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Speaker 1 (00:00): Welcome to IPC Portfolio Services, Masterminds Go Virtual. This week, Sam Febbraro welcomes Rana Chauhan and special guest David Picton as they discuss the current market and economic environment following the world's response to COVID-19. It is now my pleasure to introduce your host Sam Febbraro.

Sam Febbraro (00:19): Welcome everyone to the IPC Portfolio Services Mastermind session. Anyone can argue that COVID-19 over the past several weeks and months has pretty much changed the world to some degree. We see, for example, unemployment rising rapidly. We see market volatility in an incredible format and speed of change going down, going back up. And of course, lots of questions around whether or not this is a V-shaped recovery, U a W or even an L shape recovery. We've seen, for example, the world moved from a health crisis to an economic crisis. And the question is, are we now moving into a financial crisis? And so to try to make some sense of that, I'm absolutely thrilled to introduce two speakers who probably don't require a lot of introduction for many of you in the audience, but momentarily, we're going to hear from David Picton.

Sam Febbraro (01:13): David will be joining us. He is the president and portfolio manager of Picton Mahoney. He is also the Counsel Portfolio services, Canadian Growth Manager. And with him, I would like to first welcome Rana Chauhan our Chief Investment Strategist, and he's going to kick things off formally and welcome David. So, first of all, I'd like to welcome Rana and good afternoon Rana. How are you?

Rana Chauhan (01:38): Great Sam. This is a really important thing. Here's the thing about it. There's a lot of assumptions being made. We're getting mixed messages and I believe we're getting a lot of half truths. Okay? And that's what creates what I'm calling this environment of FUD, right? You can say FUD, FUD, FUD. All right? No, it's not a swear word. It stands for fear, uncertainty and doubt. And this is why it's important to listen to the actual practitioners and the people that are driving the car of your investments, all right? Making the decisions, and changing things. In particular, in this environment, there's kind of been a little bit of a shock in a way that things should have happened. There was a lot of belief that value should have protected us more. Value should have recovered more. All right?

Rana Chauhan (02:36): But actually we're seeing the exact opposite happen, in that growth protected us more and growth is recovering more. It's kind of very unusual when you think about downturns and things like that. So I think this is a very interesting environment to see what the changes have been done. And I'm looking forward to David telling us what are the triggers that he's pulling and what are his concerns around this area, especially around his process or group, which I think is very unique. David, welcome and please enlighten us on what have you been up to?

David Picton (03:12): Well, first of all, I'd like to extend my thanks for the opportunity to talk to everybody. And if anybody out there has people that they know on the front lines, please extend some gratitude on our behalf. Here's why I personally like to say is that, I think this market is actually acting very rationally and very efficiently. And I think there's a lot of people that have a skepticism and doubt as to why it's here and how that we're going to go back and test the lows and stocks are overvalued, but I want to present a case as to why I don't think they necessarily are and where we're positioning for new opportunities as the margin. The first thing I'd say is that markets do not bottom when you win the war. By the time you win the war, there's already been a significant recovery rally has taken place.

David Picton (03:58): Market's bottom when you start fighting back. And I think if you look back to the great financial crisis and extend the playbook that they use then to what's happening now, you'll see that the fight back has been incredibly strong and it's yielding very impressive results. The first thing is, you recognize that there is a problem. Back in the great financial crisis, it wasn't really until Lehman Brothers was forced to go under when all the authorities recognize the magnitude of the issue they are dealing with. This time around, if you look south of the border in particular, once the US president actually understood that this wasn't a hoax and that there was an actual virus out there that was hurting people and they implemented strategies, built a task force. To me, that was the first positive sign that the recognition of the problem had taken place.

David Picton (04:50): Obviously markets were reacting violently, but even then once they began to articulate even some sort of sense of realizing the issue, you began to see some stability in the bottoming process. The second thing that happened is again, borrowing from the great financial crisis, that the central banks around the world, but especially in the US recognized that they had to keep markets functioning properly. And they did an unprecedented level of stimulus and liquidity injection to make sure that was the case. If you recall back, they injected dramatic amounts back, obviously in the great financial crisis. They were doing just as an example on QE3, approximately $60 billion a month of buying. By the time we got to really heart of the issue in late March this time, the US Federal Reserve alone, was buying $75 billion plus of securities per day. So not only did they adopt what they did back in the great financial crisis, they did it on a more dramatic, a more violent, if you will, and more quick fashion than anything we've seen before.

