Steve Bleiberg
Welcome to the Actively Speaking podcast, where TD portfolio managers and their expert guests tackle current topics concerning capital markets and portfolio management. Join us for a fresh and insightful discussion from the perspective of an active manager. Welcome to another episode of Actively Speaking. My guest today is David Siino, who is the lead PM on our capital reinvestment strategies.
Welcome, David. Thanks, Steve. It's been, it's been a tough couple of years for Quality and Capri, as we call it. It's very much a quality focused strategy, like quality has really been struggling in the last few years. So I'm going to start out with just some numbers to set the scene here before we turn to a conversation.
There's a couple of ways you could look at this. So last year for example, if you look within the Acxiom equity risk model for the for the world as a whole, they have a dozen style risk factors that people are probably or our listeners anyway, are probably familiar with, like size, you know, value, growth and the absolute worst return last year in terms of the dozen style factors.
And in fact, the only one that was negative was profitability, which is, a very good proxy for quality in our minds. Again, it was the only factor that have a negative return, and it was the worst return, obviously, since it was the only one that was negative. Of the dozen factors, now there's a almost 30 years of history for maxima on these style risk factor returns.
There's only one other year prior to 2025, when profitability had a negative return, and that was 1999. And that's not necessarily a great omen, because we all know what happened in 2000, 2001, after, you know, a year in which companies were not rewarded in 1999 for being profitable, they were rewarded for other things, which people with, the longer memories they will remember that that was all about, you know, the new economy.
And, it was all about eyeballs. And, you know, profitability supposedly didn't matter, didn't end well. And, are we setting ourselves up for a repeat of that? Now with profitability again having a negative return in 2025 for only the second time? It was it was it was the first time last year that profitability was the worst performing factor.
While it did have a negative return in 1999, it was not the worst performing factor that year. But last year it was both negative and the worst performer. The other thing I would say about quality is that it does have a very good long term track record. Quality has tended to outperform over time now. MSCI, for example, has a subset of the world index that they call the World Quality Index.
We have about 44 years of history on that index. It's outperformed, 27 of the 44 individual calendar years. So that's a 61% batting average. But if you break it down, it's not you know, it doesn't just sort of it's not a random thing as to when it outperforms or not, just with a 61% average. If you break the that period, those 44 years down into baskets, based on what the overall world index did that year, from very strong returns to negative returns, what you find is that that batting average is highest when the market is down, when the broad market is down.
There were ten of those 44 years where the world index had a negative return. Quality outperformed in nine of the ten. The only exception being 2022, when energy was by far the best performing sector as the war in Ukraine broke out. And, quality indices tend to be pretty light on energy. So quality underperformed that year. But the other nine of the ten down years at outperformed and the capture ratio was only about 63% of the negative return quality.
Now there's was only down about two thirds as much as the market on average in those years. When you go to the other extreme, in years, there were 17 years where the world index was up more than 20% for the year. Qualities batting average in those 17 years was only 47%. So not only below its long term average of 61, but below 50%, meaning it underperformed more often than it outperformed.
I guess it was nine years of underperformance, eight years of outperformance, and the capture ratio on average was 100%. So it's kind of, you know, didn't really add any value in those strong up years. It sort of did what the market did and, you know, outperformed roughly half the time, underperformed roughly half the time. So that's not when quality shines.
It really shines when the market's down. It also does quite well in those periods in between those two extremes of periods when the market's up say, you know, 0 to 10 or 10 to 20%, batting averages is 71%. And in the years when, the market's up single digits and tends to capture, 120% on average of the market return.
So quality has value over the long term, but it's not necessarily going to help you in strong up markets. It's really it helps you in down or modest markets, particularly the down markets, because the smaller the hole you fall in to, the less you have to go up to get out of the hole. So those are important things to keep in mind about quality.
So last year not a good year for quality. And while it works over the long term, last year was not a surprise in the sense that the market was up more than 20%. Quality did not outperform. So now, David, I want to bring you into the conversation. Let's talk about why this has been happening. Some people are making the argument that the types of businesses that, for example, we buy in the McCaffrey portfolios, which have these quality business models, tend to be, for one thing, capital light, because obviously, but that's capital you have tied up in the business.
