March 22, 2023
Watch now: Michael Simpson webinar replay – NCM Dividend Champions
On March 22, 2023, VP Regional Sales, Grahame Roberts, sat down with Portfolio Manager Michael Simpson to chat about bank failures, the market, and how he is positioning the NCM Dividend Champions fund.
0:55 What happened with bank failures south of the border?
3:59 How have you managed to do so well given eight rate hikes and everything that's happened in the markets and economy?
7:14 How secure are your banking dividends?
8:48 Given everything that's happened, how are you setting up your fund going forward?
10:57 You’ve been successful for 25+ years - what’s the secret to your success?
12:45 What would cause you to take your U.S. weighting up from the current 25% of the portfolio?
14:42 How are you managing currency south of the border?
16:15 Why didn't you own Algonquin Power?
Grahame: Hi, everyone, and thanks for joining us today. My name is Grahame Roberts and I am VP Regional Sales for NCM Investments covering the GTA. I've been with NCM for over ten years now and I truly love my job. NCM Investments is active management for independent thinkers - everyone here today on the webinar - and we are truly made for advice.
Talking about advice I have with me, as you can see award winning PM Michael Simpson, who has been running the NCM Dividend Champions Fund in his unique style since late 2020. Hey, Mike.
Michael: Hi, Grahame.
Grahame: Thanks for coming in. Mike has been running money for Canadians across the country for 25 plus years and his impressive performance speaks for itself. Just a bit of housekeeping here. The date is Wednesday, March 22nd, 2023, and this webinar is being recorded.
Okay, Mike, let's get this thing going here. What happened last week south of the border?
Michael: Okay. It's the three S's. Bank failures, plus a forced or shotgun marriage. First in the United States, the largest bank, SVB, or as it's known to many people, Silicon Valley Bank had a failure. They had a modern day run on deposits. And nowadays some people still go to bank branches, but a lot of people do it electronically with the click of a mouse.
We also had two smaller banks, Silvergate, which was more of a crypto lender and also Signature Bank in New York City, smaller bank as well that was more focused on business accounts.
So first the larger one Silicon Valley bank. They were a banker to a lot of the venture capitalists, early tech companies that in the good times received lots of funds. They used Silicon Valley Bank for advice to deposit their extra cash flow, to deposit their cash flow, which was used for payrolls.
The bank was poorly managed. They took in a lot of deposits and they decided not to manage their duration risk. They decided in searching for yield when rates were very low to invest in government mortgages, also government bonds that were longer dated maturities. As rates have risen quite dramatically - Grahame referenced rates rising over eight times in one year - U.S. rates are now at 4.5%.
So what happened was you had an extremely bad mismatch. Silicon Valley didn't have a risk manager for seven months. So the bank had very poor managers. There became issues when Silicon Valley had to sell part of their bond portfolio and took a big loss. They had to raise equity or were trying to raise equity. Then rumors spread and people decided they had to get their money out and hence a bank failure and hence the US regulator stepping in.
The other two banks are smaller, although they, you know, they count as bank failures. But the big one was Silicon Valley Bank. So basically that's what happened. The regulators stepped in guaranteeing deposits for those banks. Going back to the 2008/2009 crisis, more stringent testing for larger banks. The cutoff was $250 billion. Silicon Valley Bank at its peak was just over $200 billion. So that's in essence, what happened in a nutshell.
Grahame: Okay. Yeah. You talked about the rate hikes. We have a slide that maybe we can bring up. Brad, please. This talks to, I think, your performance, your unique style. Eight rate hikes in Canada, eight in the U.S., maybe a ninth in a little bit of time here this afternoon. How have you managed to do so well given everything that's happened in the markets, in the economy?
Michael: Well, Grahame, the rate increases created a lot of uncertainty in the financial markets that's known as VIX. If the chartmaster could go to Slide 31. So with the volatility came opportunities.
We start with the premise that we want to build a portfolio that can withstand shocks both internal and external. We all know over the last three or four years there's been plenty of external shocks from a once in a century pandemic to, you know, the first major continental war in Europe in over 75 years.
So you manage it with having companies that have strong balance sheets, good management teams, companies that although their margins may go down during short periods or during business slowdowns or recessions, they'll be able to withstand. Companies that pay dividends, companies that can continue to pay dividends, and companies that can raise their dividend each year - what we call at NCM “Dividend Champions.”
So it starts with a process. It's a very rigorous process. We don't speculate. During raging bull markets, we will underperform. We're quite open about that. But when times are uncertain, as they were in 2022, when both the stock and bond market had negative returns over the calendar year, we're quite proud of our hard work and what we did. We delivered a positive return.
