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As the markets prepare to usher in autumn, Ben Gosack, portfolio manager at TD Asset Management, discusses the importance of following the investing process even amid the fear of missing out.
Greg Bonnell: Well, as we head toward the end of summer, it might be a good time for investors to reflect on what’s been happening in the market so far this year, as well as to sharpen their pencils and start investing in this… It can also be a good time to prepare for the rest of the year. Join us now to discuss Ben Gosack, Portfolio Manager of TD Asset Management. Ben, it’s great to have you with us. Thank you for visiting this last week of August.
Ben Gosack: Well, I appreciate our conversation, so thanks for calling me back.
Greg Bonnell: Let’s, okay, talk about the year that we’ve had, and the fact that we’re in August now, and people want to know what’s going to happen in autumn. But it could be — you know, trading volume could be down. People are not at their desks. It’s been a very difficult month to try to figure out what’s going on. What should we think about it?
Ben Gosack: Well, summers in Canada are short and fleeting. So I encourage people to get out, spend time with their families, especially now that we’re in the last week of August – arguably, I could say the last week of summer.
But August can be a tough time. Trading volume is seasonally low. We see a lot of volatility in stocks. And people will try to make up stories, or they’ll think that some things are going on. It is very difficult to detect whether there is a good signal or not.
I find August to be a great time to work on projects, do some reading, do some research, and then prepare for the inevitable September, where everything happens, and everyone wants to know where things are going.
I would say, one interesting thing I did over my summer — “What did you do over your summer” for my summer report, I was going back, we were getting a lot of headlines on China, a lot of negative headlines on China, All quite right. But I was thinking, it wasn’t that long ago, especially earlier this year, we were talking about how amazing China is going to be, how we’re opening up again. And I started looking back and looking at what had happened and whether we were able to figure out what we’re seeing today in terms of headlines and negative momentum.
Greg Bonnell: Yeah, I see you have some pictures to show us in terms of that work. You not only have a story to tell about your summer homework but also some pictures.
Ben Gosack: Why don’t we queue it up?
Greg Bonnell: Let’s take a look, here. Shanghai Stock Index, Composite Index. What is this telling us?
Ben Gosack: Ok. That’s why I think I’ve been on your show so many times. We talk about fractions. I like different. The kids are going back to school. They are going to do maths. If they say, why am I learning about fractions, you can tell them, it’s because it can make you money, and so pay more attention to fractions.
We’re looking at — you’re looking at the Shanghai Composite Stock Index. So these are local stocks in China. The upper chart is the real price index. And then below that is our excerpt. We’ll get to that in a second. But I want people to focus on the upper half of this chart. I drew a big brown arrow.
So halfway through November, you see a downward trend in the charts, and we start getting rumors that the very strict COVID-19 policies may be softening. And I think it was around the beginning of December where we saw a change in tone. And then we saw a wave of enthusiasm.
And you can see the stock chart starts to go up — up, and we get a lot of strength.
Around this time, Greg, everyone is projecting the idea of China in every area. So it could be material. Maybe they’re going to build some more infrastructure. There is pent up demand. People have been locked down in a way.
Now there is the cost of revenge which we all experience in the context of western developed economies. So transport. You looked at Macau Gaming Shares. They were 100% above their lows. So there was this kind of euphoric fear of getting lost, the need to follow the herd. And so there was a real push in China.
If we look at fractions, this is the bottom part of our chart. Then, I was playing with our charts the other week, and I was shocked by what I saw.
So what we’re doing is we’re taking that same Shanghai Composite Index, price, and we’re dividing it by MSCI EAFE. So that’s developed Europe and Asia. And that’s why I chose this as our separator, typically when you’re allocating capital outside of North America — and we’ll take that from a US or Canadian investor — you want MSCI EAFE as your type of pool. Thinking of stock picking. And if you’re going to emerging markets, you’ll probably refer to investments that you could make in developed, let’s call it, Western Asian economies.
