Episode 96: Getting down to fundamentals—Market Insights Monthly special edition

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Kevin Headland:

Commentary is for general information purposes only. Clients should seek professional advice for their particular situation.

Patrick Blais:

So when we look at sectors, we're not looking to have a certain sector weight. We're not making sector calls. It's really about our bottom-up stock, fundamental analysis, stock picking, and then building the best diversified portfolio that emphasizes that quality, minimizes the risk, and puts as much valuation on our side.

Kevin Headland:

Welcome to Markets Insights Monthly. I'm your host, Kevin Headland, Co-Chief Investment Strategist at Manulife Investment Management. Join me today is Patrick Blais, Senior Portfolio Manager and Head of the Fundamental Equity Team. Welcome Patrick.

Patrick Blais:

Hey, Kevin.

Kevin Headland:

Now of course, every fund has a team. You're the lead manager. We have a team behind it. Now, many fund companies or fund managers have a decision-maker, someone who makes the decisions, final call. They're the ones that actually make most of the decisions on the fund. Your team doesn't operate the same way. Talk about how unique your team is.

Patrick Blais:

Yeah, so of course process is important, but what's important as well is the people that are backing up the process. And I think we have something that's really unique on my team. One, we're an eight-team member, eight teams, eight members on the team. Everybody experience diligent, passionate, but I think what really sets us apart is really this mentality of working together as a group. So let me explain what that really means. It means that first and foremost, everybody's an analyst on the team, even myself, even the lead of the team. I'm responsible covering companies, initiating new research, but also we actually manage the portfolios together.

So every week we bring the culmination of all our work together and we discuss. Everybody brings forward the ideas they think that will make the portfolios better. The ones that'll deliver not just the returns, but also just as importantly control the risks. Because you have to remember, our team is known as first and foremost an institutional manager. We manage money for pension funds, endowment funds, foundations. What's important for them is returns of course, but also how you get there. Get there in a consistent fashion, get there in a way that you measure the risk, you control the risk and you deliver value for the risks that you take.

Kevin Headland:

It's also interesting as those weekly team meetings you have, you're not always the one running them. You rotate. Everyone has a chance to run them. So it's not all just leading and getting to one decision saying, "Oh, I'm presenting to my boss and he's going to have the decision." Right? Everyone has control there, so that's quite interesting.

Patrick Blais:

Yeah, no, that's right. I really think at the end of the day, if you act as a group, you'll get to better decisions than if one individual is making those decisions. And I think rotating the chairmanship, rotating the steps in a meeting and allowing people really to bring the best that they have to the table every day and every week will really lead to the best decisions.

Kevin Headland:

Now when you talk about best decisions, you had this great line where you talk about cash flow and intrinsic cash flow and this great line of where you say, "We don't follow the story, we follow the facts." What does that mean?

Patrick Blais:

Yeah, so the thing is when you look at the market, the market's very emotional. It grabs onto stories. Stocks will move according to news flow to stories, but the truth is is that presents opportunities. What it means is very often the market's mispriced when you look at individual stocks. I actually believe they can be massively mispriced, up to a hundred percent overvalued to 50% undervalued. So what you want is you want a clear process that allows you to make sound decisions and look through that noise, look through the noise of the stories, and you really want to establish yourself on something that one, is unique, fundamentally sound in that you can repeat week after week.

And I think we have that. I think we have that. It's really this cash flow mentality focusing on real cash flows. Takes a lot of work to get there, but because we have that sound process, those sound fundamentals, I think we can make better decisions than most investors out there who may mostly follow stories.

Kevin Headland:

I think you also dissecting the cash flows and dissecting the balance sheets and all the financials of the company, you have an interesting background as an actuary. So I think you come by it almost naturally to be able to really want to dig deep and get down to those brass tacks shall I say, to find the real value of the businesses and I think that's important as well.

Patrick Blais:

Yeah, no, at the end of the day, we really believe that our competitive advantage lies with understanding the real cash that a company generates. And yeah, it takes a lot of work to get there. It can take weeks, it can take months. Because what we have to do is first we have to start with looking at the very least the last 10 years of a company's financial statements. And we go through them and we understand where's the cash coming from, where's it going? And that entails actually a lot of work, a lot of actually what I like to call traditional fundamental work where you pick up financial statements, roll up your sleeves, and you understand what does each line mean and what are the adjustments you have to make? Because very often companies will present their financial statements very differently depending on the industry they're in, how they operate, how management actually wants to present the numbers, and you've got to parse through that noise. You've got to get to those real cash flow numbers.

