Playing the plan: Mawer’s Canadian equity portfolio | EP49
Director of Research and Canadian equity lead manager, Vijay Viswanathan, discusses risks and opportunities in Canada, the cannabis industry’s value chain, and potential transformations to the food retailer business model.
- Noticeable shifts in the Canadian “investible universe”—it has shrunk
- Why it’s important to remember that capital is mobile
- “O Canada” and the “Great White Short”—bullish and bearish (and balanced) perspectives on Canada’s economy and its competitiveness in the global marketplace
- The team’s position on gold producers
- Our investment theses behind Loblaw and CGI
A transcript of this episode is available below, modified for a more enjoyable reading experience. For more posts exploring the ideas we talk about in the episode, check out our Related Reads links.
Andrew Johnson, CFA
Institutional Portfolio Manager
Of Andrew’s 13-year career as an investment and client service professional, 12 of them have been at Mawer. While serious about long-term investing, his personality really is more piquant than his photo would have you believe. On the institutional team, Andrew is known for his passion and expertise around managing investments for not-for profits, charities, and foundations. He bonded quickly with his co-host, Rob, over their mutual appreciation for an uncluttered spreadsheet and listening to a multitude of podcasts.
In his sparse spare time, he likes to run, but not too far—the goldilocks median of 10 km. Really, it’s his two young daughters that keep him on his feet. Sometimes he steals away to recreate his previous life of playing guitar in a rock band and his glory days of playing basketball (being a former varsity university team captain).
Happy to be here.
Vijay, you and I joined the firm back in August of 2007, so a little over 12 years ago, if you can believe that.
Everything for the firm changed because of those two hires. [Laughter]
Barring that, what comes to mind for you when you think back over the last 12 years? Contrasting, or maybe talking about, [the] evolution between then and now?
And really, I'm going to open this up for you—you can take it in any direction you want to go in, whether it's the market or the portfolio or the firm itself.
Well, there're lots of things that have changed over the time that we (both you and I), have been here at Mawer; I mean, we were a much smaller firm then. I joined like two weeks before you, I think I was employee 46 and you were 47—something like that. And now we're well over 160 people, at least full-time. Back then we had one office and now we have three offices: we used to be just [in] Calgary, now we have an office in Toronto, [and] an office in Singapore. So I think that has changed.
We've obviously seen significant amount of growth in assets over time as well. So, not even number of people, but also assets. At that point, I can't remember how many asset classes we [would have] had, but in our time here, we've added new asset classes to offer to clients because we think we can offer them pretty decent risk-adjusted returns over the long-term. So that would have changed.
Thinking about Canadian equity—which has been where I've focused my time pretty much since I've been here—there's been, I'd say, considerable shifts in the investible universe. If you go back—actually, I had to pull these numbers up—but I went back to Q3 2007 (I would have started in August of '07) and saw, okay, how many constituents were there? Do you want to guess, by the way, how many there were?
In the index?
Yeah, the overall investible universe, trading on the TSX.
There's 269—so, you're close. Q3 2019 (I just pulled this number). What's in the index? It's 233. So there're less companies.
Oh, that was a question? That was another Q&A? Okay.
It was, like, a rhetorical question [humour]. The other piece that has changed has been the makeup. When we would've joined in Q3 2007 it was—and especially if you lived in Calgary—definitely boom time. I remember when I moved from Toronto to Calgary it was very difficult to find an apartment. You [went to] look at an apartment, you look at it, and 30 minutes later it'd be gone.
Definitely a different time here. And you've seen that with the energy sector, where it was one of the largest, well, pretty much second largest sector in Q3 2007. You've seen that drop considerably. Seeing the same thing with materials, especially within mining. You've seen that been greatly reduced when you think about the overall number of constituents, but also its weight, I guess, within the index. And a lot of where you've seen the appreciation has been industrials, driven by rails and others, as well as in financials—a lot of that driven by banks and others. And I guess technology would be the other one, which has sort of moved as well.
So those are some of the observations firm-wide, but then also just overall breakdown of the investible universe. It's also been pretty good times in the markets over that period as well.
Do we get to take credit for that as well?
Sure! Sure. I think we can take credit for almost anything that happened in that timeframe. [Laughter]
So, I think the concept that gets reinforced for me hearing you talk about the shift in the investible universe, is that capital really is mobile. It can move around to different places, not only within a market, but, we're global investors—so if we step even a little higher up, is Canada still a good place to be from a marketplace? From a company perspective? And really, in terms of relative competitiveness around the world?
