Qualivian Investment Partners commentary for the first quarter ended April 30, 2020, discussing their investment process and the power of compounding.
“Everyone is a long-term investor until times get rough. Conviction is not proven on the mountaintop; it is proven in the valley.” – Ian Cassell
Q1 2020 hedge fund letters, conferences and more
Overview
The Qualivian Focus Fund is an investment partnership focused on long-only public equities. We own a concentrated portfolio (15 -25) of understandable companies with wide moats, long reinvestment runways, and outstanding capital allocation. We expect them to compound capital at a mid-teens rate and hold them for an extended period. We have a private equity approach to public equities. We are seeking investors that are aligned with our long-term horizon. We do not short securities. We do not take on leverage. We are not macro investors. The fund primarily focuses on US companies of all sizes but can have 20% of its portfolio outside the US.
We buy carefully. We sell infrequently. We believe the stock market is a mechanism to transfer wealth from the impatient to the patient. High quality assets with durable and growing cash flows are rare in a world awash in low and negative interest rates. When they are run by able management teams with excellent capital allocation, they are rarer still. We are quite comfortable sitting back, holding on, and watching the power of compounding work. The big money is made in the waiting, not in scratching the itch to “do something”. We do not mind watching trees grow.
Our formula: Long-Term Orientation+ Long-Term Investors + Focused Portfolio + Quality Compounders = Maximizing Chance for Outperformance.
Our investors should understand how we invest so they make the right decision (both for them and us). We are not right for all investors. We would encourage investors aligned with our long-term horizon and philosophy to contact Aamer Khan ([email protected]) at 617-970-9583 or Cyril Malak ([email protected]) at 617-977-6101.
This letter discusses our Q1 2020 performance, recaps our core beliefs and thinking, and discusses a potential portfolio holding under review.
The Twitter Version
Readers of investment letters fall into several categories: (1) those who read the entire letter in detail, (2) those who skim, and (3) those who are only interested in the twitter version. For the last category here is the tweet:
“Our performance in Q1 was ahead of the SP500 by 4.8% and 4.7% on a gross and net basis. Since inception through Q1 2020, we have outperformed by 13.5% and 11.8% on a gross and net basis. The corona virus crisis does not change our strategy. We only made two trades in Q1 and are adhering to our articulated strategy. Things are proceeding according to plan. “
Now for those who would like more detail…
Performance of the Fund in Q1 2020
In Q1 2020, we were down 14.8% and 14.9% on a gross and net basis versus the S&P’s 19.6% decline, outperforming by 4.8% and 4.7%. In 2019 we finished up 40.2% and 39.4% on a gross and net basis respectively, versus the S&P 500’s performance of 31.5%, or an outperformance of 8.7% and 7.9% respectively. Since the inception of our fund in December 2017 through March 31, 2020, we have returned 15.1% and 13.4% on a gross and net basis versus the S&P 500’s 1.6% return in the same period, outperforming by 13.5% and 11.8% respectively. Appendix 1 contains a detailed quarter by quarter performance table.
Clearly, as a long-only strategy that does not short (or employ leverage or options or other derivatives), we were not immune from the record-setting drop in the markets in the back half of February and throughout March resulting from the COVID 19 virus. However, the returns from our high-quality companies with high gross and operating margins, strong balance sheets and cash flow generation were better than the S&P 500’s 19.6% decline.
Our top three contributors in Q1 2020 were Amazon (AMZN), American Tower (AMT), and Microsoft (MSFT). Our bottom three contributors were O’Reilly Automotive (ORLY), Brookfield Asset Management (BAM), and TJX Companies (TJX).
Our Portfolio and the Bat Swan
We do not focus on the macro. We consider it a distraction. It adds little value to the investment process but consumes time and energy. Case in point: how many investment gurus discussed the prospect of a pandemic last year when discussing the market? The best use of our time is to keep pressure testing the investment theses underlying our current portfolio holdings and hunt for new compounders. However, given the mental space now occupied by the corona virus pandemic, we offer some thoughts.
Why do Crises Occur?
A crisis occurs due to an unanticipated shock. Because our minds need to simplify, we squeeze a new phenomenon into the procrustean bed of a familiar category, fitting the territory to prior maps. We mistake the unobserved for the nonexistent, and even worse, confuse the unobserved for the unobservable. Uncertainty is uncomfortable, so the human mind creates crisp narratives which focus on the tangible and visible, conveniently amputating the intangible and invisible. The unknown then visits us in the form of a black swan, causing a crisis.
Some History
Since World War II, there have been 10 bear markets, which brought an average decline of 35%. During the last bear market, from October 2007 to March 2009, the peak to trough decline was 57%. Not until 2013 did we reach a new high. On average, bear markets last 14.5 months and take 24 months to recover. From Qualivian’s perspective, market declines enable us to purchase quality compounders at more attractive prices.
