Announcer: Welcome to Breadth of Experience. A TDAM Talks Podcast. You are listening into part two of a three part discussion on the equity markets featuring Jose Alancherry, Ben Gossack and Damian Fernandes. Listen in to this part for insight on the art of portfolio construction and the value creation process.
Ben: We don't need the next “n plus one”, AI, data center of play. You, know, that's not diversifying ourselves. And so that that's the part where, you know, Damian are having to say no to a lot of great ideas because we have those ideas. And so adding that “n plus one” idea isn't going to make the portfolio any better.
Jose: Yeah, the risk, it seems, is that you could own stocks in different sectors, but if they're indirectly by a second or third derivative tied to this big picture theme, you're effectively on the same boat; that single one stock.
Damian: So I'll put some names to this. I’ll put names we don't hold. Just to highlight this like, for example, think about an engineering construction firm, right? Whether it's like (inaudible), like WSP or something like that, what does that have in common with Constellation Energy, which is like a utility.
Jose: Utility.
Damian: Right. Or have in common with, you know, some(thing) like, Dell. Right. Which makes the computers - for the service. All of those are different sectors. But like if you look at all those stock prices, they've all gone. Bottom left, you know, north by northeast top, right, Because the same incremental demand that's juicing revenues and free cash flows is the massive amount of investments that these tech companies are making in AI spending.
Damian: And so this is what, Ben was talking about. You can say think you're diversified, you're like, oh, I own an engineering company and I own a utility and I own, you know, Dell Computer, but I've covered by bases. But like, it's really like, you know, how much does Zuckerberg want to spend on incrementally AI next year that that your fortunes are tied to.
Jose: Yeah. No this is interesting that you brought that up as a big surprise because I had that as a talking point in general and it's the data I found interesting that that the CapEx for big tech at 200 billion is more than the CapEx that big oil will spend in its peak in many ways. And when you crystallize or think of it, these are tech companies that are now spending way more money into CapEx than, let's say, the most CapEx intensive industries.
One of them at least oil and gas, ever spend in its heyday, 2013. In your view, do we have to view these companies differently as they become larger and larger parts of the economy or just the way they are in their business cycle? Like fleshing this out, they've even started paying dividends. So are they changing in front of our very eyes?
Ben: I mean, I don't know if they represent the economy. I think it does mean that the stock market and the economy are look like two different things. The one thing I would say from a portfolio perspective, they are getting big and they eat up a lot of your portfolio. So if we just look that, let's say Microsoft and Apple combined and whether we're looking at it from an S&P 100 level or even S&P 500 level, that's a good chunk of your capital being eaten up by two stocks.
Ben: And then if you add in an Amazon, there's I know there's two Google tickers, a Meta. What does that leave you left with? And so you might have to make choices where you don't own some of them because that frees up capital for other ideas. So I think it's making it can make portfolio and stock selection challenging depending on the benchmark that the active manager has.
Ben: So I think one of the toughest benchmarks out there would be the S&P 100 daily because Microsoft and Apple are beyond 10% and most fund managers mandates can't own more than ten. So that can be a very challenging mandate. So I think it can, unless we go into cap indices as these companies get bigger and bigger, I think it's going to run into real life friction for most management companies because it cannot more than 10% of a stock.
Damian: And what Ben was talking about, right, like Ben as a portfolio manager, doesn't want to own ... he's an active manager. Yeah. He likes, you know, these names. He doesn't want to own a benchmark position. So pretty soon, if you want to run, I have an overweight position on names. You have high confidence in outperformance because the market is mispricing fundamentals.
Damian: Five stocks could be 25% plus of your portfolio pretty easily. And I think that constant, it's not so much concentration where it's unjustified, right? Because most of stocks.
Jose: Get the thought process...
Damian: Those… those stocks that, you know, Ben just highlighted the top five, most of them with maybe the exception of actually, not even Amazon, because Amazon is, you know, generating boatloads of cash. And that's I think a three and a half percent free cash flow yield when they last checked on next year's numbers. They're profitable companies growing at scale. It's just there's some there's a bifurcation in the market where you have these names that are, you know, good companies that are growing. But people forget about the rest of it. Back to the Mag seven people are just so focused on these top performing that there are these whole other companies that don't make the top ten or 20 that are also highly profitable industry leaders, high returns invested, capital growing like stink.