Well, it's a multifaceted question and we think it's important as investors to be able to hold up opposable viewpoints at the same time. So the way I'm going to answer your question is talk a little bit [about] what I think are the pros for Canada. The “O Canada” would be the sort of … bullish arguments, and then there's sort of “Great Canadian Short” or the “Great White Short,” which would be the sort of … bearish arguments.
So, what are the positives for Canada? Well, we got rule of law and we got a stable financial system. These are things that sometimes we might take for granted as Canadians, but it is a very important thing to have in order to attract capital. Beyond that, we've made, I guess, some policy changes, which I think make sense. We have reaped the benefits of immigration over a long period of time. I'm obviously biased on the whole immigration piece [laugh]. I wouldn't be in Canada if my Dad didn't come in 1966 and forever change his life and change the fortunes of our family.
We've reaped the benefits of that as a country, and we continue to have policies in place that are pro-immigration that can be a great driver or tailwind for the economy. And people want to live here. Those are positive things. The last one I bring up is that we have a lot of stuff that the world wants. We are blessed with these riches. I know one that gets the most news and headlines today would be energy, so oil and gas. We do have lots of that. We have potash, we have uranium. We have lots of things that the world has to offer, and so those are a lot of the reasons why, you get, “Oh, yeah, this is a good reason to invest in Canada.” Beyond that, we have really good management teams. There's lots of reasons to do it.
Some of the things that may be reasons that there're some risks within Canada—and I think you alluded to a little bit around capital being mobile—is where do we stand from a comparative advantage standpoint? We have to make sure in this country we continue to create an environment that wants to attract capital, because capital is mobile. And we have seen in some industries that capital has left the country—energy would be the one that would be the most notable, where we saw a lot of, for example, drilling equipment that went from Western Canada into Texas because that's where there's lots of activity.
I think the one within the energy patch that would probably culminate this or magnify it the most, would be the news last week of Encana moving from Canada to the U.S. I mean… Encana, Energy Canada, and now well [laugh], it's not called that anymore. It's going to be domiciled in the U.S, [and is] essentially a U.S. company. Yes, it does have a Canadian workforce and Canadian assets, but for the most part a U.S. business. That is a risk: if we don't create an environment in this country that is conducive to attracting capital, because it is mobile, it will go to other places where it can earn returns. So that could be a negative, potentially, for Canada if we make it more difficult to do business and do business in a responsible way. I don't know if that answers your question—
Yeah, it really does. And I think it highlights just…oftentimes investors, sometimes clients, sometimes ourselves, we get narrowed into this myopic view of where we operate. And really, what's happening is policy, economy, markets, businesses…they all collide at some point. They converge into what makes a great place to invest.
Well, the other thing we're seeing is we have lots of global champions: Canadian businesses that have gone abroad; they're allocating capital abroad, and building their businesses. So we do have that as well. And so, as I mentioned, I think there are lots of good reasons why people should invest in Canada.
Okay. So on a related note: I think we can just change our view to the current state of the economy here in Canada. I had to pull a few things because we've had a pretty good streak of growth here in Canada. I think that's been driven in large part by the services part of the economy. The labour market has been on a tear. We've had unemployment somewhere in 5-6% range. Wage growth has followed that. So, that's been nice to see. And not surprising, consumer spending has followed that. It also looks like housing at least is trending towards more new homes being built. So we've got that going for us as well. All of that, at least on the surface, to me, appears to be positive for Canada. But I wanted to get your thoughts on, well, just on the economy itself, where your head's at with that, but also does it inform decisions that go into the portfolio itself?
Well, I agree with what you said, since you were citing facts [laughs]. You said you pulled out statistics from Stats Can, so I think, yeah, a lot of that, I would agree with—that it seems like we have very low unemployment, labour markets [are] reasonably tight. We're seeing strength in services economy and there's been a shift to more services. So those, I think, are positive. We've seen income growth. Housing—it seems like some of the controls they put in place to lead, hopefully, to a softer landing seems to have worked. And we're actually seeing a resurgence in activity when it comes to loan volumes around housing. That could be a positive, although it could lead to a negative where all of a sudden now homes become unaffordable again. And we have low interest rates, which is the sort of foundation of a lot of the asset appreciation that we—
—That can't be understated right now.
—Yeah, so that's been a big driver of asset values over time. So it does paint a reasonably positive picture. And as we've seen companies in the portfolio (from an earnings standpoint) release their quarterly earnings, the numbers look reasonably positive. We've seen some down ticks in rails and rail volumes, so that's one where, usually, it might be a flashing warning sign, although some of that or a lot of that seems to have to do with grain and sort of weather related. So maybe that'll fix itself as they start moving more grain volumes in Q4 and Q1 of 2020. So, there may be some slowing.
