Counsel Views – London calling

Stu Morrow:

Welcome to Counsel Views. At the time of this recording, events are unfolding quickly. Heavy fighting continues across Ukraine, while the humanitarian crisis deepens across Europe. Our thoughts go out to everyone who has been impacted by the recent events in Ukraine.

From a markets perspective, U.S., European, and global markets have recently entered into correction territory, which is defined as a price correction of 10% or more from a previous high. Market volatility has been driven by the escalating war, increased inflation from higher energy and commodity prices, and now anticipation of slowing global growth ahead.

To discuss what is happening in European markets, I’m honoured to welcome two very special guests from RBC Global Asset Management UK. I had the pleasure of working closely with both of these fine individuals in the past, and I’m looking forward to hearing their views and their outlook.

My first guest is Dominic Wallington, Senior Portfolio Manager and Head of European Equities with RBC Global Asset Management UK. Dominic has been working in the investment industry since 1991, and he joined the firm in 2007.

And my second guest is David Lambert, Senior Portfolio Manager with the European Equity team. He’s primarily responsible for mid- and large-cap European equities across various international equity mandates. He began his career with the firm in 1999 as a quantitative analyst, and he became a portfolio manager in 2003.

Before we move on to discuss the most recent events, following his 32-year career in asset management, and the last 15 with RBC Global Asset Management, Dominic Wallington announced his decision to retire at the end of April this year. Dominic joined the firm in 2007 as CEO and CIO of what was called RBC Asset Management UK. And over the next 15 years, he built out an extensive investment team that focuses on fundamental and quantitative analysis in a bottom-up approach to stock selection. The firm’s assets have grown considerably during Dominic’s tenure in both international, European, global, and emerging market equity funds.

There has been a natural transition of Dominic’s responsibilities over the last several years, starting with the title of CEO, which was transferred to another professional in the London office so Dominic could focus on investing activities, while shifting a number of mandates to his predecessor, David Lambert.

The appointment of David Lambert to Head of European Equities was really no surprise to anyone in the firm. David has taken on progressively senior roles in the firm to oversee European and international mandates over the last several years. And he has been working closely with Dominic since 2007, building out the rigorous investment process and stock selection capabilities that have contributed to their success.

David and Dominic co-manage the RBC International Equity Fund, and they also manage the RBC European Equity Fund, both of which are solutions on the RBC PH&N Investment Counsel platform. Gentlemen, welcome to Counsel Views.

David Lambert:

Thank you, Stu.

Dominic Wallington:

Hey, Stu.

Stu Morrow:

Let’s begin with the situation at hand. And, David, maybe I’ll start with you. I’d like to ask, what are the scenarios that you’re working with today with respect to the conflict and the war? And if you can touch on European corporate exposures to Russia in general, knowing that events are moving quite rapidly. And it seems like every day there are dozens of companies announcing that they are cutting ties with Russia.

David Lambert:

Yeah. So, Stu, yeah. I think the first thing to say, that it’s nigh on impossible to predict the path of these geopolitical events, let alone the duration of them. So, one could plausibly create doomsday scenarios all the way through to cease-fires and agreements over a new way forward in a matter of days.

The point is that all of these scenarios are finger in the air, and we’ve got no way of knowing. So there’s been damage done, but what do we do as portfolio managers? And this applies in times of turmoil and outside of turmoil. And what we do is we focus on high-quality businesses that have been around for many, many years, many pre the World Wars of the first half of the 20th century. So high-quality, stable franchises with the ability and flexibility to allocate capital globally, meaning they’re much less susceptible to periods of dislocation.

So, clearly, from a day-to-day running of the business perspective, the biggest markers we’re looking for—so going back to your question—is any exposure direct to Russia. And let’s be honest, this is typically small on a European-wide basis. And then obviously, the second order of effects of what’s happening on supply chains, as you mentioned, inflation, access to raw materials.

So these are a little easier for us to quantify, even if we don’t know the playbook of the events unfolding itself. So, that’s kind of how we would approach this sort of crisis on a portfolio basis. If we do stick to the knitting of the micro as we understand that knowing what’s going to happen on the macro is a lot more difficult.

Stu Morrow:

That’s great, David. And I tend to agree, it’s difficult to really call what’s the next move. And I think most of the pundits would agree we’ve typically, in consensus, been wrong on this in most respects, so.

But if you’re thinking about some of the macro—or sort of give us a sense of, from a financial, economic, geopolitical markers that you maybe sort of look at on a day-to-day, week-to-week basis now to help kind of gauge where you think where things could be headed or how things are progressing, are there any of those sort of markers that you would like to kind of talk about or tell us how you think about these on a day-to-day or week-to-week basis?

David Lambert:

Yeah. I mean, as I mentioned, I guess things like inflation, access to raw materials, so raw material for us in particular, I mean, these are key on a day-to-day running of the corporate, so they would be things we look at.

