty close to zero to provide liquidity, so that individuals would be able to buy and sell corporate bonds again.

And within three or four weeks, you started to see the market improve and gradually begin trading again. What’s interesting about this environment is how quickly they moved. So in 2008-9, it would have taken three or six months to have these programs developed and rolled out.

(00:12:04): And what we saw in this most recent crisis is that central banks around the world basically dusted off the old playbook from 10 years ago and implemented it very quickly. And so the timeframe in terms of the damage that was created was much less as central banks were much more aggressive. What is similar is also the damage to consumer psychology.

With the joblessness and with the concerns around COVID-19, you are seeing consumers retract and you are seeing consumer confidence at much lower levels. Even countries such as China that are maybe two or three months ahead of the curve as it relates to gradually reopening, are still seeing that it’s challenging for consumers to come back.

Individuals are just going to work and then coming home and aren’t necessarily socializing in the same way. And I think probably, the most effective analogy is the airline industry post-September 11th when that tragic event caused all air industry to stop for a couple of weeks. But as the TSA started to reopen activity, you started to see airline travel come back.

(00:13:11): Over the course of six, nine months it had maybe got back to maybe 75-80% of its normal levels. But it took two or three years before the flying public felt fully comfortable flying again. And so in terms of the path forward and thinking through some of the challenges as it relates to the harm to consumer psychology that has been caused through this event, it is most likely going to be a more drawn out process, especially as it relates to the leisure industry.

What’s different about this correction and recession relative to others, is that this was induced by an act of public policy. This wasn’t financial exuberance. And the reason that’s so important is that most recessions get defined by the time it takes to go through the default process. So let’s take 2008-9 as an example.

(00:14:01): When you had house prices decline, individuals began to stop making payments on their mortgages. They would go 30, 60, 90 days delinquent, and then eventually default. The bank would need to foreclose, sometimes go to the courts to be able to get control of the title. They would then sell that house, which would then push down prices in neighboring houses, which then created the cycle again.

A very long drawn out process. As I mentioned, this one’s quite a bit different. It’s driven by public policy, and therefore the timeframe in terms of working through these issues is going to be somewhat different. And probably the most important aspect in terms of why this correction and recession is different than others, is the degree of government intervention to help support it.

And if we look for instance in the States, the latest COVID-19 coronavirus relief bill received a vote of 96 to zero in the senate. I can’t recall the last time I saw a senate bill receive 96 to zero votes. But it shows you the bipartisan support to be able to step in and do what it takes, to be able to support the economy and to support individuals that have been affected by it.

(00:15:17): Basically the government is willing to spend what it takes. And it’s not just in North America. When you look outside of it, in Japan, in the eurozone, the European Union, Australia, Canada. Pretty much all of them are stepping up and delivering significant fiscal packages that have been designed to smooth the effects that the coronavirus shutdowns have had on the global economy. And probably the question that you’re asking and that we get asked quite often is, “Can we afford it?” Any of you who recall the early ‘90s, in terms of Canada and hitting the fiscal wall… We’ve had a similar time period in the U.S. in 2010-11 with the rise of the Tea Party. You don’t hear a lot of fiscal conservatives today asking, “How are we going to pay for it?”

(00:16:09): And so the question is, can the government afford these higher levels of debt? And I think in terms of debt sustainability, one of the most important things you can consider is the level of interest rates relative to the level of economic activity. So let’s go back to that time period of the early ‘90s in Canada. Interest rates at that time were around seven or eight percent. The economy was only growing about four or five percent. So if you’re trying to finance debt at 7-8%, and your tax base is only growing 4-5%, you can see pretty quickly how that can be unsustainable. We’re now in an environment of interest rates, where pretty much anything the government of Canada issues is less than 1%. So as long as the nominal economy – so that’s inflation as well as productivity – as well as labor force growth is above 1%, these higher levels of debt are sustainable for the short and medium term. Now, that doesn’t mean there isn’t risk. And there’s probably three areas that we look at in terms of what could potentially go wrong.

(00:17:11): The place that you see it first is usually in weakening currency. And so, this applies especially to emerging markets that rely pretty heavily on international buyers to finance their debt. When foreign investors are uncomfortable with the credit quality of an emerging market, they will end up selling that debt and repatriating that currency to their own currency, which causes that currency to weaken.

What’s interesting about this time period is that the major currency pairs – so think of Euro/Dollar or Yen/Dollar or CAD/U.S. dollar – every one of those economies are doing the same thing. So if you have one country that is being very profligate and is spending a lot of money and no one else is, then that currency will weaken. When every economy is doing it and things are priced as currency pairs, it’s not necessarily clear that you get that same weakening in currency.

(00:18:05): And that’s basically what we’ve seen to date. The other aspect you could see is through significantly higher interest rates. For those of you who remember 1994, that’s when the term “bond vigilante” was coined, when we saw bond investors sell bonds to the point where interest rates increased by two full percentage points. That’s unlikely to happen today because of central bank intervention.

So basically central banks are going through and setting an upper end in terms of interest rates, and are buying bonds back and printing the currency to ensure that longer-term interest rates don’t increase. Again a concern for the longer run, but not necessarily for the short, immediate term.

Probably the biggest risk or uncertainty that is incredibly challenging to manage as investors is the impact of a protracted health challenge. So right now, the market is expecting that we’ll have some type of vaccine or advanced therapy over the next 12 to 18 months. That would be a record time and pretty much everyone admits that would be a record time.

(00:19:09): If that were extended, if for instance we were forced to shut down economic activity again… Those types of uncertainties are really hard to manage and would definitely have an impact on markets. And in fact, today what you see is with increases in cases in Texas and in other parts of the U.S., the market is concerned now about the potential for a further tightening in restrictions. 