The easier it is to earn a high return on that capital. If you don't have a lot of dollars tied up in hard assets. So and so you think of things like software companies or, you know, or platforms, things like that. And some are making the case that those kinds of business models in particular are very vulnerable, are the most vulnerable to AI disruption, you know, software being something that you know, in recent months has come under a lot of pressure in the markets because people thinking that, you know, you're not going to anybody can can vibe code now with, with AI, you know, software businesses are the moats are reachable.
Whereas, you know, you think about sort of businesses that where the old expression was, you know, bending metal, you know, or where you're working with physical stuff like, like drilling for oil and pumping it out of the ground that can't really be displaced by AI. You can't have an AI bot produce oil from nothing. You have to actually drill into the ground, get it out and take it, you know, and ship it around.
What do you make of that argument? Do you think that's the case, that, is the definition of quality changing the definition of quality isn't changing?
David Siino
Steve. I think the where it shows up in the economy might be, but I just want to touch on a couple of things that you said, with regards to, you know, what's going on in the market.
I know you mentioned sort of eyeballs and clicks earlier. Yeah. So part of what we're seeing, in terms of quality underperforming, I think, is there's a good old fashion mania going on, you know, sort of particularly with regards to, to software. You know, we've seen these sharp corrections in software stocks, because analysts were valuing them on things like annualized recurring revenue and remaining performance obligation, you know, whenever.
And we'll start to use acronyms other than, earnings or returns, that, that that's probably a worrying sign. These maybe weren't the highest quality businesses to begin with. And by the way, you know, there's a fair degree of stock based compensation. Compensation which analysts are only now getting around to sort of not not detracting from the model.
So analysts would say, well, a stock compensation is a is a non-cash expense. Let's just, you know, let's just forget about that. You know, we'll add it back to the earnings one another cash earnings. Well, so I think with regards to your question on quality, many of these software businesses were not quality businesses to begin with. It doesn't mean certain aspects of software are not particularly vulnerable to things like vibe coding and AI in general.
But, quality is the same as it's always been. It's just where it's being expressed. You mentioned sort of, metal vendors, you know, let's just say, let's just call those companies, in the business of atoms, versus software companies in the business of bits. Well, for a long time in our economy, the bits were winning.
If you were a business that, did not require a lot of capital, that was a virtue because, you know, that the bits were sort of you have this intangible value which, wasn't necessarily manifested in sort of, the physical value of assets. But businesses that make hardware, in certain sectors, I think are I don't even want to call it new.
I mean, TSMC has always been a quality company. Atlas Copco has always been a quality company. But I think what we're seeing is the underlying drivers of the economy are moving. Maybe the bits are becoming more expensive, the atoms are becoming more, have a more pricing power. And when I say the bits are becoming more expensive, well, there will probably never be a better business than Google Search was from, you know, 2000 to 2021.
Now Google has to invest a lot of money. Its search business is certainly not under siege, but under threat from, these sort of AI chat bots where consumers seek information if not, to, to, to consummate a transaction. So the ROIC in in previously what we thought were indefensible businesses like Google and Meta have started to inflect Microsoft Amazon.
So quality is being dispersed and diffused now more so through the economy. And that is a welcome sign for various stock pickers such as ourselves.
Steve Bleiberg
Yeah. I remember, you know, during the, the.com boom 25 years ago when people would talk about this new economy. And my feeling then and now, as always, it's not.
And there's nothing new about this. It's still capitalism. You know, the definition of capitalism is somebody has capital and they're putting it at risk because they want to earn a return on that capital, and they're not going to be satisfied if you say, well, we didn't make any money, but, gosh, we got 10 million people looking at our website.
It doesn't matter. You know, they want they want to earn money because that's what capitalism is all about. And it's the same today. And so yeah, it's I always just I think that's helpful to keep in mind another, type of business that's been under siege to some extent lately, like, like some of the software companies, although maybe you're saying they're not necessarily under siege, but some are.
Yeah. So the ones another type of business that's seemed threatened is the sort of it's not software, but sort of business information companies that gather and distribute information, whether it's, you know, to insurance companies, whether it's to, you know, wires, all these sorts of things, right. Their stock and trade is just data and information and those seem like, again, doesn't require a lot of capital.
But are those are those moats being, you know, threatened?
