QVG's inflation-fighting strategies (and the next ASX 10 bagger)

In today's - frankly, mad - markets, level-headed conviction is critical. Not just conviction about stocks, but also conviction about where market trade winds are blowing. Simply having a diversified portfolio isn't going to cut it when most sectors are well down off their highs. 

This week, my colleague James Marlay hosted a webinar with Tony Waters, Chris Prunty and Josh Clark from QVG Capital. QVG manage a Long-Short and an Opportunities fund, both high conviction funds with a bias towards small and mid caps.  

Both funds have been hit by the drawdowns of the past year, a function of their exposure to small industrials and lack of exposure to small commodities. The Small Industrials Accumulation Index over the past year was down 20% while the Small Resources Accumulation Index was up 6% over the same time frame. 

That said, QVG invest for the long term, and over the long term their returns have been attractive. Over five years, the Opportunities Fund returned 8.1% per annum above the benchmark while the Long Short fund returned 16.7% per annum since inception.  

You can find the full interview here. 

In this wire, I summarise some of the key takeaways from the webinar, including:

• easing inflation pressures;
  
• fund concentration;
  
• the 'Hall of Fame' stocks QVG looks for; and
  
• the ASX stock most likely to be a 10 bagger in a decades' time. 
  

Drivers of inflation are easing

So much of the discourse around inflation has taken place at the aggregate level. While it's important to discuss headline and core inflation numbers, they do far less to expose what's happening to the drivers of inflation. And at the constituent level, things are looking better. 

First, commodity prices are easing. The graphs below show moving averages (in green) for 6 commodities, and they've all either flattened out or turned down. 

As the graph shows, most commodities are 20-30% down off their peak. 

Second, demand is easing while many supply chains are flush with inventory, which helps lower the supply-demand graph.   

"Going into the pandemic where there was an expectation that there was going to be plummeting demand and therefore manufacturing and consumer businesses would descale their investment in stock - quite the opposite was true where we had massive stimulus and huge increase in demand," says Waters. 

This table shows inventory as a percentage of revenue. If you take the most extreme example, City Chic, inventory as a percentage of revenue has more than doubled from 25% in 2021 to 53% in 2022. 

"The result of that was companies had to restock in an inflationary environment with supply chain disruptions. We're now in a situation where most companies are overstocked in an environment where we're getting rapid rate rises and a consumer downturn."

Taken together, Waters reckons this is going to be quite deflationary.  

What's more, the market has priced in the worst case scenario. So anything short of that will buoy equities.   

We saw that this week. The market expected a 50 basis point hike in the cash rate, it got 25 points, and the market surged 3.5%. 

Lack of quality = increased concentration

From a quality perspective, the ASX Small Ords is getting worse. More are cash burners than earners.

As the above table illustrates, "In the last four periods, most of the companies have been cash burners rather than cash earners," says Waters.

This has meant that QVG has had to pursue a more concentrated portfolio.

The Opportunities fund now holds 28 stocks compared to almost 35 stocks in September 2019.

This has been compounded by a lack of quality IPOs over the last two years. Only 20 companies of the 56 listed over the last two years make money. 

As a result, QVG's Opportunities Fund owns zero stocks that have listed within the last two years and four that have listed within the last four. 

What companies does QVG own in today's market?

Today's markets are unlike anything we've seen before. So what is QVG doing differently in light of it?

"Absolutely nothing," says Waters. 

The filters are the same as they've always been. QVG looks for companies that have pricing power, growth, balance sheet strength, defensive earnings, high returns on capital, high margins.

It just so happens that these businesses are well suited in inflationary environments.

Given share prices follow earnings or free cashflow per share, QVG have an overwhelming preference for defensive growth (such as CSL ASX: CSL or Aristocrat ASX: ALL) where performance comes irrespective of economic growth, or cyclical growth (such as Lovisa ASX: LOV or Imdex ASX: IMD) which are exposed to consumer and mining cycles.

"Those businesses we believe have internal organic growth drivers that can power them beyond the cycle," says Prunty. 

"We can have a high conviction of delivering growth at or better than market expectations."

QVG's top five holdings currently includes Hansen Technologies (ASX: HSN), Johns Lyng Group (ASX: JLG), HUB24 (ASX: HUB), Lovisa (ASX: LOV) and IDP Education (ASX: IEL).  

Zero carbon, zero revenue

Given QVG's emphasis on earnings, it should come as no surprise that the short book in the QVG Long - Short Fund, which is managed by Josh Clark, has a distinct lack of it. Specifically, near-term earnings weakness. 

But they also short companies that are trading at high P/Es with slowing growth - especially in today's high rate environment. 

"Think companies like pipeline tech or biotech - companies that have had lofty valuations even on a long term view but with some sort of revenue or operational hiccup in the near term."

But there's a third category - zero carbon and zero revenue. 

"The decarbonisation of the globe that retail and institutional investors alike want to get onboard," says Clark.

"But we're seeing a plethora of companies within that category that tick the decarbonisation box, tick the clean and green theme box, but they don't tick the earnings box, they don't tick the revenue box, they don't tick the sustainability of business model box. In fact, they don't have much to show in terms of fundamentals, they're just benefiting from that theme being popular in the market." 

The next ASX 10 bagger

An odd moment occurred at the end of the presentation when the team were asked if they still held a position in Life360 ASX: 360. 

For context, Life:360 has had a torrid year with the share price down 46.5% for the year to date. Prunty told investors that not only did QVG still hold a position but that it was the stock that wouldn't surprise him the least if it became a 10-bagger from now. 

"It's rapidly moving to free cash flow break even and positive, it's a business that's growing rapidly with recurring earnings, we think it has enormous latent pricing power and a significant addressable market," says Prunty.

"Of all the companies we own, if we look back in 5-10 years' time and it's gone up 5-10 times, that's the one where I'd be least surprised. We are super bulls on Life360."

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