We are seeing some pockets. Some of the businesses we're seeing some deterioration I guess, in fundamentals, but still growing. So I think that's important. What we've seen is maybe slower growth, but still growing. Definitely paints a reasonably decent picture and backdrop, at least, [to] what we're seeing. And how does it play into decisions? Well, we always say, "Think micro, not macro," but the macro does matter. And…at least at this point, we pay attention to what's going on in the general economy because it is important (what's going on in Canada), to our businesses. But what we're seeing in the businesses [themselves] is not too much stress from what gets the headlines in newspapers.
Maybe just diving a little bit deeper into looking at the portfolio overall. It's called Canadian equity, but you even touched on it a little bit earlier about having global champions. I mean, how many of those do we have in the portfolio that are operating outside of Canada, earning revenues outside of Canada?
25% last time I looked. […the] breakdown revenue by currency: 50 to 60% is Canadian dollar, and the rest would be sort of split—mainly U.S. dollar, and then euro would sort of make up the bulk of the rest of it. But most companies that are in the portfolio have businesses outside of Canada. The ones that wouldn't, well, the telcos and the cablecos that we own are pretty much domestic businesses. All the banks—they all are allocating their cash flows to the U.S. in most cases, or in Scotiabank's case, into parts of South America. So I'd say the majority of the names in the portfolio would have operations outside of Canada.
One of the general directions that happen in conversations, whether we're passing in the hall here in Mawer or in meetings here, or in conversations with clients, is just…general themes that sort of arise or emerge through the portfolio or the economy. And one of those themes, or at least one area of the market that here in Canada has proven to be a detractor of late for us, at least from a relative standpoint, when we're comparing ourselves to the index, is gold companies. We talked a little bit earlier about our history here at the firm. I think in that history, I don't think we've held any gold companies that I can recall, but maybe take our listeners through our thinking on that industry and the companies that make that industry up here in Canada.
So, we continue to revisit all names in the universe and we have re-looked at all the gold producers—at least this year we revisited—and just revisited our thinking and our assumptions. And we came to the same conclusion. We've seen some improvement, but we came to the same conclusion we have in the past—that it just doesn't fit our investment philosophy. And we know that that could be painful from at least a relative performance standpoint. But at the same time, we're going to stick to our systematic philosophy. We're going to stay disciplined on our philosophy. We're not going to chase the flavour of the month, or just chase companies or an industry just because they're doing well in a given year.
We're going to continue to allocate capital as we best see fit—our client's capital—to the best risk-adjusted returns. And that has led to us avoiding gold producers. If we continue to see those run, continue to see the gold price continue to move, [say] gold price goes to $2,000, $2,500—gold producers will probably do reasonably well. And that's going to lead to relative underperformance. Clients who are listening, who are invested in Canadian equity strategy, Canadian mid large cap equity, should know that.
Okay. So one other theme that has been brought up more recently—I think this is a more recent phenomenon here in Canada—and for context for listeners, it's regarding the healthcare sector. And I wanted to give full perspective on this sector, so I'm going to recite some facts again, as we alluded to earlier. For our listeners, there's 11 stocks that make up the healthcare sector here in Canada. Three of them are assisted-living facilities for the elderly population, (extended care would be a name many people are familiar with); to our more traditional pharmaceutical companies; and six—so, over half of the names in the sector—are in the cannabis industry. And for further context, the entire healthcare sector makes up about 2% of the total index. So, Canada's already a narrow market, healthcare is certainly a narrow sector within that market. But I think the fascination around the volatility is really around the cannabis industry right now.
My story is, it's for a couple of reasons. One, any time there's potential to make a bunch of money in a short amount of time, essentially by guessing and getting lucky or speculation, that's seductive to us as humans. And the second one, is that this is a nascent industry. It's unfolding and coming into its own right in front of our eyes and that just doesn't happen very often. So it's fascinating from that standpoint, too. I'd like to hear your thoughts on the industry, and really whether or not these stocks, when we hold them up against our philosophy of wealth creation, strong management, attractive valuations—do they fit within our portfolio?
The short answer to your question is no, they don't fit. At least not yet. The longer answer, which I will give you, sort of fits into the second point you made around it being a nascent industry. For us, that's where we took it as an exercise: we are very open and curious around, okay, well, what is the value chain? What does the value chain look like for the cannabis industry in Canada? And my colleague, or our colleague, Mark Rutherford, is the one who did most of the work—so he should get the credit. That's why I'm giving a shout out on the pod. He knows the industry really well. He looked at the whole value chain for cannabis because we had some assumptions going in and I think it started with: what was the government trying to do? What was the government's objective when they legalized cannabis?