David Siino
I think that that's been a narrative which, which I don't believe and and let's I think you were referring to businesses like relics of the old Reed Elsevier. Verisk. Right. Move. Companies with that are the so-called systems of record in the, industries and, and, communities that they participate, that they serve.
So a read Elsevier would have, 100 years of, legal documentation and, and legal sightings, which, yeah, perhaps a in an AI company can make a, a better user interface for an attorney looking for information. But the proprietary data, that businesses like Reed Elsevier various is another one. Right. Move. They have mindshare and they have years and years of data, which by definition just can't be replicated.
A lot of it is public, but the way it's been aggregated, is certainly not, not easy to for someone else to come in unless they have a lot of capital. Going back to your point about capitalism, if you want to spend billions taking on, LexisNexis, LexisNexis, and Westlaw in, in legal information, go ahead.
These companies can probably outlast you. They are not asleep. So it's not as though the these businesses are kind of these slow whales looking to be attacked. They're like the shark. They're still moving. They've they never stop. And they are adjusting to the new world. They are investing in AI to invent, enhance their user interface, to enhance their user experience, to enhance the ability of, of their products to, to serve the end user.
So, I think it's healthy competition. It will help make these businesses better. But what they have that can't be replicated still can't be replicated. Let's put it that way.
Steve Bleiberg
Yeah. I mean, you're making an important point here, which is that, you know, just because somebody comes along and says some AI company comes along and says, well, gee, we can create a software package.
You know, we've vibe go to this software that does what this other business out there does. Well, they don't do it. The software does what that other company's software does, but it can't do all the other things that that company also does, like servicing its clients. You know, there's a business is more than just the piece of software in the middle of it.
It's, you know, there's a lot more that surrounds that, the infrastructure around the business, you know, and as you say, those companies, the existing companies may well be clients of the AI companies for that software in the middle. But there's all this stuff that, you know, comes before the client acquisition and the servicing, the clients and all that stuff.
That's part of running a business. It's more than just the software.
David Siino
Yeah. The utility of the product is ultimately what the attorney or the university researcher or, the insurance adjuster, it is what they're after. And when I say utility, the product, I mean, does it have what I need? Can I access all the data that I need?
And this user interface is nice, but, the underlying data set, this is still, still where it once was.
Steve Bleiberg
Yeah. You also mentioned, sort of, in passing a little while ago about that, some of these big companies that were once we thought of as capital like businesses are now, in fact, huge, spending huge amounts of money, on CapEx, on these data centers and on the machinery to go in them.
And how is this going to you know, this obviously means big increases in depreciation expense for these companies. It's going to really change the shape of their income statements is that do you think there's, a potential trigger there? People worry about there being some sort of quote bubble in AI and is do you think that's a potential trigger for people to start getting worried when they start seeing these big depreciation expenses? You know, popping up on the on the income statements for these companies and, the material impact that that will have on their reported earnings and on their cash flow. Obviously, the CapEx itself will, reduce their free cash flow.
David Siino
Yes. And, in particular to what you said. Yes. So depreciation expense is going up quite sharply. If these companies are to maintain their profitability, which we define as their return on investment capital, then they will have to do one of two things.
All the other expenses they'll have to cut. I mean, probably a lot of people possibly. Or they'll have to generate a lot of revenue, from these investments to leverage the depreciation expense, maintaining that that dollar of profitability, the dollars of profitability. Pardon me. And to date, we've started to see some cuts at certain companies or others.
But the revenue is just not there yet. You know, it's on the come if you listen to, these company speak. But it's interesting, you know, a company like meta, not the big on them, but, you know, the most important number used to be. Well, how many? What are the monthly active users? How many people are using Facebook or Instagram or WhatsApp?
Now people ask, you know, well, how much are they spending? How much are they? What's CapEx for next year? And then we're talking figures in hundreds of billions of dollars. So if I'm just picking a number of medicines, $100 billion next year to match their current return on capital, let's say somewhere 25 to 30%, can expect to earn 20 to $30 billion of after tax profit on that 100 billion of spending next year.
That's going to take a long time to figure out if they do. And they could be right. But we just we just don't know. All we know is that right now, the profitability of these businesses, as we define it, has inflicted, which historically has not been a, a great omen for the future. Is that performance.
