Manager Ian Cooke talks to us about the QV approach
By Dave Paterson, CFA
Since the market’s low in February 2009, Canadian small caps have outpaced their large cap brethren by a noticeable margin. The S&P/TSX Small Cap Index has gained more than 80% while the S&P/TSX Composite Index rose by 54% during the same period.
Despite this outperformance, the general outlook for small cap stocks isn’t as positive as it is for the large caps. According to Ian Cooke of Calgary based QV Investors, managers of the IA Clarington Canadian Small Cap Fund, “The reality that we live in now is that the mega caps in the world, the Intel’s and the Microsoft’s, are trading at discounts to their small cap brethren.” He goes on, “You have companies with well documented successes in their business strategies, they have platforms for growth going forward, very defendable business models that are world leaders that are trading for less than small caps.”
While the environment may not be ideal for small caps, Mr. Cooke is optimistic. “We feel pretty good about our fund despite the small cap market overall, which is looking a little expensive compared to large caps.” A key reason for this is rooted in the investment approach and risk management process that is employed by the QV Investors small cap team. “QV stands for quality and value” where they are looking for attractively valued “companies that are governed by capable, candid management teams.”
“We believe that management is a very important part of quality, and we look for businesses that have enduring qualities.” The qualities that they look for are such things as discipline from a balance sheet perspective, a solid business plan and the potential to see growth in the company’s book value per share, sales per share and earnings per share. They believe that these are the “qualities that can sustain difficult periods.”
They like to see management teams that have significant ownership in the business as this helps to make sure that their interests are in line with the interests of shareholders. They also look for management teams that are honest and forthright in their discussions, and have been through some tough financial periods.
They study how the company performed during the 2008/2009 financial crisis, the technology bubble of the early 2000s and if the history is there, how they fared during the recession of the early nineties. They pay attention to how the company’s business model held up, particularly to what impact the downturns had on revenues, margins and the strength of the balance sheet.
After a company has passed the quality screens, they shift their attention towards valuation. “Once we find a company that we like, we need to look at it and see at what price we are able to make an attractive return for investors’” says Mr. Cooke.
The portfolio is fairly concentrated, holding approximately 40 well managed companies that are trading below what they feel they are worth. Like other value focused managers, QV takes a longer term view. “Our average hold period is more than five years,” says Mr. Cooke. This is supported by the fund’s portfolio turnover rate, which has averaged just over 20% for the most recent five year period.
Performance, particularly over the long term, has been strong. For the ten year period ending May 31, it posted an annualized compound return of 8.9%, which outpaced the benchmark BMO Canadian Small Cap Index by an average of 450 basis points per year. Since 2002, it has finished in the upper half in the category in every year except for 2009 and 2010. In those years, small caps were on a tear and the more conservative nature of the QV team resulted in fourth quartile returns of 29.6% and 13.9% respectively, dramatically underperforming the benchmark in both years.
“In difficult periods our risk management process has allowed us to outperform. During rallies where stories dominate and quality takes a bit of a back seat, we will tend to lag. Over time as the quality characteristics of the company shines through and the valuation discounts become more appealing, we feel that we demonstrate that this is a good process. We typically outperform in tough markets, like we see today. We continue to strive on continually improve upon our portfolio characteristics.”
When asked about the impact that the European debt crisis will have on the portfolio Mr. Cooke replied, “Certainly there will be a market impact, but it doesn’t keep us up at night.” Instead, he and Mr. Jugovic view periods of market volatility in an opportunistic way and prefer to spend their time looking to identify high quality well managed companies that have the quality characteristics in place that will allow them to not only survive through the crisis, but to also provide a return to shareholders.
One way this is achieved is by investing in small cap stocks that pay dividends. 85% of the stocks in the fund pay a dividend. Mr. Cooke says, “Historically, dividends have been an important contributor to our performance over time. It still is today.” The dividend yield on the total portfolio is approximately 2.5%, which is slightly lower than the broader small cap market. The yield is lower due to a rally in many of the dividend paying names in the fund.
“Instead of chasing the higher leveraged companies that offer a higher yield, we are looking for a higher quality company that will exhibit more dividend growth. Over time, the yield will be higher than with the lower quality dividend payers,” said Mr. Cooke. In other words, while yield is important, they are not willing to take more risk to earn that yield. Instead, they focus on the sustainability of the dividend and perhaps just as important, the ability of the company to grow those dividends over time.
They are currently holding more cash than they have in the past as a result of some merger activity in the first quarter, namely the buyouts of Gennum Corporation and Astral Media. They are looking to opportunistically invest that cash and are finding some opportunities in the oil drilling service companies such as Ensign Energy Services, Pason Systems, and Secure Energy Services. They are using this recent period of weakness to add to their current position in Stella-Jones Inc., an industrial company that makes railway ties and telephone poles. Says Mr. Cooke, “It sounds like a boring business, but they have done an excellent job over the years generating attractive returns and growing their business.”
There are a number of reasons to like this fund, namely the disciplined stock selection process, its focus on quality companies, long term track record and lower than average volatility. In our opinion, the biggest drawbacks to this fund are its MER which is 2.93%, and its performance in rising markets. Considering the above, we are rating the fund $$$. While we believe that this is a high quality fund that will do well in periods of high volatility, based on the current market environment, valuation levels and outlook, we would favour the BMO Guardian Enterprise Fund (GGF 464) or the Beutel Goodman Small Cap Fund (BTG 799).
For investors who are interested in SRI, Ethical Funds offers the Ethical Special Equity Fund (NWT 067) which is very similar except that its holdings have been put through Ethical’s rigorous ESG screening criteria.