Ben: Yeah. And just again, going back to portfolio construction, because that's, you know, something that Damian, I are very thoughtful about. You know, we want to have about 40 or 50 stocks and we want to be overweight every stock like. ... In a way we're trying to, we play off X in terms of, you know for right we want to get rewarded for it. So let's say a stock is 5% of an index in order for us to put on a proper active bet, you know, it has to be now be 7% ... just have a 2% bet. So I also think, again, for most funds, we only disclose the top ten. And I think for people listening, you know, they think your top ten is is your top bets. But in reality, I think it can be a mislead.
Jose: Yeah, that's an interesting angle. I think it's helpful.
Ben: ... so if I have Microsoft again let's say the benchmark rates five I have a 2% active bet. That may not be my biggest bet, but it might look like my top holding is like 7%. And someone might say, Oh, Ben and Damian must really like Microsoft. And it's just more of a function of we manage based ... on our active risk. So this would be are way less the weight of the benchmark. And typically that's would say anywhere between one and a half to two and a half, 3% if we’re really convicted. But like that to me ... explains our performance as opposed to looking at the top ten. And as these stocks get bigger and bigger, I think the top ten won't be very helpful to understand, you know, what's really going on in someone's portfolio.
Damian: Yeah, And sometimes you'll see names that make our top ten. They're like, Oh, you bought a new name. It's like, No, it was number 12 stock that just massively outperformed the were the other 11 that ...
Jose: Migrates it’s way up, right. Yeah that's, that's interesting sometimes a stock with a 5 bps weight in the index that we have to you know do percent as a high conviction is a bigger driver of performance than any of the top ten names you could just parse through and see and yeah that's a that's a very important distinction.
Damian: So it gets to this point, right? I think when people ... people select hopefully, for the you know, if people select us because we've demonstrated a degree of outperformance based on a process that we think makes fundamental sense. But more importantly, the reason we you know, we run 40 to 50 stocks that, you know, 2% bets and stuff is because we want to look different from the index. In the world we live in today, you can buy index products for virtually nothing. We want to add value add value create value creation for clients and and actually provide an experience that isn't... and that's what Ben was talking about and I know we're spending a lot of time on the idea of portfolio construction, but it's the little things that matter, right? The little things at the edges, managing risk from a fundamental perspective, thinking about, you know, whether your stocks have a high degree of correlation, even though they're in different industries and thinking about, hey, you know, analysts like we can't own, and I know you really love this name, but we can't own the “n + 1” next idea because our portfolio has a ... even though it's a brand new name, we already have a fair amount of eggs in that theme basket.
Jose: It's in some sense portfolio manager knows a lot about making choices right Even the “no’s” and just....
Ben: And managing your “FOMO.”
Jose: Managing your FOMO. Yeah. Yeah. It can be very easy to get caught into that “FOMO” train.
Ben: And that's why I do think 40 to 50 stocks is a good number and trying to to keep it to that because you know if you can manage your FOMO, you know you start to grab every stock again that could expose you to a lot of compounding risk. But then also, like if you're right, I what's the payoff? You've just diluted all your all your bets by holding so many stocks.
Jose: All your hard work, your effort. Yeah.
Damian: Ben's being really ... I use the word dogmatic and, you know, or religiosity around this, Right. It's your best ideas have to have the most capital behind it, because otherwise, what's the ....? Like, we can have 70 stocks and in our portfolio and they all could be 30 basis point bets. And if we know our best idea there doubles or goes up 50%, that's 15 basis points.
Jose: Yeah yeah.
Ben: And Damian does not get out of bed for 15 basis points!
Jose: Well Damian’s been delivering more than 15 so I keep getting out of bed. Yeah. You've been doing a fantastic job. And the interesting thing I would like to highlight is (that) we have a five year anniversary for one of our stable strategies coming up to you do RTD act of Global Enhanced dividend yield the first of our enhanced income suites suite of Solutions. Ben, you've been spearheading part of like let's say, adding value via alternative thought process like and you know, active option overlays and you've seen tremendous growth with this strategy. First off, just your high level thoughts on this five year journey.