Steve Bleiberg
One of the things I think we forget when we talk about the poor performance of quality over the last couple of years, is we tend to focus entirely on the AI aspect of it. And, you know, the fact that some of the companies that have done really well by supplying the, you know, the hardware or they have to pay for the physical stuff for the data centers that they are not quote quality companies by the existing definitions about high returns on equity and low leverage, all that stuff. And but the other side of this is that one of the other big components in those quality indices is health care. And health care has been doing very poorly over the last few years, you know, now, does that have something to do with AI? Maybe. Maybe not. But talk a little bit about, you know, what? And we did an episode of this podcast with, Tim Wingard, about what's been going on in health care the last couple years. But, do you see what how does it from your perspective as the portfolio manager, what do you see in the health care sector and the what that's likely to mean for quality as a as a style?
David Siino
Sure. Well, in terms of return on invested capital, we haven't seen the decline. That that you would think was implied by the stocks underperforming, many cases.
We've seen an increase in the returns on account of the pricing power and, and the underlying growth rate of these businesses. You know, we are consuming, particularly United States, more health care as an aging society and as more sophisticated treatments become available. But certainly the the sort of regulatory risk has increased. The federal government, is a big consumer of, so-called life sciences tools, in their research and, and regulatory, framework, beginning with DOJ's last year, continuing through today, this administration has been more circumspect in, in investing in these sort of things.
So, there are certain parts of health care which have, been diminished by a change in the in the regulatory environment. There's this view that, well, this so-called most favored nation, you know, these agreements that, that President Trump has made with other nations is going to have a knock on effect on the prices that pharmaceutical companies can charge in the United States.
And that has, we've had a lot of press releases, but we have not seen a, significant impact on the gross margins. You know, a lot of this is, is optics. Some of it is real. But, I think the, the political narrative hasn't helped, I think coming out of Covid, that there was quite a bit of overconsumption of, so some of these life sciences tools, during Covid and there was a lot of inventory in the channel.
The big percentage of the sales generated in China, it, as it turned out, were sort of, sham sales or kickbacks, which had an additional, additional negative headwind on a lot of these businesses. So, as we like to say, the forces of gravity will prevail. And, and, these companies will perform once again.
Steve Bleiberg
Okay. So I think you mentioned, triggered another thought about one of the other components of quality in the indices tends to be, consumer staples, you know, food and beverages. So all of those companies have powerful brands, and that gives them pricing power and high margins. But they tend not to grow that much. But nevertheless, one of the things that I think has been seen as a risk to those companies has been these GLP ones that, you know, people are eating last, drinking last, you know, how is that, how are you thinking about that in terms of the names we own in the portfolio? Are you seeing any impact?
David Siino
You know, certainly the, the alcohol name which we used to own continued to, undershoot our what we thought revenue growth was going to be. And as it turns out, a lot of it was due to, not just younger people drinking less, but drinking different beverages, drinking, drinking healthier. And, and there is this GLP one issue which has clearly weighed on demand for alcohol packaged foods businesses like Costco, Geronimo Morton's, you know, sort of the purveyors of, food which, which aggregate market share and, have very low margins.
But because of their skill and in, in generating traffic in their stores are still able to generate, quite attractive returns. And that brings us to, you know, so these so-called quick serve restaurants think of, yum brands with Kentucky Fried Chicken or, Chipotle or Domino's Pizza. You know, I think the more pressing issue for those businesses lately have been, just sort of that the, the pressure on the low end consumer, the heavier enforcement of immigration regulations, which, you know, hurts not just employment at these types of businesses, but also consumption, but nevertheless, as we said today, the returns on capital that, you know, we look at yum brands and, and, Domino's Pizza in particular, these so-called franchise models, which, are still growing, consolidated their categories. And even in spite of this headwind from glib ones, they are able to adapt, shapeshift and offer healthier, perceived healthier, offerings which maintain the sales growth. And it maintains or even expands the level of returns they've generated historically.
Steve Bleiberg
Okay. To wrap up, I'm going to sort of pull back. Let's go up to like a 50,000ft level. I'm gonna throw out a, you know, a proposition or an idea and see what you think of it, which is if you think about, you know, the last couple of decades that stocks have done, stock markets have done quite well.