Learning from a Crisis
Beliefs get tested in a crisis. Some turn out to be illusions. Constants become variables. And some variables melt into thin air. Price declines test investors’ emotions, often causing them to panic and make irrational decisions. Investors over analyze when stocks are going down and under analyze when stocks are going up. A focus on the long term provides cognitive clarity: long-term and disciplined investors who have done the work will have the conviction to hold on to or buy more of their holdings, while others are frozen or panicked by the ticker tape.
Debt Fragilizes
One conclusion one can draw from this crisis is that there will be (1) more debt at the Federal, State, and Municipal levels, (2) more corporate debt, and (3) more consumer debt. The 2020 Federal deficit is projected to be over $3.5 trillion and the US debt to GDP debt ratio over 105%. All this incremental debt fragilizes the economy and reduces its ability to recover from future shocks. In a debt-ridden world, (1) consumption is likely to decline, (2) investment is likely to be reduced, and (3) risk and fragility increase throughout the economy. Corporate robustness and antifragility become even more important.
Shift in Critical Investment Categories
Another likely outcome from the global COVID 19 pandemic will be the shift in critical investment categories from mechanical ones like profit and loss, efficiency, and optimization of supply chains, to biological ones like survivability, resilience, redundancy (buffers), robustness and adaptivity. Investors will shift their focus from a firm’s income statement to its balance sheet, and further, to its customer’s balance sheets. Fragile business models will get exposed. Robust and antifragile business models will demonstrate their durability. The gap between outstanding, average, and below average businesses will visibly widen. The strong will become stronger and the weak weaker. Problems will emerge for those businesses whose (1) earnings were juiced by leverage, (2) sales growth was enhanced by easy customer credit, or (3) earnings enhanced by underinvesting. Management teams with strong capital allocation use crises to improve their market position via investment in new capabilities, acquisitions, or stock buybacks. Weaker management teams just try to get by, and often come up with creative excuses why their business has deteriorated.
The Power Of Compounding: Has our Investment Process Changed?
Our investment process has not changed. Quality compounders are well positioned in this environment. They are much more resilient to shocks given their long-term survival characteristics including moats, secular growth drivers, high returns on capital, high proportion of recurring revenue, and asset light, high-margin businesses resulting in high cash generation. They are the antithesis of fragile business models which seek to maximize near-term earnings growth but are characterized by lack of competitive advantage, weak free cash flow, excessive leverage, and extreme exposure to economic and commodity cyclicality. Our approach is: (1) invest in quality compounders, (2) at reasonable valuations, and (3) minimize trading activity and let the power of compounding work to maximize chances of outperformance. We now give more detail about each of the legs.
Invest in Quality Compounders
There is a useful hierarchy that we can use to gauge the resilience of a firm in an economic crisis. The best firms can do (1) during a crisis, the next best (2), and the next (3).
- Grow their sales volume.
- Have pricing power to grow revenue even if sales volume is flat.
- Being able to cut costs if revenue shrinks and/or raise capital to ensure survivability.
Let Us Stress Test Our Portfolio Companies
We now highlight the “quality” in our quality compounder portfolio, given the macroeconomic backdrop we find ourselves in because of COVID 19. The following table describes the key financial characteristics of our portfolio and contrasts them with the SP500.
Our portfolio averages gross margins of 51.9%, EBIT margins of 28.8%, ROIC of 19.6%, debt/market capitalization of 46.4%, and interest coverage of 31.6X. Our companies can continue to invest in their businesses at a time when other companies are having to reduce their investments and conserve cash, allowing our companies to continue to consolidate and further gain share in their markets. Furthermore, our portfolio companies can take advantage of lower prices in the stock market by buying back stock at more value-creating prices for their shareholders or buying other companies at more attractive valuations.
Reviewing each company in our portfolio, we feel confident that in most cases, even in the face of a material drop in revenues (15% on the low end and 30% on the high end) that most of our companies with their current cost structures will be able to continue to generate positive free cash flow or break-even in the more severe scenarios. If there is an even more severe downturn in revenues, they would be able to adjust their cost structures and capital deployments to further conserve cash and remain self-funding quite easily. In most cases, our companies have sizeable net cash positions, or at the very least sizeable cash balances that will stand them in good stead through any protracted downturn. Overall, they also, have untapped credit lines with their banks that they could draw down and access credit capital markets if need be given that they are all investment grade credits.
There are two companies in our portfolio that reside in the specialty retail sectors, O’Reilly Automotive (ORLY) and TJX Companies (TJX), that may be more exposed to a protracted economic downturn. However, we feel comfortable with their ability to navigate the downturn and remain largely self-funding (while rightsizing their operating costs and capital deployments) and, in a worse-case scenario, having to access bank credit lines or credit capital markets.
This article first appeared on ValueWalk Premium.
