In biological systems, evolution entails small changes that are imperceptible over years but over centuries and millennia, can compound into large shifts that enhance the survival of a given species. Similarly in asset management, albeit over a much shorter time frame, small improvements in our pattern recognition of investable ideas and in our investment process should lead to better outcomes over the long-term. Part of the investment process at QV is to reflect on past investment decisions with the additional context of time in what we call After-Action Reviews. Some common learnings from these spirited discussions that the QV Investment Committee has had recently are shared below.
A common learning was that the quality of management matters and paying attention to their level of execution is especially important in investments where the thesis relies on turning around a weaker recent financial record into a stronger record. For example, we have observed with previous holdings that management teams who have communicated a commitment to change and a plan of action sometimes do not follow through on executing well, leading to poor relative returns. Some process improvements we have made over time to better assess management teams are to: 1) closely analyse the context behind a management change for our portfolio holdings through a formal management scorecard checklist that we have developed; and 2) more clearly document and communicate our assessment of management including their execution of articulated strategies through frameworks that have evolved over time. For example, Fenix Outdoor International AG is a fashion and outdoor goods retailer based in Sweden owned in the QV Global Small Cap Strategy. They have an excellent brand and growing awareness, but capital allocation recently has been weaker. When we spoke with management, they were candid about the mistakes they have made, outlined a plan that should lead to improved performance, and showed us progress they have made towards this plan, all of which gave us more conviction in this investment.
Another learning was around better balancing an attractive valuation with attractive qualitative characteristics. We observed that in some instances, we have added to investments whose qualitative characteristics were not improving but the valuation was, and this has sometimes led to poor relative returns. To be more mindful of changes in quality and valuation characteristics of a given investment, we have a QV Matrix tool that plots our quality and value scores for all portfolio holdings and near-investable ideas on a 2D scatterplot. The goal is not to skew towards quality without a consideration for value or vice versa, but to ensure that we have an appropriate balance of ideas across the spectrum and also that within each investment idea, there is an appropriate balance between quality and value. For example, we exited Enerflex, a QV Canadian Small Cap Strategy holding, after they announced a large acquisition that would meaningfully increase leverage which added to concerns that we already had around management turnover and weaker fundamental performance. While the stock price decreased after their announcement making valuation more attractive, we were uncomfortable with the much higher risk, hence lower quality of the investment, and decided to exit.
Interestingly, we have observed that for more cyclical companies, the pedigree of management may be less of a differentiator whereas valuation is more impactful to the investment outcome. For example, the QV Global Equity Strategy added to their weight in Bank of America, a market leading US financial services franchise, during the pandemic at a very attractive valuation and subsequently trimmed their position in late 2020 and throughout 2021 after the stock price rebounded and the valuation was less attractive (read my colleague Richard Fortin’s update on this topic here). This higher sensitivity to the valuation of a more cyclical investment led to positive relative returns for the strategy.
Candid team discussions like this about past mistakes are not easy to have but our culture of continuous improvement emphasizes learning opportunities. Just as biological systems evolve to survive in a changing environment, we believe that a curious attitude is necessary for us to evolve our patterns and processes. We think that this commitment to improve will lead to better long-term outcomes for both our clients and us as we invest alongside them.