Just slightly over a year ago, cryptocurrencies hit a peak asset value of approximately three trillion dollars and there were many advertisements about cryptocurrencies including Tom Brady and his then-wife, Gisele Bündchen, on the cryptocurrency exchange FTX. Fast forward to today, the market value of cryptocurrencies is ~72% lower at $840 billion dollars and FTX has declared bankruptcy after being valued at $32 billion earlier this year. QV has no direct exposure to cryptocurrency but there are some relevant learnings for us as investors from what has happened at FTX recently that are worth reflecting upon.
FTX was founded in 2019 as an exchange for trading cryptocurrencies like bitcoin, and at its peak, was the third largest exchange globally with ~10% market share. This was Sam Bankman-Fried’s second venture after starting the trading firm Alameda Research in 2017. Even after founding FTX, he remained invested in both FTX and Alameda and close ties between the two is partly what led to the demise of FTX. Initially, suspicions were raised about how Alameda’s balance sheet was reliant on the value of cryptocurrency tokens including the FTX-token, or FTT, whose value had recently fallen sharply. This then led to a collapse in confidence in FTX that saw its customers try to withdraw their assets from the exchange. Additional details have emerged since then that FTX has ~$9 billion in liabilities and only ~$900 million in liquid assets leading to a highly leveraged balance sheet. The remaining assets were in less liquid ones like FTT that would need to be sold at ‘fire sale’ prices in order to cover any necessary liabilities.
At QV, we respect how important the balance sheet is to a company’s resilience and it is one of our seven investment tests. In our due diligence, we look at the overall leverage, the company’s ability to pay debt during tougher economic scenarios, and the quality of the assets the company has against outstanding liabilities. Within the QV Global Small Cap Strategy for instance, we own many companies that can compound at attractive rates while maintaining strong balance sheet positions. For example, Games Workshop Group is a company that we recently added to the strategy that has a net cash balance sheet and has grown earnings per share at an attractive rate of ~23% annually over the past 10 years.
Liquidity, on the other hand, is something that we view as both an opportunity and a risk. Smaller companies can trade at an illiquidity discount or at a discount relative to their larger peers but can still be excellent investment opportunities that compound into larger, more liquid companies over time. An example of this in the QV Canadian Small Cap Strategy is Guardian Capital Group. This is a financial services company that was historically focused on asset management but over time has expanded into the insurance brokerage business as well. We observe that the business is more attractively valued than much larger asset management peers in both Canada and the U.S. after excluding their stake in the Bank of Montreal that is valued at ~55% of the company’s current market capitalization. We think the company will continue to grow the current businesses organically and holds the optionality to sell their stake in BMO further to incubate or acquire other attractive businesses. However, we also acknowledge that it can be risky to hold too many illiquid positions within the strategy as our ability to sell them during times of distress is limited.
The other issue at FTX that has come to light more recently is how the company seemed to operate with a lack of integrity. For example, they allegedly used customer funds and borrowed against them to fund risky bets made by their sister-firm Alameda without disclosure. They are also suspected to have poor internal controls and recordkeeping of both expenses and related party transactions like large loans to employees. While it remains to be seen whether these acts are illegal or not, they do suggest a culture of poor integrity towards customers and a management team with a cavalier attitude towards risk. At QV, two of our core values at the firm are to uphold a “clients first” mentality and have high integrity. Risk management is also a key component of our investment process. We seek to align ourselves with management teams of companies that have similar values as we do.
What happened with customers and investors of FTX and Alameda was truly unfortunate and perhaps this combination of leverage, illiquidity, and lack of integrity resulted in an inevitable recipe for disaster. But this is also a by-product of the credit cycle. When liquidity is abundant, risk-taking behaviour including high leverage is rewarded, but once liquidity withdraws as it has this year, then such behaviour is punished. Our aim at QV has been to manage risk over the long-term and through a full cycle with an eye towards protecting client capital through more consistent returns over time.