Hi, and welcome back to the PH&N Institutional Podcast, where we discuss issues that are top of mind for institutional investors. I am your host, Julie Ducharme, and I am a portfolio manager on the institutional team. And today we're going to be pulling back the curtain on the challenges facing global equity investors in light of the fact that the backdrop just keeps shifting the balance of power around the world.

And I am delighted to be joined today by my friend and colleague Habib Subjally, senior portfolio manager and head of global equities at RBC Global Asset Management (UK) Limited (RBC GAM-UK), out of London. Habib, welcome and thank you for joining me today.

Hi Julie, thank you so much for having me on the podcast. It's a real honour.

Well, let's get going. And we have so much that we could discuss. And the goal today is to cover a lot of interesting topics, including, investing through the different economic environments that are unfolding, navigating some of those shifts in the technology platforms, and then the concentration that's emerging within the largest companies and how to manage all of these risks, and arguably opportunities that come with them.

So, in order to set the stage for how you see the investment landscape unfolding, perhaps you could start by explaining to our listeners a little bit more about your philosophy – how your team invests, your competitive edge, and maybe in a few words, help us understand what you believe is the key to success in  managing a “best ideas” equity portfolio.

Interesting question, Julie. I think this is a philosophical question. And our philosophy is very simple – as equity investors, we want to invest in great businesses at attractive valuations. Why great businesses? Because great businesses produce wealth over time. It's not a straight line, but over time they take capital – human capital, physical capital, financial capital – and then multiply it.

And as investors, that's our job – to identify these great wealth creating businesses, assemble them in a portfolio, and then let that wealth creation accrue to our investors. Now, this is a very simple philosophy. It's easy to say, but hard to do, as identifying these great wealth creating businesses isn't easy. Historically, our industry has done this by using financial analysis.

And, if you ask most people in our industry how you identify great investments, you get a series of ratios like low P/E (price/earnings), high EPS (earnings per share) growth or low price-to-book, high return on invested capital – these kind of financial ratios. But business leaders and entrepreneurs, I've been asking them this question for like 35 years and I've never got an answer that has to do with a financial ratio. It's always to do with their intangible assets and liabilities. It's their sense of purpose, their corporate culture, that they're not afraid to make mistakes and learn from them. Their culture might be very customer centric – they delight their customers, and their customers turn into their biggest advocates.

It's also a willingness to think like an owner and take a long-term view. It's these sorts of things, contingent assets – delighting your customers, innovating, thinking for the long term, being prepared to make mistakes – that define a great business. And then of course, on the other side, there are businesses that create contingent liabilities. These are businesses that run for short-term financial metrics to meet short-term EPS targets.

We have seen we see this all the time. You see companies cutting R&D or cutting efficiency programs and software developments just to sacrifice them on the altar of short-term EPS targets. But we've seen companies fire customer service and R&D employees just to say they've short-term costs again to meet short-term financial targets.

And this may be great in the short term, but it does lead to long-term value destruction. So I think for us, philosophically, we try and identify these great businesses by trying to find what we call contingent assets – intangible assets like reputation and brand, and employee engagement – and make sure we don't invest in businesses with contingent liability that are slashing and burning to meet short-term targets and going from a series of short-term targets while compromising the long-term future.

That makes a lot of intuitive sense. You want to avoid companies that are destructing that long-term value, but find the ones that have something special. There's an intangible asset that you can also add to its financial metrics over the long term. I imagine there's more than a few companies out there that meet this criterion but probably not many.

And I know your team builds high-conviction portfolios. So that balancing act between being selective about this exclusive group of companies that you want to invest in but also having enough exposure to the countries in the sectors that are available. So how do you construct the portfolio to balance all of this?

Good question. This is something we battle with every day. When I talked about our philosophy about investing in great businesses, wealth-creating businesses, that's about identifying individual businesses. We're likening to say that these great wealth-creating businesses come in many different shapes and sizes. They come in different industries, and they are there in different geographies, different countries.

You might have to look for them. In some places it's harder to find than in others, but they are there. But when you identify these individual businesses and you start assembling them into a portfolio, all sorts of different things start happening – you start getting concentrations by country, by sector, by size, by style, volatility, and so on.

And these concentrations can really have a big impact on the portfolio level returns, which is the returns that our clients see. And this is where on our team, which is a team of 17 people with  four people that are quants, there are three portfolio engineers that are there to help us. I mean, we have seven different risk models. We made an enormous investment over the last 17 years in a framework that incorporates these different risk models and creates a dashboard that allows us to first of all measure risk – what risks are existing in the portfolio and how those risks are evolving as market volatilities change. Then to help us simulate how we can manage those risks if we move capital from one holding to another or if we add a whole new holding – what impact that has on the portfolio.