And our story—and I think it has been backed up by the government themselves—is they wanted to essentially move sales off the black market to the legal market. And you can see how this benefits the government twofold. One is that movement, and the other is, well, they get to capture the tax dollars off of that. And that's the way that the industry has been structured. So, our going-in thesis was that the federal government [and] provincial governments were going to make all the money in this industry [laughs]. And it turns out that that's most likely the case, because whether it's provincial or federal, they are essentially the middle person in this. You have producers that are going to produce [and] the price that they can sell set by the government. They're the wholesaler. And then on the distribution side, either the government is the distribution or it's a private entity where the price is set by the wholesaler.
So we've seen something similar in other markets and over time prices have come down. We've seen it in Colorado, in the state of Colorado, the state of Washington, where they're actually a little bit more open than what we have in Canada. But our going-in thesis was that the governments were going to make the most money or economic rent from this value chain. And that, after our work, was corroborated. Over time, could there be some businesses that would be investible that could make sense in cannabis? … If I think about that for a moment, it's like, well, yeah, I think there are. I think that you'd want to be closer to the customer. So you might see some brands that have some sort of recognition and may be able to charge a premium over time.
But I think the base case is that this would probably be very similar to what we saw with the wine industry in Canada, where it's really the government, and the provincial and the federal authorities the ones that are making all the money. So we haven't found anything. Back to my short answer [laughter].
Now we do have companies that benefit from the build-out of the cannabis industry. Shopify is one in the portfolio where they do all the backend for all the online sales through government channels. So that's one we could reap benefits. We have Shoppers Drug Mart that we own through Loblaw, which would provide distribution, and that would be medicinal cannabis and that'd be through their pharmacy (so I can drive more traffic, which can lead to…you come in to pick up your prescription and then you buy some shampoo and tomatoes and other stuff). That's kind of where we've landed on it. There might be other ways to get exposure, but nothing directly.
I'm actually glad you brought up Loblaw because I wanted to talk about that too. It's almost like we planned this out, Vijay. Loblaw has been a name actually we've held for quite a long time. I think 10+ years from what I can tell. And over that time, throughout that holding period, competition has picked up. It's kind of ebbed and flowed in the grocery sector. Our listeners might remember Target entering the market, picking up competition, and then subsequently leaving. Loblaw has responded by doing some operational improvements over this timeframe. They've also bought Shoppers Drug Mart as you just said. We clearly think it plays a role in the portfolio for a long time and we think it does now because I think we currently hold it at around a 3% weight. So, what's our current thinking on Loblaw? And really, where I'm getting at, is they've performed quite well over the last year or so. So what's driving that?
I think overall we start again with the business: food distribution. Mission critical to our lives is eating, and they are the largest food retailer in Canada. So, we think from a business model standpoint, it's a decent business model. Retail can be a very, very tough business. There's really no barriers to entry. But the environment in Canada's pretty good; it's pretty much a cozy oligopoly. Now, they compete and they compete tough with each other, but it is a reasonably decent industry structure, with Loblaw being the number one player in the market from grocery.
I think what's been very positive for them, and I think I underestimated it at the time, if I'm being honest with myself and our listeners, [is] when they did the transaction with Shoppers Drug Mart. I thought, "Well, that's a pretty good transaction." And I think if you look back at this transaction now, five years later, it's like, wow, this was a game changer transaction for them because it brought them a lot of the health and beauty offerings in Shoppers, brought them a lot of great locations, and—if you look at Loblaw’s numbers—a lot of the growth has really been driven by the Shoppers piece, which actually grows at 1 to 2% higher than the food piece, (the drug retailer part versus the food retailer part).
And they've been able over time to figure out merchandising strategies to bring the two together, so they've really become this one-stop shop for all of your food and then health and beauty needs, and your prescription drug needs or cannabis needs, as we talked about earlier. So I think that they've done a really good job there. You mentioned operation—they've gotten a lot better. Yes, absolutely, they've gotten better. It took them a long time. I mean, it was seven years, maybe even 10 years of working through a massive IT transformation. It was painful for the company but they got through that.