David Picton (06:02): And obviously that continues to this day. Any part of the market that they deem to be lacking proper liquidity, they have injected themselves into it, even to the extent of buying high yielding bonds, they'd call them fallen angels. And some of the ETFs that are falling out of favor. That was an unprecedented step, but it was a dramatic and an important step in the fight. The third thing that's important here is that back in the great financial crisis, the banks were the major problem behind it. This time around banks are being a major part of the solution. They have all kinds of capital that was built up using something called counter cyclical capital liquidity rules that were put in place to save for a rainy day. And they had excess amounts as that rainy day occurred.

David Picton (06:53): Now I'm not a big fan of the banks. I know lots of value managers are, but my opinion here is that while they are doing an enormous amount for social good by extending payment terms and forgiving loans and extending the payback periods, that's not necessarily good for the financial holders of the securities, but it's great for the financial system as a whole. The forth thing that was required going back to the great financial crisis, was some sort of major fiscal stimulus program. This time around we're trying to bridge the gap. There was an automatic shutdown the economy, there's going to be a restarting process, which we're seeing now. The idea behind the fiscal stimulus was to get us through that gap. It took them a couple of months to bickering back in 2008, to come up with a $1 trillion stimulus plan. It took them a week to come up with $2 trillion this time around, and then to follow that up with another trillion or so, and maybe potentially even more behind that.

David Picton (07:55): So the fiscal stimulus response in the US in particular, again, has been dramatic, and we've seen that same sort of stimulus response on a per capita basis, even here in Canada. And it's important to note that again, back in the great financial crisis, once they began implementing fiscal stimulus, the markets began to move. There is a point to me that's missing now. And this is the last step in the process. And it's to articulate a proper plan for how you get rid of and move past this quarantining phase into restarting the economy. To me, this is where politics are playing a role. And this is to me where there's potential for weakness in the markets. If you announced a plan that had proper testing measures that tried to use data to separate who was vulnerable and who wasn't. To keep people that were vulnerable quarantining and socially distant, and to allow those that are very, very at modest risk at all of getting sick back into the marketplace, and then to make sure that you were testing them to make sure they were not spreading this once they went back to their homes, et cetera.

David Picton (09:03): If you got to that step and then implement a very aggressive contract or contact tracing, so that if someone indeed did get ill from the virus, they could trace the steps and see who else and isolate those people, that would be the home run. And that would have the market screaming right back to their hives. We haven't done that in my opinion, because politics have gotten in the way. US president is more worried about trying to isolate him from the noise around the virus, as opposed to the virus itself. He's trying to pass it off to someone else. The states are trying to come up with their own plans to do this. There's no rhyme or reason to those plans. And this to me is what sets you up for a little bit of vulnerability as we go through the summer. But otherwise using the great financial crisis plan, the playbook has been executed to a T and the markets have responded accordingly.

David Picton (09:53): There was a great comment earlier about... Well, before I get to that, one other thing to keep in mind, and you have to keep in mind from all time moving forward now, is the role that leverage place in the marketplace. Back in the old days, you could get a 7% return just by buying government bonds. Let's call that 20 years ago. And obviously those returns have been eroded to close to zero where we are now. So major financial institutions and funds out there, have taken the approach that they're going to look at small little parts of the marketplace that used to generate return, and they're going to labor them up. So, if I could only get a couple of percent, I will use leverage to try and magnify that return to maybe five, six, seven, or 10% even. And that is this leverage that now causes these massive swings in the market at faster rates than we've ever seen.

David Picton (10:49): And it was really the significant de-leveraging through March that created the big, big, big decline that we saw in such a dramatic fashion. We always keep tabs on those kind of sources of leverage in the system. Just to give an example, Credit Suisse suggested that using their prime brokerage platform that they're systematic clients. These are things called CTA, or some of the risk parity funds, slashed 45% of their equity positions in a 30 day period of time. That are market neutral position funds in the US which are leveraged again, five, six or seven times, dumped 15% of their positions in a five day period of time. That third week of March was the most chaotic thing I've ever seen, where it made no rhyme or reason what was happening with securities. And it was because of this massive de-leveraging that, that was the case.

David Picton (11:49): Well, they pushed all of the correlations of all assets towards one. There was very little diversification benefit that could have been had. And that to me is the new environment that you have to lean into it and take risk on. And that's certainly what we did at our firm. We made sure that we concentrated positions, that we took advantage of some of the things that were getting tossed out in terms of babies with the bathwater. And we made sure that we had as much risk on the portfolio as we could, when the correlations went to one and the environment seemed as bad as it was ever going to be. Just to give you a couple of examples, CTAs are these trend-following funds out there, that go on they look at a bunch of different asset classes and believe it or not, they simply buy the ones that have the best momentum.

