Update: The post was included in the Carnival of Wealth and the Your Financial Independence Carnival
Note: This interview was conducted on November 4th, 2010.
Building on the approach and principles of Benjamin Graham, Philip Fisher, Warren Buffet, John Templeton and Peter Lynch, Benoît Poliquin strives to own shares of ongoing and valuable businesses. Owning top tier companies in Canada and around the globe that have demonstrated a history, ability and willingness to increase their dividends is what Mr. Poliquin places the greatest emphasis on. “We do not invest in the latest, or the next fad or technology, nor do we base our investment decisions on our (or someone else’s) ability to predict future market, macro or political landscapes,” he says. “After all, it’s not how much employment income you make that is important; it is how much income your investments can generate that will ensure your retirement.”
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Biography: Benoît Poliquin manages investment portfolios on behalf of private clients at Pallas Athena Investment Counsel. He has also taught at the University of Ottawa’s Telfer School of Management in the areas of Fixed Income investments, Derivatives and International Finance. Prior to joining Pallas Athena, he was with one of Canada’s largest securities firms working in the areas of personal wealth management and investment management.
Mr. Poliquin is an Honours Business graduate from the University of Ottawa and a holder of the Chartered Financial Analyst (CFA) designation. He is a member of the CFA Institute and of the CFA Ottawa Society.
Q: What are some of the first things you look at or tell a client when they first walk through the doors at Pallas Athena and show you their portfolio?
A: The first question is pretty fundamental: why are you here and what are you looking to us for?
I am looking to find out is what the client’s expectations are and learn about their experience and background.
From there, we want to find out what is the client’s ultimate goal. We realize it is to make money but a portfolio manager needs to quantify the qualitative as much as possible. So we’ll talk about the difference between asset ownership investing versus asset rental, otherwise known as trading. The former makes money from the assets, the latter from the markets. We are not very good traders and have yet to meet any that can consistently do it in the private client world.
The third thing I’ll want to talk about is volatility. Private clients are VERY sensitive to this. Absolute return is what matters, benchmarks are meaningless.
What follows is usually a conversation about cash flow. If you own assets that generate a growing stream of cash, that is a good thing and if this cash flow covers a known cash flow liability (the client’s real or anticipated cash flow retirement needs), then volatility from the point of view of market price is less of an issue. Take Royal Bank of Canada (RY:TSX) which pays a $2 dividend (it paid approximately $1.18 five years ago and that is why we currently own it) and can trade from anywhere between 1x to 3x Book Value. There is nothing we can do about that price volatility but to get that dividend income, we need to own the stock despite the volatility.
Eventually our conversation leads us to explain why we do trade. We try to buy things when they are priced right. Very rarely do good assets trade at depressed valuations, when they do it is because the asset has “warts” or the market is depressed. We will sell when we feel an asset is expensive or when we feel we’ve made a mistake.
We want our investors to understand what we do in relation to their situation and for that we need to understand where they are coming from. That is what the first conversation is all about.
Q: Why don’t you start by telling us in detail about your investment process and strategy (what you look to do and how to implement it), perhaps by way of an example?
A: I wish I could tell you some earth shattering secret to this investing gig. I picked up this little trick from Peter Lynch: making lists. Basically, I start with a model of what an ideal portfolio should look like. We have two: dividend income growth and high dividend portfolio. The former is for investors that are still in the accumulation phase and the latter is for investors that need income today.
The best way to describe what we do is to use the analogy of a football team. The first step is to establish what kind of team you want - we have two but most Do It Yourself (DIY) investors err in skipping this very important first step.
What I mean is that I don’t act (at least not right away) on the majority of great investment ideas that come across my desk. Investment research is a cumulative process, so you just have to keep at it. The universe of companies that we will consider must first pass a quantitative filter. We want to work a universe of companies that have demonstrated specific solvency and earnings parameters over a period of time. Most portfolios I see from DIY investors are a collection of ideas: some good, some not so good but no real theory and strategy to link the ideas.
So in our case, and for both portfolios, the potential investments have to have the following characteristics:
- 1. We have to understand the business. We have to understand how the company makes the sale, how much money it took to make the sale, how much to maintain the client and what it will take to do it again.
- I might be cynical but I assume management is not looking after my interests. They’ll issue themselves options, pay themselves insane bonuses and generally look after their own interest before those of my clients. So the only savior is the company’s Board of Directors. If the board ups the dividend consistently, it is a sign that at least the board is being diligent about looking after shareholders. Sometimes company management are owners and so the self dealing is kept to a minimum.
Too often, I hear money managers look for honest and driven managers working solely for the benefit of shareholders. Personally, I think it’s like looking like the perfect mate, it doesn’t exist. So when you are looking at an investment, you have to find one where you can live with the weaknesses because that is what is going to kill the relationship and cause you to sell out of frustration. This could be the CEO’s salary, the investor relations department or the way their story is disseminated to existing and prospective investors.