But I guess, again, not to deflect from the question, but the nature of the businesses we look at tend to be so big, so vast, so strong with moats around their businesses that, in terms of their own pricing power, whether they can source raw materials and goods at better prices because their scale is so large, or whether they have sort of bargaining power with their customers, I think what happens is that these sort of crises have much less an impact on a corporate level than one would think.

Now clearly, those companies that have stopped business in Russia altogether or paused but are still paying their employees, there is a financial impact. But again, from an overall holistic point of view, with all these businesses that are global in reach, the actual net impacts on an earnings level for the corporates is de minimis.

So I’m not deflecting away from the question, but the markers of inflation and supply chains, et cetera, are always around and always things we consider. But these would be the things we look at in particular. And when we speak to corporates and CEOs, these are the things we would talk to them about directly.

Stu Morrow:

Gotcha. No, that’s great. And if you could—if we’re putting on our longer-term hats and thinking about this external threat, perhaps a question to both of you, does this strengthen or perhaps weaken the European Union? And I’m sort of directing to something very recent, just sort of announced in this week, was a Eurobond, a joint issuance amongst the European Union. So, is this a threat that’s going to strengthen or potentially weaken the European Union down the road?

Dominic Wallington:

Shall I have a go at that, Stu?

Stu Morrow:

Sure.

Dominic Wallington:

Yeah. Great. Okay. Well, I just want to start by saying I agree with everything that David has said so far. That’s exactly my view as well. And we should always remember that the management teams for these large organizations that we invest in—pretty much all of which are, by the way, international in nature—they’re either attempting to anticipate events themselves or are reacting to them in a way that, over the long term, has always tended to be very rational. So they’re allocating their resources appropriately. And in a sense, therefore, we don’t need to second-guess them. There can be a degree of trust, if you will.

But to turn back to the issue of the macro within Europe as a consequence of what’s going on, I think it’s become fundamentally more realistic. And it’s become more realistic in the context of the fact that energy is a fundamentally geopolitical issue. It always has been. It’s formed all sorts of tensions, conflicts, but also positive things over the longer term.

It was during the period of coal that the UK was able to undertake its ascendancy in terms of hegemony, if you will, on an international basis. And as coal gave way to oil, the U.S.A. replaced the UK because the UK didn’t have domestic oil.

So it’s very, very important. And I’ve listened to many conversations over the last few years where its importance has been underestimated, I believe. And hopefully, there’ll be more realism with regard to that.

I also think that there’s more realism from a political perspective. You see the steps being taken by Germany with regard to Nord Stream 2, with regard to its general policy of looking east. Its Ostpolitik approach I think is being undermined by current events. And that might well mean that Europe becomes fundamentally more coherent and cohesive as a consequence. There’s fiscal response already occurring, and I think that that will be built upon, that hopefully will be cohesive as well. And I suspect that will long continue.

And the final aspect to what’s developing at the moment that seems clear is, again, that this is a risk to a simple-minded idea of globalization. We’ll see continued regionalization. Sanctions are in effect, undertaking an acceleration of this process, I think, at this precise moment in time. But everything will become fundamentally more regional. And therefore, the long supply chains that are fairly normal at the moment, I think will become shortened, in many respects, and jobs will come back to geographical areas that have lost them. And clearly, the U.S. and Europe have lost a lot of jobs. And if those jobs return, I think that could be relatively positive for the domestic economies.

So none of this is good news. But in the context of realism being a much better platform to build for the future, and also very much with regard to Germany’s position within Europe, I think the developments are encouraging.

Stu Morrow:

Well said. If we’re taking that to the next sort of idea and along the same lines, actually, David, if you think about where are you seeing sort of the longer-term growth underpinnings for the European economy, thinking about, therefore, how it may impact in the equity market; we know about an aging demographic, we know about fiscal strains, falling productivity, rising government debt levels, and as Dominic was sort of saying, the move from globalization to localization impact in supply chains. Can you talk about sort of the longer-term growth expectations or thoughts about European economy, and then, therefore, the equity market?

David Lambert:

Sure. I guess the first point I’ll make is that we remind ourselves that investing in European equities is not the same as investing in the European economy. So as Dominic said, we’re invested in corporates with the European domicile, and beholden to European code of governance, but the exposures of the business isn’t typically global. So as Dominic said, being global means you’re flexible in where you can allocate your capital, and one can pivot to exploit sort of areas of business which is best for the dynamics of their operation.

So, I guess, again, so that’s just trying to deflect a little bit to say, let’s not worry too much because the flexibility built within the corporates is large. But notwithstanding that, I guess things probably do have to change from a policy perspective. There are many policies sort of over the last 40 years that have clearly failed within Europe with respect to welfare policies. Because we’ve seen rising inequality. Environmental polices fail to prevent catastrophic risk. Competition policy hasn’t stopped monopolization in certain areas of industry.