And so you can see that we’re moving up in the Shanghai Composite, but the line is actually very horizontal and stable relative to the MSCI EAFE. And that tells you that there was no better performance. The local investor was giving no credit to any of these Chinese companies overall, to say that there was a relatively better performance.
Now, this is with the benefit of hindsight. Then again, we’re all looking at these price charts. We are seeing all those activities. Our mind is calculating numbers and performing.
Greg Bonnell: You said that you are afraid of getting lost. People get piled up in business.
Ben Gosack: Absolutely. And what was it telling you — and again, I encourage people to look at things on a relative basis, on a partial basis. That tells you that — and it’s quite possible that the benefits are not to be found in China, but elsewhere. Perhaps it was in Europe or other parts of Asia that were going to benefit more from the reopening of China. We can create that narrative.
But for the most part, stacking up in China and other China — I call it the N plus 1 China trade — wasn’t going to increase in value. And what we saw was that it was stepping up.
What’s very interesting about that chart is we have that horizontal line. And then it breaks down in late March and starts doing poorly. But if you’re just looking at the Shanghai Composite Index, it will probably continue to try to push up into April, May. It kind of goes sideways.
And that’s only up to this month, given some of the bad things — we — they won’t report youth unemployment. We are seeing deflation. Some steps have been taken in terms of stimulating the economy, but you also have to have capital demand. We are not seeing that.
And so now you see a breakdown in the chart. But that decline probably only started in March, plus you haven’t had any relative outperformance since the policy decline started.
Greg Bonnell: Ok. So those graphs, the fractional process that you talked about there, gives us a little bit of how you think about the world, how you think about investing. Tell us a little bit more about the process and then we’ll be able to think about the decline.
Ben Gosack: Okay, so every time we end the show, I think you always ask me for any final thoughts, any closing words. And I say, no matter what’s going on in the market, always stick to your process. And so I thought, now that we’re going back to school, why don’t we talk a little bit about our process, our process.
And look, I love a good FOMO state too. That’s me This is my personality. I have to manage it. But it’s our process that helps us manage your fear and greed, provides you with structure, and helps deliver value over time.
So I thought I’d start with the building blocks of my process. And so we’re effectively looking for high quality companies that have free cash flow and that can generate cash flow accretion. We believe that if you have compound cash flow inflows, that can drive value and outperform.
To do this, we think of four building blocks. You need a company that has a competitive advantage – that is, something they do better than others. And he can make annuity stream. So I’m making money. But if I want to compound, I need to grow.
So the next step is that, the company needs to create a growth strategy. And that could just be new products, new services, entering new markets. Perhaps it is a change in the way they are manufactured. And so we’ll see an acceleration in free cash flow as they’ve changed the manufacturing process, or they’re working more on hardware versus software. We try to understand where the growth is coming from.
Original Excellence. We want a well managed company. We want management to allocate capital in the most efficient manner and generate returns on it.
The last thing I wanted to talk about is what we call lower estimated free cash flow. So if you think that a company generates cash flow from operations, they have to invest some capital in the business to keep it going. We call it capital expenditure. And all that’s left is free cash flow. What management does with that free cash flow can have a direct bearing on how the stock performs.
If you can find a company that’s compounding, we see, again and again, it’s undervalued by the market. And it’s an unusual feature of human beings, we like to model the world in a very linear way. And if you look at any model that’s trying to capture the financial performance of any company, let’s say a banking institution, they’re always managing on a linear fashion. And so if you grew revenue 10% this year, the base gets bigger, so maybe you can only grow 7%, and then 6%, and then 5%.
But if you’re compounding, it’s non-linear. And that’s what creates the wonder. And so those are the building blocks in terms of how we find our stock.
So, yes, you can reopen business in China. Maybe Japan looks exciting because it’s reaching levels we haven’t seen since the 90s. Maybe it’s about the seven stocks the market seems to be obsessing over. For us, no matter what’s going on, we start with the four building blocks.
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Source: seekingalpha.com
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