QV has a long history of investing in the small capitalization portion of the Canadian marketplace. In fact, when the firm was founded in 1996, a majority of our client assets were invested in small cap strategies. 25 years of domestic small cap investing, along with close to 15 years investing in the global large cap market, has set the stage for the extension of this capability with the launch of the QV Global Small Cap Fund earlier this year. The new strategy provides opportunity for new and existing clients to benefit from additional diversification while harnessing the same investment approach employed across all existing mandates.
THE SCREENING PROCESS: FROM 5000+ TO 35
Similar to the rest of our funds, our goal was to build a risk-managed portfolio concentrated in 30-50 holdings – no simple task given the sheer size of the global market from which we were able to select. For context, there are ~400 holdings in the BMO Small Cap Index, one of the benchmarks for the QV Canadian Small Cap Fund, while over 5,000 companies comprise the global small cap universe. To narrow things down, we leveraged our repeatable process in our initial screening. As we have mentioned in prior letters, we view investment opportunities through the lens of 7 key overarching tests: Management, Financial Record, Franchise & Outlook, Balance Sheet, Valuation, Capital Allocation/Dividend and Portfolio Enhancement. Our initial screening work for the QV Global Small Cap Fund aimed to emphasize quality characteristics first and foremost across each of our 7 tests. For example, we filtered for long track records of resilient earnings, evidence of strong cash generation through cycles, healthy balance sheets and strong returns on equity and capital (among other ‘quality’ metrics). After focusing on quality first, we filtered for reasonably valued opportunities. It was difficult to define “reasonable value” based on near-term valuation multiples alone. Instead, it was important to consider what level of profitability we believed a prospective investment could generate over an economic cycle. We also utilized other tools, such as discounted cash flow analysis, to produce intrinsic value estimates that could act as additional checks in our analysis.
The screening process was iterative, and in total we reviewed >300 companies before reaching our current 35 stock portfolio. Our quality first approach to screening also helped identify future potential investment opportunities that may have had stretched valuations in the short term. We track these stocks in an ongoing inventory for future consideration should they begin to offer more attractive value. It should be emphasized that this is still a new Fund that may remain in a state of higher-than-normal turnover as we continue to dig into the vast universe of opportunities (our typical portfolio turnover is ~25%).
THE RESULT: THE QV PHILOSOPHY IN ACTION
Below is a chart highlighting the QV Global Small Cap Fund compared to its benchmark across various metrics which highlights the comparatively better compounding within the portfolio. Furthermore, the Fund offers comparatively better value than the benchmark, while taking on substantially less risk. This is demonstrated by a forward price to earnings ratio for the Fund of 18.3x compared to the benchmark at 23.5x and a debt to cash flow ratio of 1.4x for the Fund compared to >4x for the benchmark. In fact, 21 of the 35 holdings in the Fund today have net cash balance sheets, an outcome of the quality elements emphasized during the initial screening work.
Source: S&P Capital IQ & QV Investors
One final data point to highlight is geographic diversity. As of May 31st, 2021, the QV Global Small Cap Fund had a 48% equity weight in Europe, 37% in North America, 8% in Australia, 2% in Asia and 5% weight in cash. This compares to the benchmark’s hefty 62% weight in North America. It is important to emphasize that our process did not advocate for one geography over another; the Fund’s resultant geographic diversity was a product of pursuing the best combination of quality and value opportunities from our bottom-up screening work.
In constructing the QV Global Small Cap Fund, we harnessed the same philosophy that has been in place at QV since inception. The process highlights how to think about quality and value in tangible ways and enabled us to narrow a large universe down to a portfolio of 35 attractively positioned companies today. If you are interested in learning more about the QV Global Small Cap Fund, please reach out to your point of contact at QV.