So it starts with a process, a mindset. We don't want to hit home runs we'd rather be happy with, over a career, hitting 4,000 singles. So you know your company, know markets will give you opportunity with the increased volatility, and you use volatility as your friend. So when there is extreme pessimism, when a company misses earnings by a small amount and there's an instant visceral reaction in the market that's overdone, we step in and buy.
And similarly, we have targets on every company we buy, every company in the portfolio. And when the optimism becomes too extreme or too excessive, we'll trim. If it’s not a core holding, we'll sell outright. So that's basically what we’ve been doing, Grahame. It's a very honed discipline. We stick to it. We don't get swayed by trends or fads.
We just do it in and out. And I take a continental approach in having the opportunity to buy the best companies in Canada, the United States, and those are companies that generate free cash flow. It's not the company’s definition of free cash flow. It's our definition. It encompasses everything - cash flow from operations, interest payments, maintenance CapEx, growth CapEx, making sure you paid your dividends and you have the ability to grow your dividends over time.
Grahame: Okay, Thanks. I'm actually going to bring in a really good question here on the Q&A. We're getting a bunch of questions - this is a great one. How secure are your banking dividends? Could this be a, I don't know if you can answer. this, a Minsky moment collateral issue?
Michael: Yeah, the banking system is extremely interconnected, as we discovered in 2008/2009. I've never been one to be an index hugger or to be a passive indexer or an active indexer. I take a fundamental approach, but I use a macro overlay. So what that means is I'm not ignorant to what's happening in the world, whether it's a war in Ukraine or stresses and fissures in the banking system.
So I believe the Canadian banking system is safe. That does not necessarily mean the Canadian banks can’t have some earnings or net interest income margins declining because of the extreme inversion of the yield curve. Think about the basic banking. The basic blocking and tackling of a bank is to borrow short and lend long. Yes, they do have other businesses - capital markets, investment bankers, etc. etc., but that's what basically it does for a bank.
So as a result, I'm underweight financials. I'm looking for some area of financials - the non-bank sector. Insurance is a sector that I like, both in Canada and the US and some other non financials that don't have the same exposure to the inverted yield curve as the traditional banks do.
Grahame: Okay, great. That's a great segue. Next question is given everything that's happened, how are you setting up your fund going forward? I think that's what people really want to know is what are you doing to navigate the challenges and opportunities ahead in both Canada and the U.S.?
Michael: As sure as night follows day, recessions are inevitable. Recessions, business contractions, on average last shorter. So that's a good time. We've had extended business cycle expansions because of ultra low rates. So we're positioning the fund. We're not going to make a prediction on when a recession starts or when it ends. We're just positioning for slower growth.
So the fund has a slant to more defensive names, names that have solid balance sheets. We always do that. We always look for a solid balance sheet so you can withstand what I call the shocks. Internal. Internal could be a key executive leaving maybe new competition in your industry. External is anything in the macro world, geopolitical events, government policy change, tax changes, etc. etc. So we have a defensive tilt toward it.
When we approach commodities or resources, we know these are quite cyclical. So a year ago I would have had a higher weighting to oil and gas. We take a look at what's happening in Europe. A year ago I would have had a higher exposure to companies selling natural gas in Europe. But as Europe had a warmer winter, as natural gas prices have fallen in Europe and in North America as well, I've extremely reduced the weighting to that sector, just having the best companies that can withstand lower prices.
So as prices go lower and perhaps bottom, I may add to that sector, but not right now. So it's a very holistic approach. And within a diversified Dividend Champion portfolio, there's only a certain weight I'll take the fund to in resources because by its very nature resources are more volatile. So I like less volatility in earnings and cash flow and more more stability.
Grahame: Love it. Okay. As I mentioned at the beginning, you've been in the business for 25 plus years and doing very well. Congratulations. But what is your secret sauce? You’re a very low key guy, very confident. What is it all about to do well, in an ever changing market environment over 25 plus years?
Michael: Over that time period, there's new trends and fads from bitcoin to cannabis. It’s not to get swayed by those fads, not to get caught up in it.
So the other key is always what I learned at a young age in this business, valuation always matters. Never throw out valuation, never chase popular things. If you're going to underperform in a short period of time because others are chasing momentum stocks, that's not my game. That's not what I do.
Two of the key drivers from a macro point of view of the market are earnings and interest rates. Yes, we've had a period of interest rates rising. The good news in Canada, they seem to be on hold, which is good. And as the economy weakens, you know, they could come down, which will be positive for stock market valuations, but we don't go in looking for high valuation, high PE, high price-to-cash flow stocks. So when there is a downturn or when there is multiple contraction, our holdings contract less because we're not starting with a high valuation.
