Martin Lefebvre
Hello everyone. I'm Martin Lefebvre, Chief Investment Officer at National Bank Investment. And today I'm joined with Charles Nadim of Jarislowsky Fraser. Charles is the head of research and co-manages the firm's Canyon Equity Strategies. He's a member of the firm's Investment Strategy Committee, which ensures adherence to Jarislowsky Fraser's longstanding investment philosophy and discipline process. As a member of the firm's Management Committee, he helps to guide strategic direction and the firm's commitment to excellence in research. Charles, welcome. Thank you for being with us.
Charles Nadim
Thank you. Good morning, Martin.
Martin Lefebvre
Morning. So let's start by setting the stage. Charles, can you tell us why Canada is lagging compared to your neighbor down south in terms of market performance over the past couple of years or quarters?
Charles Nadim
Sure, sure. It's actually a bit unfortunate because if you look at the economy over the last five, ten years, we've pretty much matched the growth we've seen south of the border. The issue has been more in the composition of our indices. Unfortunately, our indices do not reflect the quality of the investment opportunities in Canada. And they're over-biased to a few sectors such as commodities and energy. Just to give you a sense, commodities, if you include materials and energy, represent 30% of our indices today, more or less, right? But they're less than 12% of the economy. And when you look at returns over a long period of time, just look at price. If I look at just the price performance, let's say the index over 10 years is up 50%, well, energy is down 4% over that period. Materials have significantly underperformed the index. So the problem is not the investment pool of opportunities; the economy is doing very well. It's our indices that have not evolved in the same way as Canada has.
Martin Lefebvre
Okay, and while we know for a fact that some sectors are very narrow, whether it's the tech sector and you know, sometimes there's just one big company in that sector, it does make a huge difference. So what kind of evolution are you seeing in the Canadian market nowadays? What kind of evolution is the market going through?
Charles Nadim
Yeah, I'm happy you touched on technology because it's actually one of those sectors that has evolved significantly. Let's use technology as an example of the evolution of the Canadian market. I started in the late 90s in investments in 2001. If I go back to technologies, it was actually my first sector I was responsible for in terms of analysts. In 2002, you had 32 names to invest in. Those were your choices in Canada. But the interesting thing is that 72% of those companies were hardware companies. Only 28% were software. And as we know, software business models are much more sustainable. They tend to come with recurring revenues, high margins, and high cash flow generation. So 32 companies in 2002, 72% hardware. Fast forward to 2022, we have 143 companies we can choose from, with a market cap of 170 billion. 99% of those companies are now software, leading software businesses. So not only has the pool increased, but the mix of quality has significantly increased. Now you ask yourself, why is that? How can you explain that evolution? And you double-click on the sources of growth and the answer is just there. For example, Canada, as you know, has the fastest-growing population among developed countries. But more interestingly, if you multiply that by the level of education of the immigration, we're actually attracting the most talent in the world. We have the most educated population of the world. We have the strongest balance sheet of the developed countries. We're ranked consistently number two or three of the best places to start a family. So you combine all that. We've been attracting talent. It's leading to innovation, not only in technology because innovation goes across sectors. And hence, you've seen significant evolution of some of these sectors. Just as a, I don't know if you've heard of this statistic, but I recently found a data point that showed that Toronto is growing more rapidly than San Francisco in terms of IT talent. Twice the rate, actually, in terms of growth. And software and services over the last 10 years in Canada has produced a return of 3,000% versus 1,000 in the US. When you look at some of the underlying quality components of Canada, they have evolved significantly and they are performing extremely well, unfortunately overshadowed by an index that has an overexposure to commodities and financials.
Martin Lefebvre
Oh, okay, so that's an interesting way to put it. Thank you for that. So where do you see opportunities nowadays, given today's economic backdrop and what's your take on the market and what are you telling clients when they're seeking out opportunities in today's market?