David Picton (12:35): I think it's crazy. I do believe in momentum, but these funds nonetheless garner significant authority in the marketplace. They sold $250 billion of securities in that month period through March towards the very bottom. They went from 100% net long the market to 100% net short the market at the lows. They were at the same short position that we were back in December 2018 when we saw a major low in the marketplace. Same thing for risk parity funds, like what a Ray Dalio does at Bridgewater. They took their equity positions down to the lowest level in three years. Money market funds saw the biggest inflows they've ever seen. And we had now something like $4.5 trillion sitting in money market funds in the US alone. So it was no surprise, I suppose. Once the market started to take hold, there was a firmer bid than anybody ever expected to it.

David Picton (13:36): And that still exists today, because a lot of these guys are now offside and they have to chase their way back into this market, especially as it moves higher and as the volatility of it falls. Now, in terms of where we're positioned. I think there's four ways of looking at securities here and it kind of encompasses are we in a U-shaped recovery or a V-shaped recovery or an L recovery. We're in all of those, depending on the securities that you're looking at. So for instance, there are a number of securities whose business got better as a result of this crisis. They're very obvious. Amazon's business got stronger and better. Shopify's business got stronger and better. The Shopify CEO just released a quote today, suggesting that it took eight years for e-Commerce as a percentage of total retail sales to go from five to 15%. It took 10 weeks for this measure to go from 15% to 24%.

David Picton (14:47): So yeah, Shopify is an expensive company, but their business model has been pulled forward dramatically as a result of this crisis. And so those stocks should be at their highs because interest rates are at their lows and their businesses are better. I would put Microsoft in that category, Amazon, and then I'd put other things. Even like off the beaten path names like Intact Financial, which obviously insurers against automobile collisions. Well, guess what? With no one driving, there's no collisions. They're still collecting their premiums. Their business is stronger than it was otherwise. So they're in the... I don't know what you'd call it, other than a straight line up to the right in terms of their leadership. The second kind of companies that we like in the portfolio are those that are going to be in a V-shaped recovery.

David Picton (15:38): Their business is going to rebound quicker and faster than you're going to see and believe. For instance, I obviously need a haircut. You can see from the camera there, it's been getting a little long in the [inaudible 00:15:50]. I hope that as soon as the restrictions are lifted at my hairdresser, I'm going to book an appointment. I expect a whole bunch of other people, maybe not Rana, but a whole bunch of other people to do the same thing. And as that occurs, my hairdresser, even though she's going to be constrained with all kinds of COVID protection, et cetera, her business is going to go from zero to as much as she can handle. She is going to have a V-shaped recovery. There's companies obviously in the stock market that you're going to see the same thing. Boyd Group, which obviously deals with automotive collisions.

David Picton (16:24): Once we start driving and obviously China is a very good test for this, because China has already started to see the recovery and their driving levels and their traffic congestion levels are almost back to the same level they were pre the crisis. You're going to see collision rates return and Boyd's business, which is way down. It is going to recover exactly to where it was. In fact, I think Boyd is going to be even stronger because they went out, raised some money, and they're going to take advantage of some weak players that don't have enough financial capacity to make it through to that point in time. And they're going to add to their revenue. Then there's going to be companies that are in a U-shape. We are less exposed to these companies, particularly as positive change and growth managers, I would put financial services like banks into this category.

David Picton (17:09): It's going to probably take them three or four years to get back to the profitability that they had three months ago. They're going to have to extend payment terms. Their provisioning rates are going to be higher. You're going to see a whole bunch of commercial businesses, Mom-and-pop businesses, smaller businesses go out of business. The banks are going to be on the hook for that. It's going to take them a while to recover. And I think that's why these banks, even though they're cheap and they're cheap everywhere in the world are laggers as opposed to leaders so far in this recovery process. I think there's a good trade in them, but I think these are U-shaped stories, not V-shaped and certainly not up to the right stories. And we want to be less exposed to those. And then finally, I think there's companies that are not going to recover.

David Picton (17:56): Let's call them L. We all know that the retail space, big department stores was in trouble. It was in a secular downturn prior to this whole mess, that got accelerated. Just like Shopify and Amazon accelerated to the upside, Macy's and a whole host of major US department stores accelerated to the downside. They're filing for bankruptcy in many cases. So, they are in an L. They're not coming back. They're not coming back anywhere close to where they were. The airlines are going to be subject to some debate here. We've been a big fan of Air Canada, we think they did everything right. It's no fault of their own, but obviously their business is going to come back at a much slower fashion. And some US airlines may actually go bankrupt before this is done. So, we had a big position there, we have much less position there because again, it's a different environment for those.