They're in a much better spot now, and they have two pieces—and then I'll get to some negatives. There are two pieces I think that are going well for them. They have a loyalty program, which I think is pretty positive for them, so, PC Optimum; and then the ability to harness that data to be able to provide a better experience for customers. I think [those] are two things that are positive. To me, the biggest wildcard, I mean…competition is always going to be there. I think the biggest [wildcard/uncertainty] around the industry is e-commerce, online penetration. We just don't know yet how Canadian grocery consumers are going to consume groceries five years from now. Is there going to be more delivery? Is it going to be click and collect? And each company within the industry has made their best judgment on that. Because that could be a real game changer for the industry if all of a sudden, we moved towards just…everyone's getting groceries delivered to their house.
Right. And then further technological advances somewhere in-between, with the cart full of groceries like the Amazon Store approach where you can walk in, grab your stuff, it's all hooked up to a card, and then you walk out and load your car and leave. I think we're seeing that already; I think I just read something recently that one of the competitors—I think it was Sobeys—is unfolding that in one of their stores right now.
Yep. They've licensed the technology from Ocado and so they are, at least in the Toronto area, want[ing] to launch home delivery. We still don't know how that's going to play out, but that is one I look at [as] an uncertainty around the industry. Once we have a better handle on what that looks like, that could lead to a whole bunch of capital expenditure that Loblaw and others in the industry are going to have to do to sort of retrofit their business. Because all of a sudden, if you think about it, you move towards more online delivery or you need smaller square footage, smaller storefronts…you have all these stores…you may not need them. That's something we're definitely on top of.
All right, well, let's move from a long-time holding all the way down to one of the newer names in the portfolio, so CGI. And this would be related to some of the IT transformation that we just talked about. CGI is based out of Montreal, they're in the IT services, IT consulting industry. What's the deal with CGI?
Well, so, their business, model-wise, I think it's a pretty good business. Half their business would be business process outsourcing—essentially think of it as outsourcing when a company or a customer would say, "Look, CGI, you run our IT department. And it's going to be a three, four, or five-year contract." So there's that part of the business—that's half their business. The other half would be people doing IT projects. I'm sure that most of our listeners, I imagine, work at a company where they've done IT projects. And I've always said that IT projects start, they never finish. And I don't mean that in a disparaging way, I just think there are constant needs for IT infrastructure and projects within a business. That's just the nature of all businesses and almost all industries.
So, that's where CGI, I think, has some pretty decent tailwinds: IT spending—specifically around some verticals that they have some expertise in. Number one is government: big barriers, very difficult to get on government contractor lists. That's a third of their business. They've got also got big verticals in financial services and built-up expertise in banking and life insurance and other financial services. I think that's one that they've done reasonably well in—healthcare is another one. So, they've got these verticals where they have decent positions. And this is global. They've executed well, so they've got a reasonable competitive position, but relatively small market share, which ties into the management piece, which over time, they've shown to be very shrewd capital allocators—very good at running operations.
And that capital allocation is important when you marry it with…look, they've got lots of opportunities to grow by acquisition, by other IT-type businesses, IT services businesses, fold them into what they're doing, improve the operations, which is what they've done historically. And valuation—I’m looking at it on a relative basis, and within the context of the universe, Canadian universe, it looked pretty reasonable. So they've ticked all the boxes for us. And, [is] one that I wished that we had owned many, many, many years ago when I first looked at it and it traded at $9 [laughs].
I'm sure you've got a long list of those ideas. [laughter]
Before we let you go, we've got Christmas coming around the corner. One of the things that I like to give as a gift is a book, and I think our listeners are always looking for book recommendations. So I wanted to ask you whether it's a book that you read a long time ago, had a huge impact, or maybe it's one that you read more recently, what's a good book for our listeners to go out and grab for themselves or as a gift?
Lots of books to choose from and much like most of my colleagues here at Mawer, we're all sort of avid readers so it's always hard to pick one. One that's really short, I think it's a really good one to read, is, a Short History of Financial Euphoria, [by] John Kenneth Galbraith. Short book, [you’ll] be able to finish it off in an hour [laughs]. Just goes through different time periods of bubbles. So, that was one. And then one they'd probably turn into a movie, but it's a great read…it's a bit long, but it's a fun read and real life, real story, is Billion Dollar Whale. It's a good one. It could be fun to read over the holidays if you want something that isn't just a financial history book.
All right, well great! Thanks for sharing those and thanks for spending some time with me and the listeners today, and we'll look forward to having you back again.
Thanks for having me and thanks everyone for listening.
- Mawer Canadian Equity Fund
- Books mentioned on the podcast: Short History of Financial Euphoria, and Billion Dollar Whale
- Playing the plan: Mawer’s Canadian equity portfolio | EP32
- Technical Debt (blog)
- Technical Debt (podcast)
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