In our Q1/22 Canadian small cap commentary to clients, we shared that diversified and sound portfolio construction continued to position the strategy for various types of terrain ahead. At the time, we had no idea how jarring and volatile the second quarter would be. Year to date there have been very few places to hide with the S&P 500 down 17%, the TSX down 6%, and bonds down nearly 11% as of May 12, 2022. With painful inflation levels and rising rates alongside economic concerns, it has been a hostile environment for most financial asset owners.
Each QV equity strategy, including Canadian small cap, Canadian large cap, global large cap and global small cap, have significantly outperformed their respective benchmarks so far this year. We believe the preparedness of QV portfolios to navigate through both adverse and favorable conditions helped play a role in this performance differential. While we are normally reticent to discuss short-term performance, this is also typical of QV portfolios over time. Consider that there have been four instances of double-digit annual declines in the Canadian small cap market over the last 15 years (2008, 2011, 2015, and 2018), and in each case the QV Canadian Small Cap Strategy outperformed by a significant margin.
While not immune to difficult periods by any stretch, our thesis is that these outcomes are supported by a bottom-up focus on holdings and a process of preparation rather then prediction for portfolios. What does preparation look like in practice? We begin with what preparation does not look like, and progress to what it does entail at QV.
Carvana Co. (CVNA) may be a timely example of when companies are not prepared for both adverse and favorable conditions. Carvana operates an e-commerce platform to buy and sell used vehicles in the US. It traded up to $370 USD per share last year, despite not turning a profit, maintaining $5-6 billion in debt and recently spending over $2 billion to acquire a competitor’s business. With the market turning, used car pricing declining, and the company underperforming expectations, CVNA recently announced that it will be laying off 2,500 employees and is on the hook for 10.25% bonds owed to friendly neighborhood private equity lenders.
Carvana’s experience also emphasizes the recent considerable changes in the market’s willingness to pay for the business, or in other words, valuation risk. The US ten-year treasury bond rate has climbed at the fastest pace in twenty years from ~1.5% last year to ~3% this week. In 2016, Warren Buffett described it this way: “If interest rates are nothing, values can be almost infinite. If interest rates are extremely high, that’s a huge gravitational pull on values.” CVNA declined to the $30 dollar range this week. Trading at 4x-5x revenues at their peak a mere 6-8 months ago, Carvana shares now trade at less then 1x revenues. While it’s unclear how much of the 75%+ compression in multiple is due to rate changes, it is apparent that high valuation, high leverage, and high expectations provide minimal margin of safety or preparedness for challenging times.
A bottom-up focus on holdings with an eye to business performance in good and bad times is one of our first lines of defence. In December 2019, packaging supplier Winpak Ltd. was a ~2% weight in the QV Canadian Small Cap Strategy, trading at 20x P/E. In this past month, it traded at 17x earnings and now represents a 5.5% weight. Due to its fortress-like balance sheet, its P/E is <14x on a cash-adjusted basis, as it currently maintains more than 15% of its market cap in net cash after any debt. Trading at its cheapest levels in 5 years, we believe it offers value and reasonable underlying resiliency (not immunity) in cashflows due to its focus on packaging for basic food products. While investing in these types of businesses is not always in vogue, or perhaps boring in comparison to the headline dominating opportunities, over a full cycle, looking for good, attractively priced businesses provides important practical and psychological preparations.
On a portfolio level, consistent holdings-level decisions such as the above have supported the overall QV Canadian Small Cap Strategy’s preparations for good and bad times. Going back to late 2019, the portfolio’s risk levels as measured by P/E (valuation proxy) and long-term debt to equity (balance sheet proxy) have improved by over 15% to ~13.2x P/E and 44% D/E, both representing advantages over the benchmark levels. In addition, the cashflow profile of holdings is more diversified on a sector basis. Finally, the portfolio’s current anticipated return on equity of ~13.5% vs ~8% in late 2019 suggests a more robust growth outlook as well.
The market will always take unexpectedly painful and positive paths. Despite underperforming the market in periods when returns are more pressing than risk, clients can expect that preparation for the full cycle at both the underlying holding and total portfolio levels is consistently driving our decisions. Today is no different.