Transcript
Hello, and welcome to The Download. I'm your host, Dave Richardson, and it is a wintery Stu’s days. Stu, are you keeping warm?
I'm doing my best, Dave. I got my wool coat on here today, so I'm doing pretty well.
Wow. But you're up in the attic, Is it a little warmer than the rest of the house or colder? What kind of heat you got going up in there?
Well, when it comes to the temperature in the house, I like to keep it in the 65 to 67 degree range. You know, growing up in the «if you're cold, put a sweater on» era. And, I got the rads pretty much turned off on the third floor because all the heat rises. So it's fresh up here.
Oh, it is fresh. I was thinking maybe you're there because, again, that heat rising aspect. And then you sit up in the warm part of the house while you freeze out your family.
Yeah. Well, when you get in these old rad houses, if you get the rads on the 3rd floor, you end up having the window open, and it's negative in the basement and, it's not the easiest system to keep the house all at the same temperature. So I think I finally figured it out over the years. I got it all fine-tuned here.
And then just for the record, Stu is saying rads, like radiators, not rats. Stu does not have rats in his house. I often get caught on that. I say rads and people who never had a radiator in their house, like in some of the older houses in Toronto, that I've lived in too, they think you're saying rats, and that's just not at all the case.
No. No rats.
But what has been kind of rat, Stu, and this is a question that I'm getting a lot of right now. So let let's just take it straight on, from advisors and investors. And we've just done a series, as you know, with investment managers from all around the world who have mandates in all different areas of the world, geographic, generally. And you always zoom in on the US, and the US has done very, very well. It's outperformed. And particularly small parts of the US market have outperformed. So valuations are higher. And you say, well, hey, we've been listening to you and Stu and others for several years and all these other portfolio managers say, oh, the US, valuations are high and for all these other, the valuation is better. So you're going to see a rotation, and we just keep waiting and waiting, and it just never happens. What do we say at this point about valuation? Because I know you and I believe in this, and we like to zoom out and look big picture, longer term, maybe more so than maybe newer investors. We always want to do as well as we can day to day. But what's most important is that we do well long term. How should people be thinking about this as we're going to say that American valuations are high, and the rest of the world is relatively inexpensive. We should be leaning more there. How do you square all of this together for investors?
It's a great question. It's always top of mind. It seems more topical recently. There’s a couple of things to think about. The first is the promise to the equity investor is to say earnings across a broad group of companies have historically grown around 7%, and those companies historically have had a collective dividend yield between 1 and 2%. If I paid a certain valuation going in and I had the same valuation when I left, then I would have collected the 7% earnings growth and the 1 to 2% dividend yield. And there's a lot of companies that have delivered on that promise for a very long period of time. More recently, the companies delivering on that promise have been overweighted to a handful of big US technology companies. So the percentage of the earnings growth that has come from these companies has gone up. And the rest of the companies, they've been solid yet unspectacular, relatively speaking. And in some cases, those other companies pay a lot more in dividends as well. So it's not the same earnings hurdle that goes on in that equation. But what it ends up doing is it's the combination of that earnings profile being above average, all the discussion around American exceptionalism, the strength in the US dollar. It has, for lack of better word, sucked a lot of capital into the United States, interested in these returns, and it becomes a little bit self-fulfilling. And there's nothing wrong with these businesses. It's just that what you always have to be worried about as an investor is something getting to an extreme where it could be a more significant headwind to my longer-term performance. And we've talked about this in the past. Two of my all-time favorite investment articles were both written by Warren Buffett, not surprisingly. But the first was in 2000, when the stock market traded at 26 times earnings. And he said stocks are not really going to go anywhere. And the premise there was not that earnings were not going to keep growing. It's just that at the time, the long-term average valuation of the stock market was around 15. So if you took 26 divided by 15, you were about 65% overvalued relative to that long-term average. So that if you had a 10-year horizon and your earnings grew at 7% and your valuation normalized, you would lose 6.5% a year in valuation and the stock market wouldn't go anywhere. So, that that then brings us back to today where people say, well, stock market's around 22 times earnings, which also seems elevated relative to that long-term average of 15. 