So, you know, that's basically it and always be mindful of defensiveness. The last crisis will not be the same as the next crisis, so always be vigilant about risk management. And that's what we do well at NCM.
Grahame: Great. Okay. So 65% invested in Canada right now, 25% in the U.S. The remaining in cash. What would cause you to take your U.S. weighting up from the current 25%? I know you have to keep it under 50% based on the category, but it could go up if you think it should. What would cause you to take your U.S. weighting up?
Michael: So basically the philosophy is a continental approach. Canada has some really good world class companies in the financial sector, in the resource sector. But if I want to get a world class pharmaceutical company, Canada has some good consumer companies, but there are more large consumer companies in the U.S. and when we're talking about aerospace or defense, I look towards the U.S. So it's all about valuation.
You know, the U.S. is the largest economy. We have the benefit of Canada being right next door to the largest economy. We have about 77, 78% of our exports go to the U.S. I'm invested in a company based in Calgary, which can now reach all the way down to Mexico - that’s CP Rail. So it would be about valuation.
But when I want to buy mature technology companies that generate copious amounts of cash flow, pay dividends, grow their dividend, I look to the U.S. because although there are technology companies in Canada, the list is very short and small compared to the U.S. So it comes down to valuation. It comes down to I'm always going to try to distinguish the portfolio by having names in the portfolio from the U.S. that simply aren't available in Canada.
But as valuation comes down in the U.S., I will look to increase my weighting to U.S. holdings.
Grahame: Okay. In talking about the U.S., how are you managing currency south of the border?
Michael: So currency, it's a great question. What we do is we have a current U.S. holding weighting. It could vary from, in my tenure, from about 20% to 30%. So we hedge every month. We use forwards And right now I'm about 40% hedged.
Oil is weakening, Canadian dollar’s weakening. The Canadian dollar has been weak. So I never want to be approximately right or absolutely wrong. So I'm never going to be 0% hedged or 100% hedged somewhere, you know, somewhere in that sweet spot of 40 to 60, maybe 65%.
You know, with equities, you can get a larger return than you can get with bonds. If I had bonds where the return was much lower than you would hedge a higher amount. But hedging is important. It's important, again, my philosophy not to hit home runs, but to really cover the downside.
That's the purpose of hedging and the currency I've experienced over the last 20 years, there are times when it can move very quickly in a very short period of time, i.e. two or three weeks. So that's why you want to be hedged, you know, to cover the downside. Hedging is not to make money, it's just protection on the downside.
Grahame: Okay, I’ll get some water there. One question here. Why didn't you own Algonquin Power?
Michael: There were a number of red flags with Algonquin. One, their debt levels were too high, Their payout ratio was too high. Number three, they made an acquisition in the U.S. where there was a regulatory change. As a result, we saw all this adding up to pressure on the dividend and we foresaw a large dividend cut.
And with the way the balance sheet was, we thought also there might be an equity issue. Those are the reason the red flags pop up. And having been in this, you know, industry for a number of years, when you get one red flag, you pay attention. But when there was three and also a change in interest rates, I said, you know, I have to stay away because I foresee a dividend cut. And that's that's really bad for the share price.
Grahame: Okay. That's the end of the formal questions. Just wanted a quick take on what you're all about and what you're going to do going forward. We don't have many other questions from the audience. If you do have questions again, please reach out to your regional wholesaler or email firstname.lastname@example.org.
Just a note here. Another housekeeping note around the fund this time, that the NCM Dividend Champions Fund does have a separate series AA or F F that distributes a 2.5% yield annualized paid monthly if your clients do require monthly cash flow. So that is there for you. There is a 2.5% yield roughly on the fund overall right now, and we believe that will stay as it is going forward, although we can't guarantee anything.
If you have any more questions again, please reach out. Thanks for joining today. Thank you, Michael. And if you need any information again, reach out. We're here for you. So, Mike, everybody, thank you so much for joining and have a great day. Always here to help at NCM.
The information in this video is current as of March 22, 2023 but is subject to change. The contents of this video (including facts, opinions, descriptions of or references to, products or securities) are for informational purposes only and are not intended to provide financial, legal, accounting or tax advice and should not be relied upon in that regard. The communication may contain forward-looking statements which are not guarantees of future performance. Forward-looking statements involve inherent risk and uncertainties, so it is possible that predictions, forecasts, projections and other forward-looking statements will not be achieved. Commissions, trailing commissions, management fees and expenses all may be associated with mutual fund investments. Please read the prospectus before investing. Mutual funds are not guaranteed, their values change frequently and past performance may not be repeated.
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