And this helps us then manage those risks so that the portfolio risk is being allocated to the areas where we feel we have skill, and which is consistent with our philosophy in those great wealth-creating businesses. And we are trying to control and minimize the amount of risk being allocated to country, sector size, commodity price, interest rates, exchange rates – all of these kind of factor risks we don't really profess to have great insights into.

On that, trying to control and mitigate some risks that you have little insight into. I am curious about the economic environment because you can't control that risk. And so managing a stable of companies when the foundation of the environment is changing, like if we go back to the pandemic, for example, there were certain pockets of the markets that were thriving.

We were all cooped up. But no sooner had we come out of the pandemic, we were facing rising inflation, rising interest rates, this notion of hard versus soft landings and recessions; and now in the past year, it's this changing political landscape around the world. Those have to be destabilizing for your decision on where to invest.

Yes and no. I think you have to know what you don't know. Some of these things are binary. Why have a portfolio of 35–40 stocks when you're making a binary bet, you might as well use an ETF or a geared future or something like that to make a call on that. And some things like coming out of the pandemic, we've never done that before. Moving from deflationary environment during the pandemic to an inflationary environment as we came out –again, we haven't seen anything like that since the 70s. So these are very hard to navigate.

And all we can do is make sure that the portfolio is hedged, that we have both “winners” and “losers”. As far as we are concerned, if on those dimensions we come out flat, we are very happy. At the end of the day, these great wealth-creating businesses, as long as that wealth creation is taking place, they’re innovating, they're winning more customers, they are taking market share, and they continue to develop and evolve, that is what will make them more valuable over time. It may not accrue in the share price in a straight line because that does get impacted by the environment and sentiment and all of these factors. But over time, that's what we look for.

You keep mentioning this word innovation when you talk about the types of companies that you want to invest in and innovation over the long-term tends to be cyclical, where you have these very momentous environments. And more recently, it appears that one of the biggest decision investors are faced with is whether or not to believe the hype in the technology sector.

And we've seen them before, whether in the past it was the internet boom or cloud computing in recent history, but now it's all about artificial intelligence or AI. And so could you talk a little bit about how you think about investing through these kind of shifts or these very exciting periods? And is this time any different for AI?

AI is phenomenal. It will leave its mark on our society, on the world, and how you and I live. I have no doubt about that. But in many respects, it is very similar to other technological shifts. Of course, we can go back to things like electricity and the printing press and things like that.

But if we just look more recently, everything from televisions to the PC to the invention of the spreadsheet to mobile phones to smartphones, we have so many different examples of new technologies that have come along. And it always starts the same way – there's a kind of disbelief or this thing will never catch on.

And there have been many technological shifts that haven't caught on, in the same way that the blockchain never really achieved its full potential. And do you remember things like 3D TVs and things like that? But when things do catch on, there is great excitement around them.

And we always underestimate how quickly consumers and users of these technologies adopt them. Initially, there's a lot of excitement around the pioneers who created the technology, whether it was who created spreadsheet technology or who created the cathode ray tube or who created mobile telephony, and those engineering companies and the telecom companies. But the pioneers aren't necessarily the ones that make the most value out of it. Like in mobile telephony, a lot of their consumers and their users have made much more value out of it than the network companies.

And the same way with spreadsheets. The initial spreadsheets were created by computer associates and IBM, and companies like that. But Microsoft with Office ended up sort of dominating that space. And arguably, I think our industry and the rest of the commercial world have got more value out of spreadsheets than Microsoft ever did.

So I think AI will be very similar. Today the hype is around the enablers and the technology companies and the hardware stack. And also where all of this model building and usage is going to take place, which is the hyperscalers – Microsoft, Amazon, companies like that. But sooner or later, the focus is going to shift to the software layer.

Essentially all of this capital spending that is going on, all of this innovation that is going on and hundreds of billions are being spent every year enabling AI. That is only justifiable if all of us, all of these people listening to this podcast actually get some value out of AI.  And we need to get value out of AI first of all as corporate users so that employers are prepared to pay another $20, $30, $40 a month in software subscriptions and licenses and things like that, and also that we all as consumers, as private individuals, are prepared to pay more in terms of subscriptions or prepared to tolerate more advertising revenue because we get value out of this.