Charles Nadim
Sure. So, you know, there are always opportunities across sectors. There's some sectors where we see more opportunities. Canada is a good place to be because we have the strongest balance sheet. So if we hit a pothole, we have the firepower to offset that into stimulus and others. But if you look at stocks in general, what are we looking for in this environment? You have an environment where the consumer, which had put money aside during the pandemic and pretty much is running out of that money, has been spending it over the last, call it two years. Inflation is running high and is coming down gradually, but rates are high and probably will stay a bit higher here for a while. So what you want is companies that tend to be less cyclical so they will be more resilient in economic volatility. You want companies that have pricing power that can price inflation, even in a tougher economic environment. And you definitely want a company that has a very strong balance sheet that can gain market share if we hit an economic rough patch but also acquire. If you combine the strong balance sheet with the right management team, that's where you can extract significant future value accretion in M&A, which tends to happen more frequently when times are tough. So less cyclical, pricing power, strong balance sheet— we're looking for that combination. And by the way, this is what JF stands for. And there's tons of examples in Canada. Exactly. I can name you just half a dozen companies that are in the sweet spot: less cyclical, in the growing market that's fragmented with a strong balance sheet— Couche-Tard, Rhéintach, Thomson, CCL, CGI, WSP, and the list goes on and on. There's no shortage of opportunities.
Martin Lefebvre
So when you compare the Canadian market and we open up the discussion on that, but tell us about the valuations, the gap with the US. Is it only tech-related, the fact that we don't have as many companies in that sector? Is the Canadian market cheap nowadays versus the rest of the world? And is that a good thesis to start from?
Charles Nadim
Yeah, I definitely see a valuation gap here. You know, global investors, Martin, it's a bit unfortunate. The world has moved more and more towards indices and being close to indices. You know, you have index funds, quantitative funds, and pressures overall to stay closer to indices. And global investors look at Canada and they say, well, it's 4% of the world index, right? I like it maybe a little bit more, I'll buy 5%. What do I buy? I'll grab an energy company, a bank, and maybe a consumer stock. And you get all the rest of the high-quality companies that are flying under the radar screen, trading at very attractive valuations. So when we look at the gap of those valuations versus the US peers, we are now at a time where the expected return or the gap in returns is at a very attractive level. But you can't look just at the surface level. You really have to dig in and differentiate yourself from the index in terms of exposure and look at the names that are typically not in these global funds. And that's where the opportunities are. You look at areas where global investors are not looking at. And unfortunately, Canada is still viewed by global investors as a resource and bank play, which it's not anymore.
Martin Lefebvre
Another thing that you need to figure out, I guess, as a portfolio manager, is that although in terms of size, most of the companies in the Canadian index are much smaller than even small caps in the US, sometimes we produce champions, whether it's Nortel, Valeant, Blackberry. So how do you manage that? How do you offset the risk of not being invested in those champions while at the same time making sure that you participate in that momentum? Because I find that the Canadian market is really a momentum market. If you're not in these big names, even though they become very risky at some point in time, you kind of have to be invested in those. So how do you counteract that risk?
Charles Nadim
Yeah, I think, Martin, and having followed very closely the Canadian market over the last 20 plus years, the depth of the market has become much, much better. So yeah, I mean, Shopify, it's 3% of the index, okay? 3%, 4% of the index. It is one where we think, for example, longer term has all the right ingredients: a strong multi-strand balance sheet. It is investing, so short term, you don't see earnings, but that's not the way we look at valuation. We tend to look at a longer term.
Martin Lefebvre
How high was it at the top of the market at the end of 2021? Shopify, how much of the index was it before it went down?
Charles Nadim
6, 5, 6 percent, 6 percent around. So that would probably have been close to Royal Bank. And every time something gets close to Royal Bank, you see it in the headlines. But there's still beyond a Shopify of this world. There's significant depth across sectors. You know, in technology, we have, you know, six, seven names in the portfolios.
Martin Lefebvre
It's funny, could it be the indicator you're looking for whenever it becomes as big as RBC, you're worried?
Charles Nadim
I don't know. I mean, I don't really care about that. But yes, it's been interesting. Longer term, it still has significant potential. But my point is that you look at sectors today versus 10, 15 years ago, and you can have a very well-diversified, high-quality portfolio that's very deep in terms of moat. And you don't have to depend on one or two stocks for price performance. We own 35 names approximately in the fund. We have today little exposure to commodities. We're not in telecoms, we're not in utilities, and yet we have a pretty high-quality portfolio of 35 names. So there's enough depth out there to build something of high quality.
Martin Lefebvre
Okay, let's talk about dividends. We know the TSX is yielding more than the S&P 500, perhaps one percentage point more. What would attract, what would you tell an investor that sees either government yields or corporate rates much higher than that with the potential of some even capital gains on top of that? What would you tell them to attract them in a dividend strategy?
