Q: How has the fund evolved? Could you give us some background information?

Grandeur Peak was set up as a global firm. From the onset, our mission was to establish an industry-based research structure, which would be a critical component of all the firm’s funds. At Grandeur Peak, I don’t think of individual funds, but of the entire research team, because we collectively work on all the strategies.

The Global Reach Fund is our key strategy, run by our five industry teams. Each industry portfolio manager runs a tranche of that long-list portfolio, which serves as an umbrella fund for everything we do. It is a critical part of the Grandeur Peak process and affects all our funds, including the International Stalwarts and Global Stalwarts funds.

The firm started with one global and one international strategy, which were primarily focused on micro and small caps. The next products were the Global Reach and the Emerging Markets strategies. All four strategies closed relatively quickly; meanwhile we had a growing team with desire to take on more responsibilities, as well as clients who were clamoring for more capacity. 

We decided to speed up our long-term plans for a SMid cap strategy, which would provide more capacity. We identified the market cap of $1.5 billion as a critical level for major liquidity constraints. The results of the back-testing were positive and that’s how we launched the Global and International Stalwarts Strategies three years ago.

So, we are not just a micro to mid-cap specialist, but a global research team that aims to be world class in what we do. Any time we launch a new strategy, we ask ourselves if we can be in the top decile over a 10-year period. If we can’t answer affirmatively, then we are not willing to launch the strategy. 

The Stalwarts strategies are consistent with the other strategies we manage. The only difference is the market cap hurdle of $1.5 billion and above. We are disciplined about closing strategies and the International Stalwarts Strategy is approaching a closing level of AUM.

Q: What core beliefs drive your investment philosophy?

We look for steady performers that we believe can continue to deliver returns over the long-term. We focus on the highest quality subset of our huge universe, but are valuation sensitive.

One of our guiding principles is that we want to own companies for which we have sufficient conviction and confidence to buy more when they are down. Then we can use such opportunities to our advantage. If the stock is down because of a macro factor, an exogenous factor, or a short-term blip and if we believe it will get back on track, then the correction is a blessing. We would be excited about the opportunity to buy more of that company. 

Q: What is the significance of the word “Stalwarts” in the name of your strategy?

We view the Stalwarts portfolios as our high-quality portfolios. Across the firm, we focus on three types of companies, which we identify as: best-in-class growth companies, stalwarts and fallen angels. When we talk about stalwarts, we refer to the truly stable, solid, high-quality companies, for which we have conviction and which seek to avoid permanent loss of capital.

In the micro-cap arena for example, quality is less certain as there are younger and smaller companies which may provide bigger payoffs, but with greater risk. In Stalwarts we focus on the high-quality subset of the smid-cap universe to capture solid returns while trying to avoid big mistakes that would detract from the performance.

Q: How do you assess and define quality?

We define quality as companies with good business metrics, management teams, balance sheets and with the ability to continue to grow their business going forward. We spend a lot of time on the trend, the level and the volatility of different factors, but we focus particularly on growth and margins and how they flow through to return on capital. 

We believe that the companies which exhibit these characteristics historically are more likely to have sustainable competitive advantages. That’s why our quantitative screening begins with identifying the companies which have had positive characteristics in the past. Then we delve into a more qualitative approach, where we try to understand if the historic numbers can be extrapolated forward and if there is a sustainable competitive advantage.

Q: What are the critical steps in your investment process?

There are roughly 30,000 companies in our global investable universe. We have our own screening methodology utilizing our own version of a DuPont analysis. Essentially, it provides a snapshot of the company’s financial statements over the last 15 years, such as the income statement, the balance sheet, the return on invested capital, the cash flow statement and the different ratios. There is also a valuation section. 

On a weekly basis, our quant team sends screens to the industry teams. Then the industry teams look through the sub industries and scan through the numbers looking for interesting levels, trends and volatility. Then, as a team, we analyze and discuss the most interesting companies. Our goal is to focus on one or two really great names from the different screens and to make them first priority. Then we create a separate pool of candidates that we want to watch and monitor. We have done this for years, so we have a healthy set of watch lists.

