After a tough year, QVG believes small-cap returns could look very different from here

QVG Capital has just endured one of the toughest periods in its history.

In its September investor webinar, QVG Capital founders Tony Waters and Chris Prunty, alongside Long Short Fund Portfolio Manager Josh Clark, unpacked what went wrong, what has changed, and, importantly, where they see the opportunities from here.

The QVG Opportunities Fund returned -21.8% in the 12 months to August, compared with -1.2% for its index, a dramatic reversal from the previous year, when the fund returned 44.1%. Tony Waters isn't pretending otherwise.

"Certainly in the last 12 months, it's probably been one of the most challenging years, I would say, in terms of my 30-odd year history in terms of managing small cap money in the market."

QVG's argument today, however, isn't simply that performance will eventually bounce back. It is that the underlying earnings of many of its companies have continued to grow while their valuations have fallen sharply.

That, the team believes, has created one of the more attractive opportunity sets it has seen in some time.

"It hasn't been our best 12 months. There have been significant rate headwinds to the portfolio, but the underlying performance of the businesses continue to be in aggregate, excellent, and the growth prospects for the portfolio are outstanding," portfolio manager Chris Prunty says.

The market rewarded almost everything QVG doesn't own

The biggest problem has been relatively straightforward and impacted numerous managers - resources dominated.

Small resources returned almost 80% over the period covered in QVG's presentation, while small industrials fell 3.1%. Despite that extraordinary divergence, QVG notes that industrials have still outperformed resources over the 36-plus-year history of the small-cap index.

For Waters, chasing the resources rally now would amount to abandoning the investment process precisely when it has become uncomfortable.

"We've given you a similar story in terms of our process and how we invest in good quality compounding industrials over the cycle, and we're not going to change even if it's not working short term."

That doesn't mean QVG believes resources can't continue performing. Rather, its process is designed around businesses capable of compounding earnings through the cycle, supported by strong balance sheets and improving returns on invested capital.

The long-short portfolio tells a similar story. Resources returned 47% over the past 12 months while industrials fell 7%, a gap of roughly 54 percentage points.

"The market just doesn't care. It's rewarded commodities over compounders over the last 12 months," portfolio manager Josh Clark says.

"We remind ourselves that cycles like this don't last forever. They're just a point in time in markets."

The other culprit - the price of money

Resources aren't the entire explanation. Australian 10-year government bond yields have risen by roughly 380 basis points since September 2021. QVG's illustrative valuation framework shows what that can do to growth stocks: holding the equity risk premium and earnings constant, the theoretical unlevered PE falls from 19.1 times to 12.7 times, a 33.6% de-rating.

That is particularly painful for portfolios owning companies where a larger proportion of value sits in future earnings. But there is another side to the equation.

Higher discount rates mean lower prices today, but if earnings continue growing, those lower starting valuations potentially increase future returns.

QVG has been here before. Its Opportunities Fund has experienced several significant drawdowns, with the presentation showing an average two-year return of 41.4% following previous drawdown troughs. And whilst QVG stresses that past performance is not indicative of future returns, Clark highlights 2022 in particular.

"You end up in a scenario where you have a bit of short-term pain for long-term gain because discounting those cash flows at a higher rate means a lower share price today."

The key lesson from 2022, he argues, is that bond yields didn't actually need to fall for QVG's portfolio to recover.

Earnings haven't been the problem

This is probably the most important part of QVG's case. In the long-short fund, consensus FY27 earnings forecasts for its long positions have risen by around 4%, while forecasts for its shorts have fallen around 17%. Yet fund returns have been negative.

In other words, QVG argues it has largely been on the right side of the earnings equation and the wrong side of the valuation equation. There have certainly been mistakes.

Clark is increasingly concerned about EML Payments (ASX: EML), where a turnaround is taking longer and costing more than expected.

"As we move through time, that one's starting to look more and more like a genuine mistake."

Elsewhere, QVG sees share-price falls that look increasingly disconnected from changes in earnings.

Take MA Financial (ASX: MAF). Clark says next year's earnings expectations have fallen around 6%, reflecting weaker sentiment towards private credit and softer expectations for asset management inflows.

The share price, however, has roughly halved.

"It really looks like a disproportionate response to what appears to be temporary. And at around nine times earnings, that business, to me, certainly looks like it's baking in being at cyclical lows into perpetuity, which looks really unlikely."

Waters similarly points to Zip (ASX: ZIP), Lovisa (ASX: LOV), CAR Group (ASX: CAR) and MA Financial, which initially rallied strongly after reporting results before surrendering much or all of those gains. His explanation of the current market is colourful:

"If it looks like a crow, it gets shot."

Where QVG sees the opportunities

Rather than retreating, QVG has become more concentrated in its highest-conviction ideas.

The long-short fund has reduced its number of long positions from 46 in March to 37 at the end of August, while gross exposure has remained almost unchanged. Its largest positions are clustered around infrastructure and electrification, financial platforms and selected software, telecommunications and consumer businesses.

Clark highlights infrastructure-facing holdings including GenusPlus (ASX: GNP), Southern Cross Electrical Engineering (ASX: SXE) and Duratec (ASX: DUR), which are exposed to spending on electricity transmission, renewables, fuel infrastructure and defence.

Then there is HUB24 (ASX: HUB).

"HUB24 appears to be at peak investor fear at the moment with recent tax changes, uncertainty across asset classes, and they're still inflowing at $4 billion per quarter. So we think we're picking that up at an attractive price."

Zip is another standout.

"They continue to execute and we're getting a 20% plus grower for around eight times. So that equation is too attractive to ignore."

In the Opportunities Fund, the five largest positions are Generation Development Group (ASX: GDG), Zip, Aussie Broadband (ASX: ABB), Life360 (ASX: 360) and MA Financial. Together they represent roughly one-third of the portfolio.

A very different starting point

Perhaps the most compelling change, according to QVG, is valuation. 

A year ago, the QVG portfolio was trading on around 27 times forward earnings. Today it is around 19.4 times, despite forecast revenue growth remaining broadly similar and the portfolio moving from effectively no net debt to a net cash position.

Consensus forecasts imply approximately 23% portfolio EPS growth from FY27 to FY28, before considering any change in valuation multiples.

Nobody knows when the macro environment will turn. QVG readily admits it doesn't either. That's precisely why Prunty says the Opportunities Fund remains essentially fully invested.

"We do know we want to be there to capture that upside when the market comes to the view that rates have peaked because, as we've seen in the past, stocks can move very quickly and we want to be positioned to capture that."

There is another signal coming from inside the companies themselves. A record 33% of the Opportunities Fund by weight is currently invested in companies with announced or active share buybacks, including Zip, Aussie Broadband and Life360.

For QVG, the investment equation from here is therefore considerably different to a year ago: earnings expectations remain strong, balance sheets are healthy, valuations have fallen, and management teams themselves are increasingly buying back stock.

The question in QVG's eyes is when, rather than whether, those fundamentals begin to matter more to the market.

A replay of the webinar is available on the QVG Capital website.