Damian: You don't know what I want to do. As I remember this vividly, I want to ask you, can I can I take your role for like 30 seconds or and I want to ask because. Okay, so for those on the call, we've been writing options across all their strategies for a while. Ben is being the the gatekeeper, the architect, who spearheaded this, and we were writing options and our regular products using put options. This is before the launch of “TGED” (TD Total Global Enhanced Dividend ETF) which had a phenomenal five year track record and which we ... all of the portfolio managers own and Ben, like how did that idea come about? Just the because we were writing options in our funds And what did you think about the actual conception like, well, you know, how can you build a better mousetrap? Like what got you there.
Ben: For writing the calls and the puts?
Damian: Yeah, and just the product itself though.
Ben: Yeah, I well, I've been reflective this month so we're doing a lot of sort of collateral. So, you know, thinking back I remember. So on paper, this came about in 2018. There is a few things that were going on. TD Asset Management was making a move back into ETFs and again, it's still the probably one of the hottest products out there. But even at that time, let's say five years ago, Covered call strategies were particularly hot. We also wanted to make complementary ETFs of the existing lineup, so let's say so nothing that would substitute an existing mandate. So it wasn't like so we have great product and we didn't want to make a substitute product. The part ... I just, I never like covered call ETFs and that's why we always did it right.
Damian: But by the way... ... for those listening when Ben says he'd never like covered called ETFs, that's actually an understatement of massive proportions because if we were under more informal circumstances he would use much more forceful language and maybe why Ben like what what is the problem with covered calls and what's unique about what we have there?
Ben: So effectively, most people, so people, they're sold based on distribution. You so think of, you know, if you ever bought a stock because it had a high dividend yield, it's either completely mispriced or the market's already sniffed out that there's a problem with the company. And most people have had bad experience chasing high dividend yielding stocks. I'd say this is the same for covered call strategies that are basically sold on a high distribution yield. You know, anywhere from 5 to 15% distribution yields. People feel like it's free money, but it comes at a massive cost. You're paying for these funds. So, you know, anywhere between 75 basis points, 80 basis points. And it always underperforms the underlying holdings. So you were just better off not to write these calls. And ... just a lot of it's just this passive writing methodology. You give yourself very little upside and, and you cap out returns. So I think going back ... again on paper I didn't like in 2018 was a it felt like at the time investors had to make a choice. You either saw income or you saw growth. And so think about 2018. We're talking about back to the heyday of the FAANG stocks. So, you know, we're talking, you know, tons of tech stocks, communications stocks flying. So that was the growth. And then on them paid dividends and then, you know, then there was the income angle and people wanted to chase those high income. And so I never like to be painted in a corner. And I was wondering if we could go with a total return approach and give you your cake and let you eat most of it. So go after growth, go for a lower distribution yield, but then, you know, really be thoughtful about writing the calls, writing the puts. I was really confident that, you know, we've been running this program since 2016. I was really confident on the program that's basically selling insurance to the market. I had a good sense that we could come in a better, thoughtful manner in terms of writing these calls, but I didn't know. It was one of these things where it's like he couldn't really back test the strategy. So I remember the early days going out marketing and people would say like, show me your back test. Then I'm like, But we're actively writing these calls. Like, I can't go back. And, you know, I was kind of looking back and sort of ...
Damian: We wish we had paper back tests, but they don't.
Ben: But you can't ... I can't go back and say, I would have written this call at this price, like this is my performance. So I had a sense of what I would do based on the style of how we were on write these calls. And so as more, I'm going to be like, Well, we're going to see how this works.
Ben: And if you think about what we've gone through in the last five years, you know, we've had up markets, we've had some of the new markets, We've had very rip-roaring, rip your face off... you know, the over the recovery out of COVID even through 2022. I think we had a whole bunch of bear market rallies and then even this rally. And if you actually look at our performance, we actually do even better in rising markets, which is typically is not how covered called strategies are supposed to work. But again, it's a testament to how we design the product. And so I wanted to going back originally to your question, Damian, like I wanted to build an all-in-one solution.
Damian: Income and growth.
Ben: Income and growth.
Jose: Is a core solution. You know.
Announcer: Thanks for listening into part two of the Equity Roundtable for Q2. Stay tuned for part three coming out shortly. Please share this with a friend or colleague. Follow like or comment on your preferred app or send us an email in the address listed in the description.
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