Counsel Views – Back to the future

Stuart Morrow:

Good day, everyone, and welcome to Counsel Views. It’s certainly been a rough start to 2022 for investors and perhaps a little bit more so for growth investors. Rising inflation and fears of Fed tightening took a toll on stock prices in January, seeing the S&P 500 sell off about 5%, tech-rich NASDAQ Composite declined about 9%, meanwhile value, top growth in January in energy stocks were the clear standout.

While most growth stocks have felt the brunt of a change in the outlook for interest rates, we don’t believe that all is lost on growth. For the most part, the forward outlook provided in the latest round of earnings remained fairly positive despite rising inflation and interest rates.

With me to discuss the outlook for U.S. growth stocks is my very special guest, Ken Stuzin, partner and Portfolio Manager at Brown Advisory who’s the subadvisor for the RBC Private U.S. Growth Equity Pool.

Ken is a partner and a portfolio manager of a large cap growth strategy at Brown Advisory, and prior to joining the firm he was vice president and a large cap portfolio manager at J.P. Morgan Investment Management in Los Angeles. Previously, Ken worked as a quantitative portfolio strategist in New York, where he advised clients on capital markets issues and strategic asset allocation decisions.

The investment philosophy of Brown is based on low portfolio turnover and concentration derived from sound bottom-up fundamental research that can provide an opportunity for attractive performance over time.

Ken, welcome to Counsel Views.

Ken Stuzin:

Thank you so much for having me. It’s great to be with you.

Stuart Morrow:

Great to see you again. Latest earnings, Ken, we’ve seen a sort of real bifurcation across technology, communications services in terms of the results and the outlooks. So thinking about the bigger swings, we saw names like Netflix and Meta and Amazon and Microsoft, just to name a few so far. What if any of the market reaction to earnings and the outlooks, has surprised you and your team?

Ken Stuzin:

Yeah. If you think about the individual names that have moved down, it may all seem rather surprising, particularly when, from our perspective, these are very high-quality business models with huge addressable markets and competitive advantages as well.

Having said that though, you know, this isn’t my first rodeo, as they say, and having sort of managed this fun through the tech bubble and subsequent bust, I’m not surprised in the short term.

You know, when we look at individual companies doing what they’re doing in this market, we have to be reminded that in the short term, you know, people tend to be traders. It’s only in the long term that people are buying business models. And these business models don’t change dramatically. They haven’t changed in the last quarter.

Now I’m the first one to admit that valuations were very, very high. In fact, our biggest challenge sort of going into last year and throughout most of the year, is that we didn’t own a fair number of companies that we thought were really good companies because we didn’t see a clear path to essentially making absolute returns.

And so, you know, taking the long view, this is good. I realize that sounds sort of like a bizarre thing to say, but it sort of clears the deck. It will create, at some point in time, a foundation for these companies to make investors real money.

And it’s a cycle. It’s played out again and again and again. One new sort of wrinkle I suppose, because if you look back, it’s been a long, long time since a U.S. Federal Reserve has been gung-ho about raising rates, and I would argue—and I won’t spend a lot of time on macro, it’s not what we do. It’s an incredibly dovish institution these days. The new governors who are being tapped, I would suggest will be, if you can imagine, even more dovish. And I think the only thing that’s held their feet to the fire is the fact that, you know, U.S. consumers are having to pay a lot more for goods and services. And so they were really forced into this, too late I might add.

Stuart Morrow:

Yeah.

Ken Stuzin:

So, you know, this notion that federal, you know, central bankers can sort of magically thread the needle again has proven to be a myth. And so we live with the volatility, but, you know, again, we’re big boys and girls here. We’ve seen this before. Our job is to not lose our heads and just to sort of continue to do what we do, which is to seek out great business models, own them for longer periods of time, and as a growth manager, I often invoke Warren Buffett, you know, let the magic of tax-free compounding be a wind at our backs.

Stuart Morrow:

Well said. Yeah, and I think, you know, to your point, this shift in the environment, sort of really lends credence to the active approach as opposed to a passive approach which people have been following more so in the last number of years.

So, you know, if you think about this environment, where we’ve seen interest rates start to back up in the last few months, the Fed’s clearly signalled that it’s going to start to do something next month, in March. Can you talk about, from a bottom-up perspective maybe then, how has any of this change at all impacted how you look at companies in terms of the valuation, or your investment process in any way?

Ken Stuzin:

Yeah. You know, if I were running a different sub-asset class, if I had companies that were heavily levered, if we had more cyclicality as a characteristic of the portfolio, you know, you begin to worry about interest payments increasing, you begin to worry about, you know, how do I manage through the macroeconomic cycle, et cetera. That’s really not the case here.

If you looked at this portfolio that I run as a single stock, there is no debt. In fact, if anything, you could argue given short-term returns, there’s way too much cash on the collective balance sheet.