Charles Nadim
Well, first I would say be careful with statistics you see on the TSX. Because when you have 30% in commodities and when the oil price is at $100, they tend to trade at a very low multiple. And because of the balance sheet that they have today, as a result of the oil price, they are paying out high dividends, but they remain cyclical companies. So I'd be careful in thinking that oil companies have become dependable, long-term dividend plays. You are still very much exposed to a commodity. But put that aside, I think, you know, your question in terms of should somebody like to be buying dividend stocks? Yes versus high-quality investment corporate bonds. I mean, the difference is with the valuation you're paying today on the equity side for some of these stocks, I think it's definitely worthwhile. It's some of the best valuations we've seen in a long period of time given where inflation and interest rates are. But the other thing that you get is you get the optionality of having a corporation that has a strong balance sheet that can extract value on top of a regular coupon, right? So the combination of valuations that are attractive and potential for dividend growth make them more attractive, especially at times like today.
Martin Lefebvre
Okay, let's switch gears a little bit. We know that JF takes pride in its sustainable investing. Can you talk a little bit about that? What are some of the principles and how does this resonate with your clients? Do you have lots of demand or is that something that's really much involved?
Charles Nadim
Yeah. Well, thank you for bringing it up. I don't know if you may know this, but in 2020, we just won the biggest chunk of equities for the Canadian ESG Championship in Canada. So there were over 60 companies that participated in a Canadian competition. Two firms got a big chunk of the assets that were given by foundations that pooled their money together to find who's best at doing ESG. And we were one of the two companies and the one in equities in general that got the championship. So why did we win? Why is it important for us? Because at the end of the day, everybody can show you nice slides with, you know, some green and lower carbon emissions. But what we differentiate in is the ability to change the outcome. To change the outcome, you need four things. You need a brand. We have co-founded the Canadian Coalition of Good Governments. We've been doing this from the beginning. It's ingrained in our way of investing. So we are known in the Canadian market for quality investing, increasingly S&G. The second thing that you need is a long-term investment horizon. Companies will not take you seriously if you're an investor for a year or two. They know we'll be back year after year. Our investment horizon typically is 10, 15 years. So we have the horizon, we have the reputation, we have the scale. Obviously, if you buy 0.5% of a company versus 5, 6, 7% of a company, you have a bigger word in terms of what happens. And finally, for us, it's our own analysts that are responsible for the ESG file. When we disagree with something, it's the analyst presenting the case, it's the analyst talking to the management team and to the board to explain why we voted the way we voted and why we want to see change. So the fact that we incorporate all these four elements is not only the reason why we won the championship, we've been able to change the outcome. I would love to say five times out of five, but that's not the case. Hard track record—let's say four times out of five over a long period of time—we've been successful. So that's, I think, what's the most powerful in what we do and how we differentiate.
Martin Lefebvre
Okay, and what do you tell clients? I mean, there's so much noise surrounding ESG and all of that. So what are the key factors that they should focus on?
Charles Nadim
Yeah, it's exactly, I mean, you're absolutely right. There's so much marketing and funds that have added the kind of ESG name to the name of the fund. And everybody now has become pretty much ESG. But you really, what I'm saying is put away all that noise and ask the question, how is it really incorporated in your research process? Give me examples of how you've influenced the outcome. Dig in, try to understand who's engaging with the company. What have been your factors of success? And that I think counts way more than some buzzwords and some nice marketing slides.
Martin Lefebvre
Yeah, can you give me an example where the ESG process, how do you make a different decision in investing on that?
Charles Nadim
Yes. So, you know, the nice thing is, you know, at Jarislowsky, we really think as owners. There's a big engineering company in Canada where we weren't satisfied with the composition of the board, the depth of the industry knowledge at the board, and the chairman itself. And we actually engaged with the board and pushed forward one of our nominees to get changes at the board, including a change in strategy towards a more sustainable model, which also led to a change in the chairman. So we get, you know, we're not in the news always about these things, we're not on TV, we always work in the background, engaging with these companies, enacting change, but we actually, every quarter, we give examples. We have a package that we send to our clients with everything we've done in terms of engagement, and the list goes along.
Martin Lefebvre
Well, Charles, this is all the time that we have. Thank you very much for participating in this podcast. Everyone listening, thank you very much for tuning into this podcast. We'll talk again next month. Thank you very much.
Charles Nadim
Thank you, Martin. Bye-bye.
Martin Lefebvre
