The beginning of the second quarter of 2024 marked the three-year anniversary of QV’s launch of our Global Small Cap strategy. As we wrote about here, the QV Global Small Cap strategy was launched to provide existing and new clients with exposure to a broad and deep universe of high quality small cap opportunities globally, while benefiting from the same risk-managed investing philosophy as other QV strategies. Since inception, the 3-year annualized gross return of the strategy to the end of the first quarter of 2024 was 10.7% which compares to the benchmark iShares MSCI World Small Cap UCITS ETF which returned 3.8% in the same timeframe.
Downside Protection and a Risk-Managed Approach
At QV, one of the underpinnings of our investment process is a focus on risk management. We define ‘risk’ as the potential for loss of capital, and we manage this risk by measuring and monitoring various portfolio characteristics on both an absolute and relative basis. The result of this critical analysis of risk factors has led to a strong history of downside protection, whereby our strategies at QV hold in better during down markets. An example of this favourable downside-capture in small cap investing in Canada historically can be seen below. QV’s Canadian Small Cap strategy has protected in the 8 down years exhibited below:
Source: QV Investors
In the three years since we launched the Global Small Cap strategy, the recent down year for markets broadly in 2022 was an initial test year for the potential downside protection offered by the strategy and where we saw outcomes of the QV philosophy replicated. During this year, the Global Small Cap benchmark was down -12.9% (in CAD), while the Global Small Cap strategy held in better down only -2.7% (gross).
A driver of this relative outperformance in a down market year can be attributed to the risk management characteristics of the strategy. As mentioned, the universe of global small cap stocks is very broad with over 5000 stocks. One of our goals related to our investment process is to construct an enduring, high-quality portfolio from this expansive opportunity set. Given the number of opportunities, we have been able to set a high threshold for quality metrics while building a concentrated portfolio. The result is a strategy which offers fundamental characteristics that can allow for favourable downside protection. For example, as of March 31st, 2024, the aggregate 4-year average return on equity of the strategy holdings was 13.4% in comparison to only 5.1% for the benchmark. Furthermore, the strategy maintains a debt-to-equity ratio of 23% in comparison to 57% for the benchmark. In fact, half of the strategy’s37 holdings have no net debt today (excluding lease liabilities). Clean balance sheets can act as a margin of safety and help to explain part of the defense played by the portfolio in a tougher period. Finally, the portfolio offers the above for a price-to-earnings multiple of 14.3x in comparison to 18x for the benchmark.
Under the Hood
Howden Joinery Group plc., a top ten holding in the strategy, exemplifies the above discussion. Howden is the largest distributor of fitted-kitchen cabinetry and hardware to builder customers in the UK. The company has a decentralized business model, with an intensely local store footprint, and self-manufactures 1/3 of the products they supply. Convenience and a one-stop-shop for local contractors are value propositions.
From this position of strength in its market served, Howden has delivered a 5-year average return on equity of 33.6%. This return on equity is particularly attractive given that the business has maintained a roughly debt free balance sheet over that five-year period, today with ~6% of its market capitalization in net cash on the balance sheet (excluding lease liabilities). Growth over time has been commendable, with both the 10-year sales and operating income compound annual growth rates at ~9.5%. Currently, the stock offers a 17.7x price to earnings multiple, a modest premium to its 5-year average of 17.4x. Clearly the risk management characteristics of Howden exemplify the portfolio overall.
One additional aspect of Howden’s track record makes an apt comparison to the risk-managed approach of a QV strategy. In historical periods of market softness, Howden has outperformed, taking market share in the process, which is similar to how the QV risk-managed process has led to favourable downside capture. For example, in the below chart, sales in fiscal year 2020 declined 14-15% for the market, while Howden’s sales declined 2%. While full results for the peer group aren’t out for 2023 yet, Howden estimates that the market declined 10-15% in the face of a normalization in the renovation market following a COVID demand bump. Meanwhile, Howden’s UK same store sales declined only 1.7% in 2023, indicating the repeatability of Howden’s execution in difficult markets.
Source: Howden Joinery Presentation Feb. 2024
Process is the North Star
As mentioned, the universe of global small cap stocks is large, with over 5000 stocks. That’s a lot of rocks to turn over! Thankfully however, that isn’t the approach that we take to managing the strategy. Instead, we utilize the investment process at QV that has proved well in small cap investing historically. As an example, we can take a simple definition of quality, such as continually high return on equity generation, and apply that to the universe. Out of 5000+ stocks in the global small universe, there are just over 400 which have delivered 10% return on equity or greater in each of the last 10 years, and of these, 18 are in the Global Small Cap strategy. One of our ‘Seven Tests of Equity Investing’ is ‘Portfolio Enhancement’ which answers the question “what does this holding bring to the portfolio?” We narrow our focus further by applying this portfolio enhancement test and seeking companies with the ability to execute and navigate full cycles, like Howden Joinery.
When it comes time to perform in-depth due diligence, we find no limitations with respect to the rigor we can apply. Occasionally much can be gained from speaking with management of small cap businesses, especially those that are off the radar of many. Engagement with management has been a valuable part of the due diligence process for the Canadian Small Cap strategy, and positively, this has been something the Global Small Cap strategy has been able to incorporate. For example, we have conducted virtual due diligence meetings with businesses based around the world, including the UK, Germany, Sweden, Australia and even Japan with the help of a translator!
In short, the above serves to demonstrate how a successful history of risk-managed investing across QV has been imparted onto the Global Small Cap strategy. As we wrote about here, we think that current valuations for small cap stocks are suggestive of reasonable risk-adjusted returns, while the Global Small Cap strategy additionally offers the benefit of geographic diversification. If you are interested in learning more about the QV Global Small Cap strategy, please reach out to your point of contact at QV.
