QV launched its Global Small Cap Fund at the beginning of the second quarter of 2021. At the time, I wrote a commentary introducing the Fund, explaining why we launched a Global Small Cap product and demonstrating that the Fund was built to harness the same philosophy that has been in place at QV since its inception. I emphasized that we constructed the initial portfolio by screening for companies with strong quality characteristics, such as long track records of resilient earnings, clean balance sheets and strong returns on equity and capital.
Since inception (April 1st, 2021), the Global Small Cap Fund has generated a 9.1% annualized return, handily outpacing the benchmark return of 0.7%. Over 2 years to July 31st, the fund has advanced 5.6% per year compared to the benchmark which lost -1% per year on an annualized basis. While there are a few drivers that explain this relative outperformance, acquisitions involving several Fund holdings have been one of the contributing factors.
UNEXPECTED TAKEOUTS IN THE GLOBAL SMALL CAP FUND
Since the inception of the Global Small Cap Fund, five portfolio holdings have been acquired. When a company gets acquired, the acquirer typically pays a premium well above the current share price, which helps to generate immediate unrealized return. The average acquisition premium for these Fund holdings was 40%.
It is important to stress upfront that our investment thesis for these holdings was not that they would eventually be acquired. It is not a part of QV’s investment philosophy to invest based on short-term or event-driven outcomes. However, a reality of investing in small cap businesses is that they can attract the interest of their larger counterparts as they look to grow; therefore eventual acquisitions are not uncommon.
We recognize that our investing strength is not in predicting the probability of certain events. However, as part of our analysis process, we will try to contemplate the probability of certain “alpha considerations” unfolding, such as a holding being acquired, a holding seeing material valuation or margin expansion, etc. This form of analysis helps complement our base case, ensuring we are thinking probabilistically across scenarios. Out of the five portfolio holdings that were acquired, we only contemplated a takeout as a possibility for two of them. In the case of one former holding, Brewin Dolphin Holdings plc, after we had surmised that a takeout was a remote or low probability event… the company was subsequently acquired 2 months later at a 60% premium!
While these outcomes can be seen as lucky events, there are also lessons that reinforce the benefits of following a repeatable process.
INVESTMENT PROCESS GUIDES THE WAY
Brewin Dolphin Holdings plc was a wealth management company serving the UK and Irish markets with a broad spectrum of offerings. Our original investment thesis highlighted a cash flow generative business with limited capital requirements and a track record for steady high-single-digit book value per share growth through cycles. Brewin Dolphin was one of the largest UK-based wealth management companies (top 5 player) and as such benefited from economies of scale relative to peers. We acknowledged in our analysis that it was a cyclical business that did have exposure to equity market volatility. However, a mitigating factor that provided us comfort was the company’s clean balance sheet which featured no operating debt and a substantial cash balance. Brewin had managed to generate an average 15% unlevered return on equity over 10 years, while maintaining a net cash balance sheet that entire time.
In February 2022, higher equity market volatility led to valuation compression for Brewin Dolphin, an outcome we anticipated as mentioned above. The company’s earnings multiple was discounted 30% from its 10-year average. With this valuation compression, we saw a favourable risk/reward developing under conservative medium-term assumptions. Thus, despite the nearer-term uncertainty and no immediately apparent catalyst, we felt comfortable adding to the position. It’s important to emphasize how the company’s clean balance sheet contributed to a margin of safety for this investment. We didn’t face a risk of permanent capital loss from a prolonged down-market because of the company’s financial strength.
One month later, in March 2022, RBC Wealth Management announced an offer to acquire Brewin Dolphin for 20x earnings, well above the ~12x earnings valuation it was trading at prior to the announcement. We didn’t need to predict the eventual takeout of Brewin Dolphin to benefit from this investment. Instead, all we had to do was trust in our investment process and analysis. Fear of the unknown and uncomfortable emotions during a time of multiple compression were offset by a guiding process that led us to action.