So an example would be YUM (YUM:NYSE) Brands. I came to the conclusion that the Chinese stocks we owned (PTR, LFC and CEO) were very richly valued. My associate disagreed with me because of the potential China represents. He is right but so am I. However, in investing, it isn’t a philosophical contest but a financial one. So I was looking for a stock that fit our dividend growth parameters after our income statement, balance sheet and capital efficiency tests had been administered. YUM Brands fit the bill. The valuation made sense so I purchased the stock at about a 2-3% weighting.
Luckily our timing was perfect and soon after we purchased it YUM Brands began attracting investor interest precisely for the reasons I bought it and believe it or not that brings on its own set of problems.
When buying the shares of YUM Brands, I had in mind a hard sell target. The sell target was predicated not on an absolute price but on valuation (ie. at the point the stock becomes expensive relative to itself, to the market and to the price of money/interest rates). This sounds a lot more complex than it really is. Essentially this valuation metric is reflective of the company’s financial success and recently our sell target was reached so I sold the stock. I haven’t regretted the decision …yet!
Q: Can you talk a bit more about your selling discipline?
A: The buying and selling decision making process is where the investment science becomes more of an art. Mathematics gives way to judgment calls. All else being equal, we will sell investments when we realize we have made a mistake (and hopefully, this assessment is made relatively quickly!), or when we have made a significant gain, and the integrity of the portfolio is skewed towards this gain. We will also sell an investment (or a partial sale) if we find better opportunities elsewhere, or if we find that the ingredients for the success are waning. We do not sell because a particular investment is “up” or “down”.
Other secondary factors will be considered such as asset allocation questions, the client’s tax situation along with a myriad of other market driven factors. We do not manage our portfolio in relation to any benchmark, where our goal would be to exceed the performance of a certain index or benchmark.
We prefer to ease into (or out of) a particular position by averaging both the purchase (sale) price and the timing of the purchase (sale). The goal here is to use market volatility to our client’s benefit.
Q: Can you talk about your asset allocation parameters and strategy and how that might change/differ with different clients/needs?
A: Under normal circumstances, our asset allocation is 50% bonds and 50% equities, which is what we consider neutral. However with today’s low rates, these are not usual times and so I am revisiting/ questioning the wisdom of this rule. This rule is actually taken from Benjamin Graham’s The Intelligent Investor - Chapter 4 I believe. If it was good enough for him, it should should be good enough for our clients. We have not strayed much from this type of allocation in the past. On the bond side of the portfolio, we generally prefer a laddered, diversified (a large number) of Canadian corporate bonds. On the growth side of the portfolio, we will include Canadian stocks, but we put an emphasis on larger more established names. We do leave room for smaller issues, but they must reach minimal trading liquidity thresholds. Depending on prevalent pricing, we might deploy assets more quickly to one asset class versus another but the long term goal is a balance approach.
Q: How do you approach and control volatility, if at all?
A: This probably the biggest issue if you manage money for retail investors. We are seriously looking at a covered call + collateralized (with cash) put strategy. Essentially, the theory is that if I have “hard” sell and purchase targets, it makes sense to actually collect a premium to have them. This would in effect, sell volatility and in Canada where the options market is very thin, the seller has a distinct advantage as the seller is the provider of liquidity. However, I am not sure thus strategy controls risk that much. I mean, if the market were to tank 20%, you’ve been put the stock, and yes, theoretically, you made a killing on your calls but from experience, during times of market turmoil, theory goes out the window and correlation for every thing goes to 1. But what this strategy does for you is keeps you in line.
Every money manager will have a tendency to try to outsmart the market. Once your stock reaches your target, you tend to want to “squeeze” every extra bit of $$ out of them and that can end badly if the market drops on a Monday morning and you missed your target. Same thing on the entry point. You wait and wait for your price, meanwhile your clients ask you why you have cash lying around and then as you see your price the urge to get a better price is so strong that you continue waiting and then you wake up on a Monday morning and the futures are up 3%!!! With selling call and puts my goal is to simply add the premium income to the overall return. So if my portfolios earn 4-5%, I can add 50%-100% of that with income from the option writing program and this is independent of what the market will do. The downside is that you are left behind in a a strong upward market as all your calls get exercised. Getting the theory right is one thing and I believe we are there but getting the mechanics of trading is another and that is still a work in progress for us.
Q: Can you talk about your general view of the markets currently from an earnings, valuation, interest rates and investor sentiment standpoint? Secondly, does your macro view of the markets in general play a role in your investment process or do you focus strictly on bottom-up stock/bond picking?