The issue, the real central issue for growth stock investors is, obviously—and I won’t bore you with it because you know it, it’s the mathematics behind how to value stocks and this notion of discounting future cash flows from the future back to the present, right? It’s one technique for valuing things.

But here’s the funny math thing that people sort of forget and we must remind ourselves from time to time. If you’re not making a lot of earnings in the short term, right, and you’re making it in three or four or five years, and you have to discount that back to the future, there ain’t much left, right.

Stuart Morrow:

Right.

Ken Stuzin:

It’s really that simple. Now, you know, I watch—I guess these financial news shows are in the backgrounds of our lives. I see it, Stu, in the background where you’re sitting.

Stuart Morrow:

Yep.

Ken Stuzin:

And, you know, you hear people talk about these incredibly expensive stocks and you should sell those, and, you know, Apple has a forward P/E of 27 times and I have to—I chuckle about the bad advice that’s being given to people.

It’s not just the forward P/E. And furthermore, P/E is not the only way to value stocks. It should never be the only way. We should look at a number of different techniques. But if we are going to talk about P/Es, there has to be a relationship with the underlying growth rate. And I mean no disrespect to Apple. I’m surrounded by Apple gear. We owned it. We made a huge amount of money in it. But it doesn’t meet our growth requirements any more.

Stuart Morrow:

Right.

Ken Stuzin:

It’s over a full market cycle. It’s a high-single-digit, low-double-digit name. Selling at 27 times, give or take, that’s actually not that cheap if you think about it, right?

Stuart Morrow:

Yeah. Yeah.

Ken Stuzin:

And so, you know, just getting back to this point that for growth stock investors, it’s this valuation issue, which I don’t think people necessarily understand it well, but it doesn’t matter, because when the stocks start trading down because somebody remembered what they did read in their textbooks at business school, then everybody goes with the flow in the short term.

Now, just to get to, I suppose, the point. When you see stocks’ business models whose fundamentals have not changed dramatically and yet their stocks are down 20%, 30%, 40%, 50% or more from their peaks, you really see valuations compressing very, very quickly.

Stuart Morrow:

Yeah.

Ken Stuzin:

But we have to remember, the pendulum over swings.

Stuart Morrow:

Yeah.

Ken Stuzin:

The market was expensive, too expensive on the upside, it will be too cheap on the downside. Now I’m not calling a bottom here. In fact, you know, it’s interesting that people keep saying well, maybe this is the bottom or that’s the bottom, or this day or tomorrow. The Fed hasn’t even started raising interest rates yet. In fact, the irony of all ironies is they continue to engage in quantitative easing. You know, it’s like a clown car filled with central bankers to be very candid with you.

And so, you know, an investor asked me the other day, okay, you have to pick a time or an event where you think we’ll bottom out. And I said, well, I’ll be oaffer on this, but I would humbly suggest that let’s actually see them raise rates, right? Let’s see that first Fed funds rate be announced to see what the reaction is going to be. I think it’s going to be in March sometime. We’ll have a little bit more data in terms of inflation and things of that nature.

And so it might be prolonged. It might not be prolonged. I mean my personal view is I’d like to have this shakeout be complete and be done for and get to a more normalized interest rate levels, at least from the perspective of the Fed.

And so, you know, it’s it. It’s all about this strange kind of cyclical thinking where rates go higher, let’s sell growth stocks; growth stocks are sold and trade down; the short-term trading crowd sort of jumps on top of that negative momentum; and you know, the next thing you know, you have a good old-fashioned bear market. And that’s what’s happening.

Now, I will say this by the way. Given sort of the shakiness in people’s views right now, in the short term, if you miss your earnings number, we saw that with—and I don’t own Facebook, although we owned it years ago—

Stuart Morrow:

Mm-hmm.

Ken Stuzin:

—that’s a huge company. It lost 25% of its market cap in a trading session. Do I think that’s fair? Well, you know, in this case, not only did they miss a number and guide differently, they possibly announced that they’re changing their business model, right?

Stuart Morrow:

Yeah.

Ken Stuzin:

And that’s a death knell. And so, you know—and I keep reminding my colleagues here, you know, do not fixate on a name that you’ve liked since before. If there is anything that has changed in the business model, we are surrounded by increasingly cheap stocks, right?

Stuart Morrow:

Mm-hmm.

Ken Stuzin:

So, you know, don’t sort of—don’t stick your flag in the sand and say, you know, this is it for me. I’m going to defend this stock. It’s not necessary. The beauty of a proper crescendoing bear market is there’s value everywhere, right? You don’t have to actually—if you’ve done your homework, you don’t need to spend that much time. You just need to pick a few that you want to add to your portfolio.

Stuart Morrow:

Well said. I like the not being fixated on a particular name. That’s very comforting over time I think.

