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Differentiated Thinking, Differentiated Results

A Big Win for QV Clients

2024-06-19, Steven Kim



Last week, long-standing QV small cap holding Canadian Western Bank (CWB) announced that it had reached a definitive agreement to be acquired by National Bank. The deal’s premium of over 100% represented a favourable result for our small cap clients. Following the private equity acquisitions of Neighbourly Pharmacy (NBLY) and Logistec (LGT.B) earlier this year, it also marked the third announced take-out of a QV Canadian Small Cap Strategy holding within the past twelve months.

Applying a Private Approach to Public Markets

The recent takeout transactions in our portfolio highlight the benefits of incorporating a strategic investor’s mindset.  Equity investing is ownership of a business, whether taking out an entire company or buying a fraction of it. Over the long run, whether deploying capital in public or private markets, we believe investment performance will generally follow the change in earnings power, valuation level and income generation of the purchased business. In the Globe & Mail, private equity titan and Brookfield CEO Bruce Flatt recently commented on the “distractions of the public markets,” recognizing that some public market participants approach fractional business ownership like they would games in a casino. Despite many differences, including much, much lower utilization of debt and less control, there are shades of similarities between our small cap public market approach and private equity investing. Investing in the small cap space often requires broad perspectives on the valuations of companies, because direct comparables are not always obvious. Taking a step back and considering what an informed strategic investor would pay for a business is often a useful and fruitful exercise.

Doing Your Homework and Assessing the Potential

As public market investors we can benefit from the tremendous opportunities that arise when share prices detach from underlying intrinsic value. In CWB’s case, there were many reasons for its depressed share price and recent valuation level of <0.7x price to book.

Source: S&P Capital IQ

In our assessment, CWB had been ‘underearning’ relative to its potential earnings power for a number of years. This view was based on our perspective that a heavy but necessary investment phase had been weighing on net income, and that the management team was taking the appropriate steps to set CWB up for the next decade. Additional factors such as the company’s relative size and “western bias” may have also contributed to the stock’s lackluster performance over recent periods.

In hindsight, many of these concerns proved to be short-term ‘noise.’ We can view the recent bid of ~1.4x price to book as what a strategic and informed investor was willing to pay for this business. Through this lens, CWB was in fact $1.00 trading for $0.50, hiding in plain sight. While it had been challenging for the company to make the necessary investments and seek to execute its business plan in the public eye, this may have contributed to the opportunity for QV. In addition to the other two recent portfolio takeouts we mentioned, there are several companies in our strategy trading at significant discounts to peer and historic valuations. To us, it emphasizes the opportunity in maintaining a strategic investor’s mindset.

Importantly, we were comfortable with the fact that CWB’s core lending operations were soundly run on a credit basis, in absolute terms and relative to larger peers (see chart below). In addition, we believed the steps management was taking to improve its cost of funding would unlock significant value. Our thesis was that CWB was closer to the end of its heavy lifting phase, and that the depressed valuation level was not reflecting the underlying franchise quality and potential to grow. Fortunately, we were not the only ones to see this, as QV Canadian Large Cap Strategy holding National Bank will potentially benefit from the opportunity over the indefinite future. Our view is that the deal is logical, reduces risk through diversification, and enhances the growth profile of both businesses.

Source: National Bank, QV Investors

Partnerships, Patience and Time Horizon

A key feature of a private equity approach in public markets is a long-term investment horizon. We respect that discounts can persist for years. This demands patience, a commitment to tracking business performance and an attuned sense of potential catalysts to realize value. We salute our partners and clients who have shown confidence in the QV team and process. Without this mutual patient approach, it may not always be possible to realize a slower-burning but ultimately impactful opportunity like the CWB acquisition.

Although some market participants may rightly focus on shorter time periods we will use this to our advantage and remain rational as we simply look to buy businesses with a different horizon in mind. We readily acknowledge there is no secret formula, but the domain knowledge, persistent hard work, intellectual rigour, and flexible mindset we have cultivated while operating in the Canadian small cap space for the past 25+ years make a difference. It’s not always easy or comfortable to maintain an alternative view than the market. But differentiated thinking & behaviour are imperative for differentiated results.

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.

ABOUT THE AUTHOR

Steven Kim | Portfolio Manager, Canadian Equities

Steve oversees QV’s investment process and makes portfolio decisions for the Canadian small and mid cap strategies.