A: Since the crash, even us bottom-up guys have now had to keep an eye on macro events and frankly, I don’t like it. In my humble opinion, PhDs in economics/finance should be barred from 200 yards of any trading floor. Right now, Helicopter Ben is messing with valuations with his quantitative easing. We all know this is going to end in tears. The valuations in most stocks simply don’t coincide with the economic reality of today and what a reasonable investor can expect 6 months from now.
The truth is that we cannot predict the future and PhDs in finance and/or economics spend countless hours trying to model the world of finance. There are too many variables and imponderables to model. So to make modelling easier, variables are excluded. The problem is not so much the models or the brilliant people who build them; it’s that these models are then put in the hands of people who essentially test the limits of these models with other people’s money and leverage.
So in short, I am very bullish on the markets over the next five years but over the next 6-12 months… not so much. I do hope I am wrong as I have been in the past more times than I care to admit!
Q: Given your focus on dividends, can you talk about some of the characteristics and metrics that you look at and analyze when selecting dividend paying companies to buy?
A: When you look at an asset that pays you a stream of income, you have to do the following (in my opinion):
- 1. Understand how you are getting paid?
- Is this model for paying sustainable?
- How is this payment going to grow?
- What is a fair valuation for this stream of cash flows?
Q: Other than buying dividend paying companies, how else do you build an income portfolio - do you buy preferred shares etc?
A: We buy bonds and common stocks. I cannot understand why anyone would buy preferred shares. They are great for the issuers, very lucrative for the firms that bring them to market and the firms that trade in them. I once remember reading about a trader at Scotia Capital who only traded preferred shares . I am fuzzy on the details but I remember he was getting fired because he essentially had an old school contract of 50% of the P&L (banks do not issue those anymore but somehow this guy had one of these relic employment contracts from the past) and the guy had made an insane amount of money, something like $20M, making a market in Canadian preferred shares.
On the Pallas Athena website, we’ve published a tutorial on preferred shares that highlight some of its problems. The bottom line is that a preferred share has the downside of equity (no contract to ever see your principle) and the downside of bonds (interest rate risk and no upside in dividend increases). You issue preferred shares to buy an asset. The asset pays for the preferred issue and as a shareholder you are not diluted while your bankers and bondholders are happy (because you didn’t add leverage). Once the preferred issue matures, you can re-issue more or if you structured yourself correctly, the asset you purchased paid for the preferred share issue.
My favourite observation is how Paul Desmarais (of Power Corp.) built his fortune with preferred shares. His companies are one of the largest issuers of preferred shares in Canada. An instance would be when he did purchased Canada Life, a whole bunch of his subsidiaries did almost simultaneous preferred share issues. Given that the Desmarais family are the largest shareholders they don’t want to either lever up too much or dilute themselves when making an acquisition so preferred shares are the perfect vehicle for them. They use the tax system and the Canadian brokerage system in their favour. If you look at their corporate history, you’ll see that a major acquisition usually is either followed or preceded by a preferred share issue. That is how he has been able to leverage a bus company running routes in Northern Ontario to owning the Voyageur Bus Lines in Eastern Canada, owning paper mills to owning a lock on French newspapers, oil and water in Europe, mutual fund companies and insurance companies in North America.
Q: When it comes to bonds, what are some of the characteristics and metrics that you look at before making a purchase? Is there a particular type, duration, grade/rating of bond that your prefer over others?
A: Since we manage retail money, we over-diversify our bond portfolio. No issue is more than 3% of the overall portfolio and no industry is more than 10%. We historically have only done corporate bonds but we did buy some Aussie and Aussie State/Provincial bonds a few years ago. So we try to stretch a little on the bond side of things. The problem with bonds is that you can’t stretch too much without worrying about currency issues.
Q: Before we wrap up, what is your highest conviction investment idea currently?
A: I think for anyone with a 5 year horizon, Natural Gas is very compelling. It is the most despised asset class right now and new technology along with advent of shale gas has convinced everyone one that we have an excess supply of natural gas. No one, it seems, remembers the brown outs and power outages and gas at $15/mcf. I am not convinced shale is the panacea because of the drop off in production volumes after about 24 months of the wells being tapped. That’s a debate that seems to get ignored.
In the resource world, the company that has the best land package wins, period. We think Encana (ECA:TSX) has some of the best land holdings because it used to be part of Canadian Pacific Railway (CP:TSX) and they were given the very best lands by John A. MacDonald (in fact, if memory serves me correctly, his government fell because of scandals surrounding the creation of the Pacific Railway). Not only does ECA pay a nice dividend but they have also increased it during difficult times. They’re also profitable at the current low natural gas prices. Another interesting one is Precision Drilling (PD:TSX).
The accounts that I manage own both PD and ECA.
Thank You, Mr. Poliquin!
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