In our mind, real cash flows drive economic value at a firm. If I was to buy a company personally, what would I care about? I'd care about how much cash am I going to get out of the business. So if you understand that, I think you're in a better place to really understand what counts when it comes to investing in a business. What we like to call at the end of the day, the real facts of the business, not the story, what's really happening at the business level.

Kevin Headland:

I think it's important where we talk about following the facts on the story is you can get those companies that are perhaps overhyped in the story and those companies that perhaps are valuation sold off on a story perhaps. Can you give us an example of where currently in the portfolio you've been really following the facts rather than the story?

Patrick Blais:

So we're aiming to really identify opportunities in the market. And I think it's become easier and easier for us because over the last 10 years with eight individuals doing this work, looking at the real cash flows, we've done actually all the research on over 350 names. So we have an inventory of 350 names that we can select from, and these are 350 names that we want to invest in. And why? First and foremost, because we know they're quality businesses, meaning that we know they generate a lot of cash. Not to get into too much detail, but we do measure that cash generation in an objective fashion and it's really about how much cash can they generate when they reinvest in their business, what we call cash on cash returns.

Secondly, we understand the risks to those 350 businesses that we've analyzed. And to us the risk is what could happen to the cash flows if things go wrong? And if the risk is too great, we probably won't invest in those companies because sure, we may like a company, sure, there may be upside in a normal environment, but if things go wrong and they often do, if we're going to lose too much cash and the stock's going to be down too much, we're actually probably not going to invest in that name because it just brings too much risk to the forefront. Remember, we like to manage risk, so we're not going to take excessive risk. We're going to manage it in a very risk appropriate way.

Then thirdly, this is the part where you have to be patient, it's all about valuation. So we build portfolios with 40 odd names. We want to own the right names that are the right quality, not too much risk, but also have valuation on their side. And that's what we're doing. We're picking the 40 odd best names in our list of 350 names that we've researched and that we continue to add on that meet those three criteria. But the third one is the one that you can have the most control over is buying them when they're really attractive at the right valuation. And if you understand the real cash flows, you've got a better chance of assessing the real value of a stock and knowing when to buy it and also when to sell it.

Kevin Headland:

I think that's a great point in under saying the real valuation because of course when you look at the financial statements of many companies, they put it out there and there's a lot of numbers and they're all calculated, and of course everyone has their way of calculating, and then you start stripping things out and you realize, okay, well that's really not a worthy value. That doesn't count today for the value of the company, or perhaps their projections are not as great as we think they are. So when you strip things down, you get the actual end result where it almost seems like you don't value the business nearly as much as the street does or maybe the individual company does, but you find your kind of, I call it almost like a margin of safety and evaluation, and identify what am I paying for and what price should I pay for that as well?

Patrick Blais:

Yeah, no, that's right. I mean, if you take a look at, well, we think by looking at what we call those real cash flows, real sustainable recurring cash flows, we can look at any company across any sector, across any geography in the same way and really figure out, okay, those quality, the risk and evaluation. And that can lead to actually very different insight than the market. The market likes to focus on a lot of other measures, sometimes very simple measures that sound insightful but maybe are not. For example, EBITDA earnings before interest taxes, depreciation, amortization is a very common measure. However, I think it's a flawed measure. One is EBITDA isn't clearly defined. It means different things to companies and management has a lot of leeway over putting forward numbers that they may want to emphasize. Secondly, EBITDA doesn't include the investment required to run the business. And that can be very different, not just companies in different sectors, but even companies in the same sector depending on how they run the business.

So you have to be really careful with those easy metrics that are out there. But even cash flow, I mean we look at real sustainable cash flow. It's ingrained in our philosophy. We think we do it better than everybody else. But there are measures of cash flows out there, but very often our measure of real sustainable cash flow will be very different than the metric that the market sees. And I think that gives us a real edge because we really see the real underlying quality and the real valuation, and it's helped us to avoid names that at the end of the day weren't sound, they weren't of the highest quality, they didn't have the valuation on their side, and ultimately, those names disappointed. But we think because of our insights, we're in a better place to maybe avoid those names and take advantage of names that are being ignored by the market and that give us the opportunity to buy high quality stocks with little risk and with a lot of valuation on their side that ultimately tend to outperform.

Kevin Headland:

Think it's a great comment when you talk about that portfolio construction, you want to have decent valuation, you can't always get low valuation or super cheap, but quality and identifying where that fits, that balance and finding. Okay, not only whether I should buy it, but also what weight I should assign it within a portfolio and how to construct the portfolio together.