So if you think about beyond the short term, which we try to do as investors, and think about, you know, longer-term investment themes, can you talk to some of those longer-term themes that are perhaps playing out in the fund today or you have exposure to and how do you see those themes playing out or progressing over the next few years or perhaps even longer?

Ken Stuzin:

Sure. Sure. I just want to be clear about one thing. You know, we are not thematic investors in the sense that we don’t every January 1 have a strategist come up with the three or four big ideas of the year and then we backfill them with names. But in our search for best-in-breed business models with high, sustainable growth rates, there are certain market opportunities that present themselves and are able, therefore, to support the kind of growth that we’re seeking.

And I’ll give you just two sectors and sort of just below the surface what we’re looking for. I would argue that we’re big fans of software companies, particularly Software as a Service, which tends to be a little bit more defensive because you’re paying a subscription. But software companies that are helping enterprises, helping businesses run themselves more efficiently, cheaper, potentially with less headcount and sort of eliminating paper trails and things of that nature.

I mean, you know, companies like ServiceNow with respect to help desk, or Autodesk with respect to designing and building things. I’d put Veeva Systems in there, right, which is just kind of a smaller market cap software company that works with the pharmaceutical industry, right? Imagine how difficult it is for a drug company to oversee the required testing of safety and efficacy with patient populations around the world with different regulators. They do all that with a software package.

You know, we also own a company that it’s characterized or categorized as an industrial company, but Roper Technologies has been in this fund for many, many years, and essentially, they are a portfolio of industrial software companies. And so that sort of desire, and we see it in investing in companies, we all do, companies want to be leaner, more efficient. They want to spend time doing the things that are really germane to their mission, not the array of sort of running of business things that are not central to producing cars or making drugs, et cetera, et cetera. So that is one area that we like.

And in particular, what we’re really looking for is we’re looking for those market leaders, right? Because the kinds of software that I just described are not easily torn out, right? Meaning that if they’re working, you know, the company hierarchy’s got better things to do than tear out all that software and put in a new one, unless it is an evolutionary change in efficiency and operability. So that’s one important area that we invest in.

The other, I would say, is within health care.

Stuart Morrow:

Mm-hmm.

Ken Stuzin:

And I think, you know, too often health care is thought of as, I don’t know, owning physical plant, hospitals, and drug companies. And we don’t like either of those spaces to be perfectly honest with you. We like technology companies that are helping patient outcomes, that are helping physicians do their job better. You know, companies like Intuitive Surgical, which is the far-and-away leader in robotic-aided surgery through their Da Vinci robotic surgical system.

Edwards Lifesciences—

Stuart Morrow:

Mm-hmm.

Ken Stuzin:

—which makes a minimally invasive heart valve replacement, I mean, which is extraordinary if you think about it, right? They can do something minimally invasive where you go in in the morning and you’re out that afternoon; when historically, a cardiologist would—not to be too graphic, but would crack your sternum open—

Stuart Morrow:

Right.

Ken Stuzin:

—operate on you, and you’d be in the hospital for several days. So you talk about both better patient outcomes and particularly in the U.S. where, you know, health care costs are very problematic, you know, bending the cost curve, that’s a solution that is really, really important.

And I would throw in a company like Dexcom that we own. They make a relatively inexpensive device that helps people deal with diabetes, right, in terms of going hypoglycaemic. And that is—you know, we’ve owned that for years now and the thing that most interested me is that how expensive diabetes is to treat in this country and in the world for that matter, right?

Stuart Morrow:

Hmm.

Ken Stuzin:

Because what ends up happening is it’s not an easy thing to manage, right? We’re not all particularly gifted mathematicians and our lifestyles will change sort of the blood sugar levels and the like, and if you don’t do it right, you end up in the hospital. And in the United States, when you end up in the emergency room, that’s when the cash register really begins to ring.

So we’ve got employers, insurance companies, the U.S. government is falling over themself to get people to use continuous glucose monitoring devices. So I like it when not only is a product good, really strong management, big addressable market, but I love it when the government and the final payers are rooting hard for you to succeed. So that’s another area that we’ve been big investors in.

Stuart Morrow:

So great longer-term stories behind these companies and I, you know, want to say thank you very much for taking the time, Ken, to speak to me today and speak directly to our clients. I know they really appreciate hearing the insights into the large cap growth stocks and then, of course, into the fund you manage for us as well.

I think even getting that perspective on understanding what’s happening today and the short-term noise that’s happening, but, you know, having an eye on the longer-term narrative in your portfolio, I think it’s very helpful for our clients to understand. So thanks for taking the time for that.

Ken Stuzin:

Well, I appreciate your inviting me and I enjoyed the conversation, so thank you very much.

Stuart Morrow:

No. Great to have you and we would love to have you to come back.

And to our clients, thank you for spending some time with us today. We hope you found the podcast to be useful. If you have any questions about what you’ve heard today, please contact your investment counsellor at any time.

Thank you and take care.