22 divided by 15 is not quite as elevated; maybe 40% relative to that long-term history. And I want to touch on this in just a moment. So if earnings grew at 7% and you had to normalize valuations, that would be, like, a 4% headwind. So instead of getting 7% in earnings, 1 to 2% in dividend, you'd have to subtract that 4% headwind dividend or in valuation change. Two things that have really changed over time. The first is the margins of business have really expanded. If we look at something like Microsoft, ten years ago, their margins were 30%. Today, they're 50%. So margins have expanded. And when margins expand, the free cash generation of a dollar of earnings goes up. And this is trying to subtract maintenance capital, not just, investing capital as well. And, also, inside of earnings is a lot of R&D investment, which is expense. So, there is this idea that American business is more profitable. And these more profitable companies, they exist all over the world, but they're predominantly US oriented companies. Perhaps the valuation doesn't need to go all the way back to 15 times to normalize. Perhaps it's a higher number. Maybe it's 18, 19 times. There needs to be some risk premium, relative to fixed income, but it also acknowledges that there's growth and all sorts of things. So you could boil it down. You could say that the stock market is overvalued by some percentage that does represent a headwind to long-term returns. The final point that really comes to the fore—and we've talked about financial stocks doing better, and we've talked about the slope of the yield curve—the American stock market is heavily exposed to technology businesses and less exposed to some of the more conventional sectors, of which one is financials. The global markets are more exposed to financials, if we think about the Canadian stock market, if we look at European stock markets. And if the yield curve goes back to having a positive slope and stays there for some time, which it looks like it might, perhaps there'll be some room for some of those global exchanges to start to deliver on those longer-term earnings power things. So when we look at these statistics, unfortunately none of them are timing statistics. They're not mechanisms where I can go out and say, well, just because I know this, it's going to start working tomorrow. But they are road signs that, as drivers, we need to pay some attention to to generate some of those longer-term performances. When you get into stock specific examples, and we look at some of the enthusiasm that can go in a stock's path, you can just look at countless examples of stocks that go up a long way, stocks that go down a long way. And, what we're trying to do as investors is tilt our portfolios towards those positive options. And by positive options, I mean areas where we think the multiple can stay the same and the earnings can grow or areas where the earnings can grow and maybe even the multiple can expand. And then we get a double-barreled approach to return potential. So, when we have these discussions and we look at some of these tried-and-tested models over long periods of time and they suggest things for us to think about, we're going to naturally think about them. And then as for the exact timing of those things, just like I love dollar cost averaging, the timing around those things also is something that you often kind of dollar cost average around. Because we know they're not timing vehicles. We know that when we see all these statistics, they don't forecast imminent change. They're more of a longer-range kind of weather forecast.
Yeah. Well, I guess I'm cheering for some of these other markets because I've often been described as solid yet unspectacular, as you described the markets outside the US. So I kind of have a kindred spirit with these other markets. But one of the ways to think about it, as I mentioned on some of the podcast, I'm doing a lot more hiking these days. And I go and I'm going to hike up this mountain, and it's 1000 meters high. And I look at the estimated time to get up there, and it says it takes the average hiker about an hour to hike up there. I know I'm carrying a little more weight than the average hiker and a little more age. So I'm going to do it in an hour and a half. So that sets your expectation around the returns, which is your 7% plus your 1 to 2% dividend. Which means over a long period of time, say over 10 years, I'm going to expect to get my 9%. Or 20 years. Same thing. It's going to take me an hour and a half to get up the hill. But I get going. I'm pretty excited. I'm going to get to the top of that hill. They say an hour and a half for the old guy. He's going to get up there faster. I start the first half, I’m racing along. I'm looking at my watch. It's telling me my pace. I'm going to get up there in 40 minutes. And then all of a sudden, the reality kicks in. I'm breathing heavy. And now I've run another 100 meters higher, and now it's saying it's going to take me an hour. And then I'm slowing down. I'm stopping. I'm looking at the view. I'm taking a sip of water. And then sure enough, by the time I get there, I got there in an hour and a half. But I got way ahead of the pace at the front end of the first half of the climb, and then I just fell back to earth over time. The saying that when things get ahead of themselves in terms of the valuations, which is how much you're paying for the earnings, you expect it to be more like 16, 17, and now you're paying 22. Okay. But at some point, that valuation's going to come back down, if there's not a reason for it not to be higher. And you mentioned a couple of reasons why it could be a little bit higher than normal now. But it's going to get back to that. So it's going to take you that same time to get there. And you want to take that step back and look at valuations because it's not going to tell you when. I don't know exactly when I'm going to start to slow down as I'm running up the hill. I might have had a good breakfast that day, a couple extra coffees. Maybe I'm in a little better shape. I had a bottle of wine the night before. So my first half is really fast. But, generally, I'm going to take that hour and a half either way, and the same thing goes with stocks. Eventually, things kind of slow down and settle down and normalize. And that's what we're talking about here. So I don't know exactly when I'm going to slow down, but I do know I'm going to slow down, and it's going to take me that similar time to get up there. And with stocks as well. We don't know exactly when the valuations are going to matter, but there's going to come a point in time where it matters. And then, you want to make sure you've been conscious of the valuations and relative assets that you can buy.