David Picton (18:52): Finally, some of the REIT stocks fit into this category. I think REITs were considered to be low risk, nice sources of income. And I think this model has been proven to be very, very subject to economic conditions. And again, if you are a REIT owner with a whole bunch of malls, especially strip malls or US kind of a big retail chain based malls, I think your business model has been changed forever. Just like it was going to be anyways, but it just happened much quicker. So, I think the markets are in appropriate level. I think there is stocks that are leading that are appropriate. I think some of them are expensive. I'm worried about two things. I'm worried about a not so successful rollout of a proper strategy for testing, for restarting the economy. And then I'm worried about politics entering the fray.

David Picton (19:47): I believe the US president is on his last legs and he's going to do everything he can to go down with a fight to try and get re-elected. Keep in mind what his holdings are personally. He's in golf courses, he's in luxury hotels. He is a highly leveraged individual. So, you're going to see all kinds of rash behavior, whether it's completely ignoring any kind of response to the crisis or whether it's now taking on China to be the scapegoat of this. And I think it's those tensions that we have to worry about as we approach election time. And so maybe we should start to build up a little bit more of a modest cash position here, as we advance through the summer, as we start to see the data get better. But as we approach that election day and the inevitable kind of irrational response that we see from president Trump as we go through that. With Rana, why don't we kind of throw it back to you, maybe talk about a few questions that have been incoming.

Rana Chauhan (20:47): This is one of the opportunities for active investment managers here. All right? That you can selectively pick the eears as opposed to the passive world which picks up everything. But how does Canada stack up in this environment against the rest of the world? Are we holding ourselves up and are we doing well? Because we keep on hearing about the US, the US, the US, but you're a Canadian growth manager.

David Picton (21:16): I would say that if you look at those four categories, I talked about, up to the right, V-shape, U-shaped, L-shaped. Our Canadian equivalent companies are acting exactly as the US peers are doing. If you look at Shopify and you compare it to the big leaders in the NASDAQ, Shopify as an up to the right company, it's been incredible. Yeah, it might be a little expensive here, it might be a bit overdone, but it's holding its own. If you look at those V-shaped recovery companies, Boyd for instance, some of the other kind of maybe insurance companies, they're doing exactly what the U S guys are doing. If you look at the U-shaped recovery companies, like the banks in particular, they're acting exactly like US banks and the L-shaped are acting the same as well. What I might argue is that our composition of the index is a little less tech because we don't have the names that we had. A little bit more financials and resources and so like for like, we're acting exactly as we should. And the opportunities are the same here as there are there.

Rana Chauhan (22:20): Also, during this whole crisis thing, we got another thing thrown at us and that was the oil, Oil Armageddon that we had. And we had this weird day where oil was minus 40, all right. What are your thoughts on oil and in our portfolio? And is it a growth thing or not for you?

David Picton (22:44): I'll repeat my longstanding view. That oil is the new coal. And what I mean by that is that, people are going to use less of it over time. It is politically incorrect. It's being banned and dated out of ESG portfolios everywhere around the world. And the companies have suffered as a result of that. But for the first time in a while, I would argue that the conditions are set for some kind of recovery rally here. Basically in the energy space we all know that low prices solve low prices, but what we needed was a real shocking event like that minus day, like OPEC falling apart briefly, finally kind of creating some kind of systematic shutdown of all the excess capacity and the horrible business models that exist in the oil space. And we're seeing it at the margin everywhere. So, you're starting to see production cut back. Now you've seen demand fall dramatically. You needed that too. You're going to see demand, come back. We go through the summer and hopefully those production shutdowns and remained in place.

David Picton (23:50): And you could see a barrel... I can see barrel at 50 bucks again, very quickly as a result of that. And some of these stocks might actually find the benefit because they have finally seen religion and the writing on the wall that they can not just waste capital like they are so prone to do over time. So I don't like the group long term, but I'm a positive change manager. And I do believe that this setup for positive change finally exists in the oil space. Now I might do it differently. I might buy companies like midstream companies like [inaudible 00:24:19] that have been down and out. We own a bunch of [inaudible 00:24:22] gas, which has half a utility, a half a midstream company. And I might buy some of the less indebted oil companies. Whether it's Parex or maybe Prairie Sky. I might play it differently than just buying a couple of big oil companies. But nonetheless, I think there might actually be an opportunity here to find.

Sam Febbraro (24:40): Okay. Well, gentlemen, thank you once again. David, Rana, all of the information has been wonderful. And with that ladies and gentlemen, on behalf of Rana on behalf of David and obviously on behalf of the IPC family, we thank you for joining us, be safe and stay connected. Thank you.
David Picton (24:57): Good luck to everyone. Rana Chauhan (24:58): Thank you.