So, the answer to your question is, I don’t quite know, but I suspect there will need to be policy change that addresses environmental sustainability, rising well-being, falling equality, resilience of economies. And people far smarter than me will have to sort of come up with these. But I suspect that that will be the route out or the route forward. But drawing back, it’s more important about what the corporates are doing themselves.

Stu Morrow:

Well said. Well said. And we can bring this back to talking about your team’s investment process, then. Aand I think it’s probably a good time, then, to remind our clients about your investment process.

So maybe we’ll start with you, Dominic, and then, David, you chime in as well. But how do you sort of—how are you approaching portfolio management from a philosophical perspective? And if you can outline a little bit of the team’s process to help our clients understand how your focus on the company level is so important.

Dominic Wallington:

Okay. Thanks, Stu. Yeah. I think probably one of the most important things I’d like to talk about today is the fact that we will never hold our performance to ideology. We’ll never get so hung up on the philosophy that we’ll allow that to be the primary consideration.

Having said that, we do have a process, and we believe it’s effective over the longer term, and we would adhere to that. But the reason why I mention this is because sometimes we’ve articulated our approach as being focused on high-return businesses with very deep, wide moats, and very importantly, a capital-light approach, asset-light approach in terms of the structure of the business.

Whereas we have pivoted somewhat in the last few months. And we started doing so in December towards an exposure in the oil sector because we can see all sorts of things from a geopolitical perspective which make the sector more attractive. But also, we can see a capital discipline in the sector that removes it from the worst vagaries of a commodity industry. And also, very cheap valuations.

So, I think it’s coherent for us to incorporate oil and gas into the portfolios. And funnily enough, I see recently in the press that Buffett was doing a similar thing at the same time. So, given that Buffett has been an inspiration for David and I for a long time, I feel pretty relaxed.

But the core idea behind our approach is economic compounding on an annualized basis. We believe there is ultimately a link between the ability of a business in the real world to grow its economics by conducting its business, and that those will ultimately be reflected in share prices. Now these things never work on a lockstep basis because markets are human artifacts. They whiz around because the assets are long-duration assets, but. And that’s the key. And we’ve built our process on the back of that. But there has to be a degree of flexibility when things change, and that’s why I pointed to oil and gas.

Stu Morrow:

Is there anything to add there? And, David, maybe I’ll say and ask you, then, as incoming Head of European Equities, is there anything in the process in how you’re looking at the funds that you’re responsible for? In any way, would that sort of change with your appointment?

David Lambert:

I mean, the answer to the first point there is, no, absolutely not. I mean, it’s a continuation. We’ve been working together for 15 years. And it’s a journey of things, the investment process, and philosophies evolve and grow. They’re organic. And that will continue. But nothing’s changed.

I mean, I whole heartedly agree with Dominic, as you’d expect, we’ve worked together for so long. But the DNA of what makes a good business hasn’t changed. But valuation is an important aspect. And Dominic, was talking about parts of the equity market have effectively been abandoned for whatever reasons, for ideological reasons or for other reasons. And this creates opportunities that we have to be pragmatic and flexible to recognize when, also, parts of that industry are changing with respect to their capital intensity or the cash generation that they make.

So, I’d echo exactly what Dominic said. We continue to sort of have a core theory of what makes a good investment. But at the same time, we’re humble enough to accept that there are times and periods where other assets become appropriate to be put in the portfolio.

But from the underlying client experience, it’s no change. We’ve been sort of fungible for a long while. And I think even our hairstyles have got similar as the years have gone as well. So I just haven’t quite gotten there on the facial hair.

Stu Morrow:

Yes. I think we can all attest to the similar hairstyles over the years since I’ve known you guys. I’m more advanced than you, so.

I do want to say, I’m just mindful of our time, and I’d like to say it’s always an absolute pleasure speaking with both of you. And, Dominic, on behalf of the RBC PH&N Investment Counsel business, I do want to wish you all the best in the next stage of your life and wish you well in your retirement, although I hope we do remain in touch.

Dominic Wallington:

Stu, that’s very kind of you. And if stock markets keep falling, then you might see me more quickly than you expected [to leave]. But I think it’s a tremendous organization that you work for, and you represent it really well. And I also wanted to add, I think, if there are any changes to be made by David, they’ll be for the good. So you’re in great hands.

Stu Morrow:

Well said. Well said. And, David, again, congratulations on your appointment. We certainly look forward to welcoming you back on the podcast, of course, in the future.

David Lambert:

Thanks, Stuart. Yeah. I look forward to it. Thank you.

Stu Morrow:

Thank you both. And to our clients, thank you for taking the time to listen to our podcast. As always, if you have any questions about what you’ve heard today, please reach out to your Investment Counselor. Take care.

Dominic Wallington:

Goodbye.

David Lambert:

Bye.