Patrick Blais:

Yeah, no, that's key. At the end of the day, it's great to have a research team that can do great research on stocks and maybe that leads you to identifying some opportunities, but at the end of the day, we're not selling stock picks, we're building a portfolio and we're managing that portfolio. And a big part of it is yes, buying the right names, but well diversifying the portfolio and also weighing what we'd like to call our high alpha names appropriately. And that means the ones that have the best upside with the less risk. And that's what we're continuously doing. When we meet every week, yes, we may introduce a new name, we may sell a name outside of the portfolio, but very often we're actually taking advantage of market volatility, market dispersion, stock name specific dispersion to actually rebalance the portfolio and really weigh the names that are offering that best upside with that little risk.

Many years, if you look through our portfolio, you'll see significant changes to take advantage of market gyrations. There was one particular year where the market was afraid of a recession. What happened? They bid up defensive to valuations that were quite expensive. Why? Because the market was looking for insurance. Insurance against operational risk, and cyclicals were significantly de-rated. Sometimes some of them fell by 50%.

What did we do? We identified that opportunity and shifted the portfolio from those overvalued defensives to quality cyclicals that were at valuations that were extremely attractive. Lo and behold, those types of decisions tend to pay off significantly well, when you take advantage of that emotion, that fear, those stories in the market, but you base yourself on the facts to really put as much valuation on your side as possible without taking risk and making sure you buy those quality companies.

One thing we'd like to highlight is what happens to our funds when the markets are challenged, when the markets are down? If you look at 2/15, 2/18 and 2/22, three calendar years the markets were down. Those are actually three of our best years relative to the market and relative to our peers. And I think that really speaks to the portfolios we've built. Right?

At the end of the day, what do we own? We own quality names where we believe through our analysis, there's limited downside risk, and thirdly, we have as much valuation on our side as possible. And those types of portfolios tend to perform well in the long term, but especially well when the markets sell off. Because what's the market looking for? It's looking for quality companies that generate cash, that have little risk and have valuation on their side.

Kevin Headland:

It's also really important, I don't think a lot of investors might understand is they look at annualized returns. You said you beat 3.3% on average, but how that compounds over time. And that extra outperformance really adds value. Also, by protecting the downside, you're not catching up as much. You have more money in your portfolios working towards and generating those returns over time.

When I started the business almost 25 years ago, every fund company had these Growth of 10,000 Mountain Charts to show you the value of compounding. We got rid of that in '08 because of unfortunately the mountain turn to a cliff. But I think it's also important to show you that idea of over time, protecting the downside in those down years, which you can't do much about, it's a market down here, but the companies do better, you come out on the other side much better, in better position to get to performing well. Now, you talked about the portfolio being 50/50 or 51/49 I guess has to be 1% more in Canada on a cash basis. Most of the funds I find in that category tend to be half Canada, half US. Your portfolio is not that. You're actually finding opportunities outside of North America. Talk a little bit about that.

Patrick Blais:

Yeah, so you would've looked at our portfolios seven, eight years ago and you would've seen mostly Canada and the US. However, because of the relative performance of the markets, we're actually finding a lot of value in places outside of North America, namely in Europe. So we're finding companies that have the same quality, with the same level of risk, but significantly better valuation on their side than their North American peers.

And at the end of the day, we're mercantile. We're going to go where we can make the best money with the less risk. And to us, it doesn't matter where you're operating from, it doesn't really matter where you're listed. If the opportunity is there, we're going to take advantage of it. So yes, the last few years we've found these great opportunities in Europe and we've been adding them to the portfolio. I think it's led to a better portfolio, a better diversified portfolio with just as much quality as in the past, the same level of risk, but significantly more valuation.

And surprisingly many times when we're finding these European names, their operations are very similar to their North American peers, and I mean operationally, but also geographically, they have the same exposure. So to us, this is a mispricing and it comes down, again, base yourself on the facts, don't base yourself on the stories. Yes, there are great companies in the US but you don't want to just chase stories. You really want to look for the best opportunity out there. And right now we're finding some in Europe.

Kevin Headland:

It's great you're not limiting yourself to North America. Having a global mandate like Climate Action Fund also allows you to open your opportunity set to identify some of those opportunities globally and you're able to put some of the best names within this portfolio as well.

Patrick Blais:

Yeah, so the Climate Fund, for example, is a hundred percent global. So there's little Canadian. It allows us to really take a look at the best opportunities in the US, Europe, or even Asia. And given our process, which we truly believe is scalable, repeatable, applicable across sectors, applicable across geographies, we're going to take advantage of that flexibility.