This is where I think the focus of AI has to shift. And  then one step further than that is going to be how AI impacts the balance of power and the competitive position in different industries. Artificial intelligence has the power to change the medical industry in terms of diagnosis, in terms of, reading scans and X-rays, in terms of new drug development, in terms of the efficiency of hospitals. It's going to impact the accounting profession, the legal profession, the architecture profession, the engineering profession. And which software companies, which users, which corporates are able to take this, adapt it, deploy it for maximum value creation?

There are going to be an enormous number of “winners” and “losers”. I mean, just think what smartphones did. It made certain things like maps completely redundant.

And we can't live without them anymore. And I like this idea of being prepared to pay more for AI. And frankly, in some of those great use cases you've described, I think all of us would be happy to see companies pay more for that. However, the investors seem to be prepared to pay more right now for the hyperscalers, and there's a lot of hype around the leaders in AI right now or at least the perceived leaders today.

And these companies are just getting larger and larger as part of the index (MSCI World index) and are also concentrated in the U.S. So we're seeing this extreme concentration happening within the kind of flagship benchmarks that equity investors use globally. Is this a bad thing or can we learn lessons from the past and extrapolate on this, or do you just have to be patient and wait it out until this broader recognition of who's going to benefit from some of the applications of AI will actually manifest itself?

If this is something that a good thing or a bad thing, I don't know, but it's something that no global investor can ignore. It's something you have to address and you have to manage.

These companies did not become the size that they are by accident or by fluke. These are truly great businesses. They have innovated in an amazing manner, they have executed, they have loyal customers, they generate billions of dollars in revenues and cash flows. So they deserve to be there at the moment. Now it is also true to say that no company stays great forever. At some point they get disrupted or complacency sets in and they get lazy.

You can go back to the history of the stock market. I've gone back and I've looked at things like the composition of the Dow 30. The Dow Jones is America's greatest sort of companies through the rearview mirror. And you look at how the Dow constituents have evolved over the last century and it's remarkable.

And I have no doubt the same thing will happen again. And this is why with these great companies we have to look for the chinks in the armor and where they are getting stuck in their ways, where they're getting disrupted, where they're not staying nimble enough and they're not cannibalizing themselves.

This notion that no company stays great forever. It's hard to think about that now when we look at some of the competitive advantages that some of the heavyweights out there have. And, and I love kind of this notion that history may not repeat itself, but it often rhymes. And what better example to take than Amazon.

Their founder Jeff Bezos once said that he's often asked what's going to change in the next 10 years, but he's almost never asked what's not going to change in the next 10 years. And for a company of his magnitude, they probably need to be worried about both of those.

But he believes the more important question is what is not going to change in the next 10 years. And so in the context of you as an investor, can you talk about what is it as important today as it will be in 10 years to the best of your abilities?

I come back to that, the thing about sort of contingent assets and contingent liabilities. The hallmark of any business – whether it's in the mining industry, it’s in retail, it’s in financial services, it's health care, it's technology – is how people come together and work as a team. How they play to their different strengths.

But the whole is greater than the sum of the parts – that they are prepared to take risks, but not defining risks, how they learn from their mistakes. You cannot innovate without making mistakes, but how you learn from those and how you don't become too bureaucratic and how you don't become complacent once you've had some degree of success.

Also, human nature being human nature, you will always have successful companies trying to cut corners, trying to extend their period of dominance by lobbying politicians and cutting corners by taking advantage of their customers or their suppliers or their employees. And this  has always happened and will always happen.

The tools that they use will change, the settings will change. But at the end of the day, entrepreneurialism, this is what the stock market is all about. And this is why I love what I do so much, is that we have the privilege to look at all of these entrepreneurs and to see which entrepreneurs will continue to execute and create value and which ones will not.

At the end of the day, there is a life cycle and you can fight that for a while. The truly great companies stay great for decades. Some stay great for a few months or years and that's the privilege of this role, actually; it’s to find those.

I can say based on my experience with you Habib that you're not just talking the talk but you walk the walk. Your team has been known for taking risk, has learned some hard lessons, has had to innovate and not be complacent. That is summary of some of the discussions we have had with our clients.

I think those are the key words that not only reflect your investments but also your own team's work ethic and discipline. You're truly amongst the great investors Habib; it’s a pleasure to have had you today to share your thoughts with us. I think our clients and soon-to-be clients really appreciate hearing your insights.

So thank you very much and we look forward to having you back again in the future.

It's a pleasure. Thank you for having me, Julie. Really appreciate it.