Yeah. No question. I'm just overwhelmed. I thought you were like Rocky Balboa there climbing the steps of Philadelphia. You look so strong, and then you kind of petered out a little bit in your example there.
It's more like Rocky 4 when he’s in Russia, you know, in the snow and going up the mountain, with a car, that kind of a thing.
And, of course, the other thing to weave in is, for a long time, recently, anyways, bond yields are very low. And, when we get to around 5% on the bond yield and we're comparing it to all those scenarios, 5% doesn't look so bad. And it's been a while since there was an alternative of that realm. And, the other thing we didn't talk about, which we also know almost happens to every long-term investor, is at some point, there will be a concern about a slowdown. And that often drives the bonds lower, and that's often when you get the valuation change in a bit more of a hurry if you start to see some downward revisions to the estimates with which valuation is applied.
Yeah. Now to zoom this in and make it a little more relevant to what we've been watching over the last couple of days. We saw the Trump inauguration yesterday. We saw all the executive orders and a lot of the talk about at least the economic plan that they have in place and the expectations of how it will work out and drive better economic growth. And one of the things that you might point out about Canada or Europe is that the regulatory environment is tougher than the regulatory environment in the US. So there's a competitive advantage to companies and stocks in the US. Now the US is even talking about the part of this policy and say let's take regulations back even farther. And we could do a whole other podcast on the short- and long-term benefits of regulation versus not regulation. But I see the head of the European Union's out overnight saying, well, one of the ways they're going to be competitive with the US is by doing the same thing, starting to look at regulation and rolling it back. So there's always something that tends to come into play that shifts that balance back and, again, makes that point where valuation is important at that point in time.
Yeah. That's for sure. And, like anything, the analogy that always fits the bill on any piece of news, really, but, when you drop a stone in the water and you watch the ripples, and it's often the 3rd or 4th ripple away that you have to really think about. So, getting excited about deregulation in the United States today, that's kind of known. That's an area that is a real focal point for investors versus if the European Union wakes up and says we're going to get focused on deregulation or other areas that haven't historically been. It's that small rate of change that investors often get very focused on, not what is in the current focus.
Yep. Well, whether you like him or loathe him, the new president is not throwing pebbles or stones. He's throwing boulders into the water. So, a little bit more of that. But the same thing applies, right, Stu? No matter how bombastic or big it is, it's still the same idea around the way the waves spread out from the initial drop in the water.
100%. The one thing that we know from time, all of history really, is that just as when we think something is stable and in place, there's a change.
Yeah. Something we haven't talked about. We don't talk a lot about politics. We do try to keep politics out, although we recognize the impact that policy in different countries and towards different industries make a difference in terms of the performance of a stock and the ability of the company to grow, etc. I think the big thing that you walk away with, for Canadian investors who have a lot of concerns about what happens politically down in the US, is just your analogy there that short term feels big, but longer term, you know, hey, just think things are going to play out. And historically, your 7% earnings and your 1 to 2% dividends, that's the way things play out over time, no matter what's happened, wars, famines, diseases, everything.
That's right, Dave.
Wow. Again, I just feel solid but not spectacular. I thought I was going to get a «yeah, that's it, Dave».
Well, some people say solid yet unspectacular. I say solid and unspectacular because that's the way a dividend guy rolls. I like the two combined.
I think I just got a compliment. I think I'm a dividend guy too. We should all be dividend guys, though. Because dividends are good. But we'll cover that, I'm sure, in another podcast, and we'll get back to dollar cost averaging as usual. That was a spectacular Stu’s days today.
Great. Thanks very much, Dave.