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A Margin Of Safety On Balance Sheets

2023-11-03, Amit Shah

The cost of debt for both consumers and businesses has increased materially as interest rates have risen from 0.25% in early 2022 to 5% today. Consider a hypothetical company with an earnings margin of 15% before interest and taxes that is leveraged three times earnings. This company could have seen earnings decline by ~13% as a result of these higher interest rates. The impact on earnings is directly proportional to the amount of leverage a company carries and the interest rate at which it can secure financing. For companies that have been negatively impacted by higher inflation as of late, the earnings decline could be more severe than highlighted in this example. In this update we highlight the importance of balance sheet strength for weathering this period of higher interest rates.


Small cap companies have generally underperformed large cap companies over the past year, as shown by the relative performance of the Russell 2000 and S&P 500 indices, respectively.

Source: Capital IQ

This may be partly explained by smaller companies being disproportionately impacted by higher interest rates; they tend to have greater external funding needs but fewer financing options and higher funding costs. According to RBC analysis, US small cap companies (Russell 2000) have a greater proportion of higher-cost variable rate debt than US large cap companies (S&P 500). Moreover, small cap companies have a shorter maturity on their debt, approximately 4.5 years versus 8.5 years for large cap companies, implying that they have a shorter window before they need to refinance at higher interest rates. This increases the fragility of smaller companies as they may also have less resilient business models and have less operational flexibility versus larger counterparts.


At QV, our investment process yields investment opportunities that punch above their weight on both qualitative and valuation attributes. One key criterion is ensuring that current and prospective investments have resilient balance sheets that can withstand duress from economic weakness and other potential risk factors. As an example of this, both our Canadian and global small cap strategies have leverage ratios that are below their respective benchmarks.

This backdrop of higher interest rates has increased financial discipline by most companies. There has been lower liquidity in capital markets; according to Refinitiv and PwC analysis, global M&A volumes and values declined by 16% and 52%, respectively, in the first half of 2023 versus the first half of 2021. For companies with sound balance sheets, however, this has been a buyer’s market with more attractive acquisition valuations. Take, for example, Canadian small cap strategy holding Definity Financial, the 6th largest property and casualty insurance company in Canada. It currently has no net debt and is in the process of reorganizing its capital structure towards that of other publicly traded insurance peers. It has used some of its excess capital for smaller acquisitions of capital-light insurance brokers with less cyclical earnings profiles than its core insurance business, which has been a reasonable way to diversify the business. Once its reorganization is complete, it will have additional balance sheet capacity to continue deploying capital opportunistically.


Highly cash-generative companies are at an advantage in this regime of higher interest rates. Gateley is a UK-based legal services provider in our global small cap strategy that has relatively low capital requirements. Most of its excess cash goes back to shareholders in the form of a dividend that is currently yielding 7.3%. The remaining excess cash goes towards small acquisitions at attractive valuations that have helped diversify the business towards other service offerings like consultancy that can be cross-sold to customers alongside core legal services.


When we selectively invest in companies with higher debt loads, our due diligence is focused on what the balance sheet could look like under distressed scenarios and whether we are being fairly compensated for the additional risk. For example, Parkland is a holding in our Canadian small cap strategy with a relatively high leverage ratio. However, it has recently made progress towards a lower stated leverage target. Additionally, its debt is well structured with maturities laddered over the next several years, reducing refinancing risk. As such, we think the risk of permanent capital loss is very low and the valuation remains attractive even after considering a distressed scenario.

It is impossible to predict whether inflation will persist or if weaker economic conditions could lead central banks to relax interest rates. Our investment process reinforces holding a diverse portfolio of resilient companies that have differentiated underlying drivers of risk and return. We believe that this process will help our clients realize attractive risk-adjusted returns across different potential interest rate backdrops.

All views and projections are the expressed opinion of QV Investors Inc. and are subject to change without notice. This Update is provided for informational purposes only. QV Investors takes no legal responsibility from any losses resulting from investment decisions based on the content of this Update.


Amit Shah | Research Associate

Amit analyzes investment opportunities and monitors existing holdings for QV’s small and mid cap strategies.