Kevin Headland:

Bringing it back to the Fundamental Equity Fund, talking about the sectors and clearly you're underweight financials, underweight energy. Is it a sector call? Is just you don't like those sectors? How is it that you become underweight relative to assets?

Patrick Blais:

So again, we're going to go where the opportunity lies and at this point in time, yeah, we actually do own less financials, less energy than we've owned in the past. We're still well represented. However, given for example, in the case of energy, the stocks, the sector has done significantly well over the last few years, we've taken the opportunity to take some off the table. We still think they're good companies. We still think they generate cash, but there's risk. They are dependent on the oil price and you really want to weigh your names appropriately to take into account that risk.

Same thing for the banks. I think we're all aware that with the rise in interest rates, it is putting pressure at the end of the day on the consumer, and there is the risk of a credit cycle, and we want to reflect that in a weighting. We're finding other names in other sectors where we're getting the same quality with probably less risk and just as good of a valuation on their side. And with that, we can build a better portfolio.

So when we look at sectors, we're not looking to have a certain sector weight, we're not making sector calls. It's really about our bottom-up stock, fundamental analysis, stock picking, and then building the best diversified portfolio that emphasizes that quality, minimizes the risk, and puts as much valuation on our side. And at this point in time, it's just a reflection where we think those opportunities lie.

Kevin Headland:

So you might have a completely different relative weight in a couple of months time if something happens and banks sell off materially, for example, you might take advantage of the opportunity.

Patrick Blais:

Yeah, that's right. At the end of the day, it really comes down to a process. It's not a question of we like banks, we don't like banks thematically. It's really a question of where's the best risk return profile in market at this point in time? And we have to remember, right, it's all relative. Banks might be cheap, but there might be a lot of other sectors that are even cheaper and you're taking less risk and you're getting as much valuation on your side. So it's dynamic, it's continuous but rest assured, every week we're taking a look at our portfolio, we're taking a look at the ideas in the market, and we're making sure that according to our process, putting the right 40 odd names into our portfolio.

Kevin Headland:

Now, it's not just the Fundamental Equity Fund, but you also have a balanced version. And one thing that's quite interesting is actually available in corporate class. So balanced fund in corporate class. I don't know if you know this, it's actually very rare in today's Canadian mutual fund environment. So that's quite something special. And is there anything different do you apply to the balanced fund versus the equity period fund?

Patrick Blais:

No. So the Fundamental Balance Fund is one of our flagship funds as well. And what it is, it's really levering off the fundamental equity for the equity portion. So fundamental balance, the benchmark is 65% equities, 35% bonds. The equity will be very similar to fundamental equity, and that's paired with the bond funds from our Canadian fixed income team. Great fixed income team added a lot of value through duration through credit selection. So you're getting really two good managers within this one fund that can manage the two main public asset classes.

Now, we tend to run the equities slightly above 65%. Our range is actually 62 to 72, we'll go up to 72 when the markets sell off and it offers us a lot of opportunities. And we'll go down to the low sixties when the market gets significantly overvalued and we're paid to be in bonds. Now the asset allocation does rest with my team, and we apply the same philosophy when it comes to the asset allocation then to investing in stocks, where is the return worth the risk? And I think over the last few years we have allocated appropriately.

A few years ago when interest rates were one, 1.5%, half of our bonds were actually in cash. Why? We weren't paid to be there, we weren't paid for the risk, the potential risk, that inflation might spike up and rates might spike up. It's definitely a position that paid off exceedingly well. Today we're reinvested in bonds. We think that you're getting paid to be there and we're overweight slightly equities, but at the end of the day, what I think you're getting is a standout balance fund with a great equity manager, great bond manager, and really a risk return approach to asset allocation.

It actually has the honor of having won the Lipper Award for best fund in its category over the last 10 years. So we're quite proud of that, but it's really a reflection of the process and the team coming together and really at the end of the day, selecting the right names with the right quality, the right risk level, and having as much valuation on your side.

Kevin Headland:

So ultimately, whether it's an equity fund or a balanced fund, it really does come down to following the facts, not the stories.

Patrick Blais:

Exactly. Right on

Kevin Headland:

Patrick, I want to thank you very much for joining us today.

Patrick Blais:

My pleasure.

Kevin Headland:

Patrick and his team have demonstrated incredible performance over a history of managing these funds. Once again, we show the performance here where they're outstanding in their class and proven to provide great returns for your clients. Thank you so much for joining us today and have a great day.

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