After the team identifies the most interesting names, we pursue further due diligence, which flows into our decision-making process about quality. Our watch list includes companies of A, B, and C quality, with A being the highest. We continue to review and monitor the quality of each company over time to make sure we stay focused on those of the highest quality.

Our key competitive advantage is setting up a research structure and being extremely disciplined. We’ve visited about 10,000 companies in our universe over the last seven years. Sometimes we arrange conference calls, but most of the visits are on site. We’ve visited the higher-quality companies multiple times. Our industry teams vet this huge universe and monitor the names for opportunities. 

Our quant team sits down with each industry team bi-monthly to discuss companies whose numbers are becoming intriguing. I believe that the key to our success is the quantitative approach with the qualitative layer. It is unique that we have a research team of 25 people truly working together, as opposed to three or four individuals running one strategy.

Q: What metrics do you use in your process?

We aim to focus on the companies with attractive business metrics and a bright outlook. We build five-year financial models after examining the companies historically. We try to estimate an expected return given current valuation and our five-year model projections. There are different ways to approach the varying accounting standards globally, but we have built about 5,000 proprietary earnings models in our database. We undertook a huge task several years ago, when we transferred all of our models into a comparable format. 

Basically, there are three sets of numbers that we focus on—reported numbers, adjusted numbers, and the Grandeur Peak adjusted numbers. Because companies adjust their numbers differently, we make consistent adjustments to be able to correctly compare the companies, regardless of their industry or geography. The adjustments are a critical element of our process, because they are necessary to achieve a true, comparable, cash-adjusted set of numbers.

All the companies are also assigned a risk premium based on the country in which they reside. We use the U.S. for our baseline. For example, the current account deficit issue in India would indicate a structurally depreciating currency. We expect an average of 4% annual devaluation on the Indian rupee, so we need to account for that in the valuation. We also try to account for macro or geopolitical risks in each country. All of our expected returns are discounted by the relevant country risk premium.

We constantly evaluate and make adjustments. For example, because there are structurally positive factors in India, we have revised down our risk premium there. Actually, India remains our favorite country in terms of investment opportunities and as a firm we have been materially overweight. There’s a huge set of micro and small cap companies in India that we do not see in other parts of the world. Not only the number of companies is impressive, but also the quality of the managements and the western approach towards return. In comparison, China represents an entirely different story, where the management teams aren’t as sophisticated.

Q: Could you illustrate your research process with some examples?

We have taken a bigger position in Aalberts Industries NV recently, because of the opportunity that has arisen. Part of our process is to know the companies over time and to wait for the right opportunity. As we get to know our companies better, we can become more comfortable with bigger positions.

We’ve known Aalberts for about five years. Based in Netherlands, the business provides parts and systems for fluid and air systems in a myriad of industries. The products are used in the automotive industry, industrial equipment, construction, etc. It is a specialized business with broad product application. Because it has its own niche, the company has strong margins. The industrial companies we select typically have niches, good margins and efficiencies over time.

In addition to having a good business, Aalberts also has a strong management team. The CEO continues to rationalize the business and to focus more on high-end, specialized applications, and on achieving efficiencies and higher return on invested capital. The business itself is focused on increasing the efficiency of their products. The story hasn’t changed in five years, but the business is playing into growth markets that will continue to compound over time. It is a stalwart name because it is a high-quality company, but not a huge growth story. 

We believe that the management team makes the right decisions for the long term. Historically, the numbers have been solid, but we expect acceleration due the rationalization. They sold off some of the weaker businesses and now the company is less cyclical. Following a period of sizeable investments, we expect a positive trend for the return on capital going forward.