And so you have uncertainty that is really hard to price. What is the strategy that you take to be able to manage that uncertainty? What we do is focus on what we do best, which is understanding companies. So we spend our time looking at those company fundamentals in terms of how effectively that company is going to be able to manage a prolonged cashflow interruption.

(00:20:01): And it depends on the industry that that company operates, how much fixed costs they have relative to floating costs. How effectively they can reposition their company to be able to manage it. If they are able to survive a prolonged cashflow interruption. 

Then the question is, is the right investment vehicle through the debt or through the equity for that company? And this is where the coordination between our equity and credit teams is so absolutely critical. What I’ve seen here at Leith Wheeler is that due to the fact that we’re all owners, we have a degree of communication and coordination that is unlike any other firm that I’ve worked at before.

And when you’re dealing with an uncertainty, where you have an environment that you need to draw as much insight as possible, bringing together those different viewpoints has been particularly important for us. So we will have our debt investors looking through the loan covenants, looking through the holders of the underlying debt to make sure that the companies we invest in are financially resilient and are going to be able to survive.

(00:21:12): So what types of companies do we invest in? The same type of companies that we’ve been investing for over the past 38 years. When you look at the types of investments we make on your behalf, first off, they need to be established businesses. And whether you’re grappling with COVID-19 or not, you will know that an established business is going to have a product or service that’s easy for them to sell, no matter the environment.

“Financially conservative” means that they have the right levels of debt, that they’re going to be able to service that debt no matter the economic environment. A quality management team ensures that the company can get repositioned. And most importantly, attractively priced. For us, the price we pay is by far one of the most important components.

(00:22:05): What we’ve seen in the first quarter is attractive pricing for a lot of these higher quality companies. So Stephanie and David Slater will give you some examples of companies that we’ve been investing in on your behalf, because of the cloud that’s been created because of COVID-19.

What do we not invest in? It tends to be companies that are trading at very large valuations. So if we can’t get comfortable with how the market is pricing that type of company, then that will be a company that we wouldn’t want to invest in. In the late ‘90s, early 2000s, there was a company by the name of Northern Telecom. At one point it represented over a third of the total market cap in Canada.

We then saw RIM/BlackBerry. Valeant, which is now Bausch Health Companies, briefly became one of the largest companies in Canada. And then currently, Shopify has had a significant increase in its valuation. Again, a company we can’t get comfortable with.

(00:23:13): We would rather invest your hard-earned money in companies like Royal Bank or Toromont, which is one of Canada’s largest CAT dealers. Companies that are able to grow through time, where the valuations make sense and we’re comfortable we’ll be able to deliver the returns that you expect.

The reason those valuations are so important is because of this chart on the left-hand side. When you look at the price that you pay, it has a very, very high correlation to the returns that you can experience over the next 10 years. So when a company is trading at say 20, 25, 30 times earnings, in general, it isn’t able to grow fast enough to be able to justify that type of valuation.

And you see returns that tend to be lower. What we’re looking for are companies that are more trading in the 10 to 15 times range. Where we’re able to get a quality franchise, but be able to buy it at an attractive price. And what we’ve seen in the marketplace is a very high premium to growth companies.

(00:24:18): So those that have high anticipated earnings growth are trading at the highest level of valuation relative to value companies. So despite this move up in stocks, there’s still a lot of companies that we hold on your behalf that are very reasonably priced. And those are the ones that we’re looking to continue to hold and to continue to invest your capital in.

How does that work over the long run? This shows the returns for one of our typical balanced funds over the last 20 years. You could see that there’s some ups and downs in 2007-09, 2015-16 and most recently. But over the long run, this approach of buying high quality companies at attractive prices has been proven to create the right mix and the right balance for our clients over time.

(00:25:05): So just in conclusion, in our view, a recession is pretty much certain as it’s defined as two quarters of negative growth. You could see that in the jobless rate. We think a pretty significant portion of that comes back over the next three to six months, but that the last portion is going to take time. Potentially as long as a year or two for those individuals to get gradually redeployed.

The response from government has been absolutely unprecedented. So in isolation, this recession and slowdown would be very problematic for companies and for the economy, but the government is stepping in and providing support. And as I mentioned, they have the opportunity to be able to do so because of the record low level of interest rates. This type of uncertainty creates opportunities for us, and David Slater and Stephanie will go through some of those.

And probably and most importantly, in conclusion, own a well-constructed, diversified portfolio of these high quality companies that are bought at the right price. We expect to continue to provide that solid performance that you expect over time. So thank you very much, and I’ll turn it back to Jerry now.

Jerry Koonar (00:26:18):
Thank you, Jim. Just a quick technology reminder: again, if you have a question, you can find that Q&A button at the bottom of your screen. Just give that a quick click and a pop up screen will appear. You can type in your question, submit it and we’ll address it at the end of the presentation. Thanks again, Jim, for that great outlook.

Before I joined the firm over nine years ago, one of big attractions to me was our independence. Jim touched on that a bit, that our firm is collectively run and owned by our employees. And consensus building is in our DNA. Roughly seven years ago, we recognized that we were missing opportunities in parts of the U.S. equity market, and specifically those parts were U.S. small and mid-sized companies.

(00:27:06): We were fortunate enough to attract two very high quality individuals to build out and lead a small and mid-cap U.S. equity strategy, that now has a successful three year track record and is a part of many of our clients’ portfolios. We have one of those individuals today as our next speaker, David Slater. David is a U.S. equity analyst with Leith Wheeler and co-lead of our U.S. small and mid-cap equity strategy. He’ll be discussing some attractive opportunities that we’re seeing within that space. So over to you, Dave.

---

If you’d like to read the full transcript, please click here.