It it's largely been driven by kind of an upward trend in margins, you know, in businesses in general, in particularly in what we've come to call these quality businesses, these capital like businesses. And so like the profit share of GDP has tended has been pretty high. The labor share of GDP has been low. And when you think about what AI is possibly going to do to the economy, you know, it seems like, yes, there's this potential risk to some of these capitalized businesses that had been very high margin.
The question is, where does what happens to profitability in general? Is it that in the several scenarios one is, well, one, obviously it's just stays where it's been, but if it's changing, does it is it that profitability shifts to what used to be sort of, quote, lower quality businesses like we talked about the, you know, the physical manufacturing, you know, it's hard to see how those why those suddenly become more profitable, start earning higher returns on capital.
I'm not sure why that would happen. You know, maybe I had some way to make them more profitable that we haven't been talking about. Or is it that, you know, the profitability just kind of goes back to labor, although that two seems hard to fathom in a world where AI is putting jobs at risk, it would seem, why would the labor share of GDP benefit from this?
Or is it just that the overall level of profits goes down that in essence, this I just makes the economy more efficient in the sense of there's just less, sort of surplus to be had by companies that that makes it harder to distinguish yourself and harder to charge higher prices and have pricing power. And so maybe there is just a lower level of profitability overall that would sort of come out of that, that, that those quality businesses, I wouldn't necessarily get read it, consumers would benefit, in a sense, from lower prices.
David Siino
Yeah. Well, that, that that would be a big call to make. I think the only evidence we have is human nature and history. And, Steve, if you and I were doing this podcast there, and what we would have been doing in, in the 1870s, we'd probably be having the same conversation. Or will the railroads do this or will be the next one?
Will the automobile do this? Will electricity do this? Will the internet do this? That's the most recent fear. Well, you know, the internet is going to put main streets across America are going to be empty because we won't need physical stores anymore. Everything's going online. Maybe that's a little bit of an extreme scenario, but, you know, we both were in the business then when when it seemed that, brick, brick and mortars were, under threat as, as a broad category and a lot of that was true.
A lot of the retailers that were popular then or no longer popular now, but there are new retailers that have found a way to succeed in this environment, with a lot of employees. And, I think if human nature tells us anything is that, we don't put ourselves out of work, I think it's not in our self-interest.
We are very self-interested, creatures, and as are most. And I think that, you know, fears of we will adapt, businesses will adapt. They use it as an efficiency tool the same way we've used the PC, the internet, the auto, the automobile, the elevator. I mean, just all these things that, could have been perceived to threaten broad swaths of the the employee market.
I don't think there's evidence to say that I will have the sort of that sort of impact. It will be a tool. I think it'll it'll have the most impact in what I thought of as lazy or big, inefficient businesses like, you know, like banks, for example, or financial services, typically very, capital and human intensive business, which the number of employees employed in financial services in the United States has flattened out.
But the profitability contribution to the to the broader economy continues to go up. So maybe these tools will have the greatest impact on businesses that could probably use, maybe some more streamlining or, more efficient processes. But I don't think it will have this sort of cataclysmic event which makes for good, makes for good reading. But, I'm highly skeptical.
Steve Bleiberg
Yeah. The, I think if we learned anything from history, it's that these sorts of technological revolutions, they do, disrupt things a lot, and they do eliminate some jobs. I mean, you know, mechanized farming, reduce the number of people who work in agriculture dramatically. But there were, you know, new jobs were created. And that's the tricky part, is that it's always difficult to see where those new jobs are going to be or what they're going to be.
You know, 25 years ago, nobody knew, you know, before the iPhone came along, the idea that somebody that would spend their time as an app developer, I never even would have known what that was. If you talk to them, if you went back in time and said to somebody in 1995, like, oh, yeah, you know, we develop all these ads like, what's an app?
What do you mean? We don't even know what those new jobs are going to be. And that's why people get, worried and nervous. I think it's because they don't they can't see those new jobs because by definition, you don't know what they're going to be. And so they can't imagine what the what they could possibly be.
And they will. Everybody's gonna be out of work. But yeah, that's certainly not not what's happened historically, as we've always found, you know, new avenues for people to, to express themselves to work. You know, it seems to have worked out okay in the past, so. Well, David, thanks for joining me. This has been a great conversation.
David Siino
Thanks, Steve.
Steve Bleiberg
And, to our listeners, thank you for listening.
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