Another example would the Metro Bank PLC in the U.K. Since the global financial crisis, the theme of the challenger bank has arguably accelerated. Metro attempts to challenge the UK banking oligopoly through a best-in-class service offering. That service attracts customers willing to make deposits without a high sensitivity to the yield they earn. The result is a large and growing base of stable-cost liquidity, which the bank can use to fund low-risk assets. That makes Metro a bank with high returns, a remarkable growth rate, and lower sensitivity to the cycle.

While most banks are developing digital platforms and closing branches, Metro has taken a contrarian view. It is building branches aggressively, aiming to make them a platform for a best-in-class customer experience. They are open seven days a week from early morning until late evening. The bank doesn’t have to advertise because referrals and organic growth from customers, who consolidate accounts at the bank, generate sufficient growth. 

Q: How do they handle the issue with bad loans?

This issue relates to high-quality service, which provides the low-cost deposit that allows the bank to invest in a lower-yielding or lower-risk asset. Banks with lesser deposit franchises are compelled to invest in higher-yielding and, consequently, higher-risk assets. 

Q: What is your portfolio construction process? How important is diversification?

Quality is the major factor for our buy and sell decisions and also for the decisions on position sizes. We balance quality with valuation and with fundamental business momentum, or how the company is doing today and how we expect it to do over the near term. We have a QVM matrix, or quality, value, and business momentum matrix. In a nutshell, the better a company fares across those three metrics, the more willing we are to own it.

For instance, a low-quality company with a huge expected return is not a company that we would own. However, we may accept a lower expected return for our highest-quality ideas, if they have good business momentum. Then we can still hold the company at a reasonable weight. 

Quality is typically static, but momentum and valuation are constantly moving. We have tools that identify when a company has shifted out of a buy box into a hold or sell box with the QVM matrix. These tools flag opportunities and help us stay on top of the portfolio from a weight perspective.

We are big proponents of diversification, but we don’t need to focus on it, because we are well diversified as a function of our research process. Structurally, we are set up globally and across all industries. The Stalwart strategies have about 130 names on the global side and about a 100 on the international side and are well diversified across industry, geography, market cap, etc.

The performance of the funds is not driven by one or two ideas. We are not built to deliver huge outperformance and should not be not overly exposed to huge underperformance in a given year. If we can deliver outsized returns at a lower level of risk, that’s a reflection of a sustainable research process, not a function of a few big winners.

We are benchmark aware and use benchmarks to help measure our long-term performance, but we do not use a benchmark index to set portfolio weights. 

Q: Do you have any limits on position sizes at the individual, sector or country level?

We don’t have formal limits. Our biggest exposure has been about 3.5% in a single name, and 5% would likely be the ceiling on position sizes. There are some limits regarding our exposure in emerging markets, but because we are so diversified structurally, we are not overly exposed to any market segment. There are ebbs and flows in terms of allocation, but we typically tend to invest about 30% in emerging markets.

Q: How do you define and manage risk?

We view risk as the loss of value, so we always consider the probability and potential magnitude of a negative payoff.  We focus on the risk of an investment failing to contribute a sufficient return over a five-year holding period.

Before we invest, we build our own models for every company. These models contain assumptions about balance sheet strength, cash flow generation, growth, and margins. We evaluate several scenarios, so we develop several sets of assumptions for each company and we distribute probabilities among those scenarios. Based on that work, we can observe the probability of a candidate failing to contribute a sufficient return and the weighted average magnitude of failure. That’s our definition of the risk of an investment.

In terms of risk management, our due diligence and quality scoring methodology are integral parts of the selection process. We score every company that we consider and the scoring system represents 20 mutually exclusive sources of risk that could harm the investment. For us, managing risk means having a rigorous system as a decisive part of the selection process. In other words, regardless of how good value and/or momentum are, low quality is sufficient to disqualify a candidate. Quality is also the primary determinant for our position sizing.

In our quality scoring and analysis, there is an update for an endorsement or a dispute of the scores at least once per quarter by at least one analyst or portfolio manager. I believe that’s a crucial part of our approach towards managing risk in general.