AEC Commentary (Q1 2024)
April 2024
OVERVIEW
After a strong 2023, the first quarter gave back a slug of last year's gains. The fund declined 8% versus a positive 1% return for the benchmark. While an acute drawdown in Indian small caps weighed most on our performance, there was broad pressure across the entire portfolio in most sectors and geographies. We often point to our stock selection as our greatest attribute, but in the first quarter our portfolio holdings were clearly out of favor. The question is why? Well, we’ve done some diagnosis: The fund captured 18% earnings growth last quarter – not shabby given we view earnings growth as the primary and most enduring driver of stock prices. Was the market expecting more? Qualitatively (excl. ~8% cash), 41% of our holdings reported earnings better than we expected, 24% reported earnings worse than we expected, and the remaining 28% were inline with our expectation. Taking a closer look, the “better” holdings returned 10% over the past three months and showed average earnings growth of 41%. The “inline” declined 8%, but still grew earnings 13%. The “worse” dropped 7% after reporting earnings declines of ~20%. These results underscore the importance of earnings growth. Without a historical record of better, worse, and inline reports, it’s hard to say whether the stock declines for the inline reporters is off-trend. Yet, by the math, earnings on the whole went up while the stocks went down. We cannot say if last quarter’s trend will continue, but for over two decades our focus on capturing earnings has been effective. This gives us confidence in our weighted-average portfolio sitting on a 20x trailing price to earnings (P/E) multiple and an expectation for 23% earnings growth over the year ahead.
| Periods ended 3/31/2024 | AEC | MSCI Emerging Markets
Small Cap Index |
|---|---|---|
| Quarter | -8.10% | 1.06% | 1 Year | 7.45% | 20.56% | 3 Years Annualized | 4.12% | 4.23% | ITD Annualized | 8.91% | 4.54% |
Data shows past performance. Past performance is not indicative of future performance and current performance may be lower or higher than the data quoted.
PERFORMANCE
At 34% of the fund, India alone detracted 4% from our Q1 performance. On the whole our exposure declined 10% through the first quarter. We began the year trimming many of our largest Indian weights in order to rightsize positions and reallocate capital following phenomenal performance last year (returning 51% in 2023). In March the portfolio was hit with additional pressure after the Indian regulator (SEBI) vocalized concerns over manipulation of some smaller issue IPOs and “froth” in the small-cap market. Although there was no explicit action taken by the regulator, the noise alone led to indiscriminate selling. Between March 4th and 13th the India small cap index dropped 10%. With our exposures firmly in the lower end of the market cap spectrum, we too were caught in the downdraft. While we have no exposure to new IPOs, we don’t take noise from a regulator lightly, and in response we triple checked our positioning. We curbed our selling through the correction as it appeared overly dramatic, and left our positions at attractive valuations again. After allowing the market to digest the commentary for a few days, we followed through with a few smaller position sells, but also took advantage of the pullback and added weight to others. Now a month later, 70% of our positions have recovered to levels higher than their pre-correction prices on March 1st. What’s more important to us is that, by our estimation, our exposure is poised to grow earnings 26% over the coming year while trading on a 17x forward P/E ratio. We remain highly confident in the earnings of the companies we hold, and it gives us much comfort that they trade at very reasonable valuations.
The rest of the underperformance was split between several other culprits: weak performance by Ifirma (IFI PW), and a combination of offbeat stock selection coupled with misallocations across industries and geographies. We realize the blurriness of this explanation, but have settled on this articulation because there wasn't any strong dispersion through the quarter to point at. Taiwan, for example, was strong and we are underweight, but our holdings there didn't outperform. From a sector view, industrials happened to be the strongest performing sector and, again, we are underweight, but again our performance was broadly weaker. Apparently our positions just weren’t in vogue over the past few months. As an aside, we track a few industry peers that also aim to be high quality growth investors. While we don’t know the exact nuances of their portfolios, all put up weak Q1’s, corroborating our conclusion that quality growth and/or smaller companies were out of favor this past quarter.
Ifirma (IFI PW) was our single largest detractor, pulling 190 bps from performance. The stock was down 29% in Q1 after reporting a second consecutive quarter of surprisingly weak earnings as a result of higher marketing expenditure. We have owned Ifirma for four-plus years, and over that time the weight has grown with the very strong stock performance. We have not purchased shares for over two years, yet at the end of ‘23 the stock price had increased 400% since our first purchase, and the position had become the largest in our fund. Given the shot across the bow with the weaker prior quarter, we passively trimmed ahead of the Q4 release. But when the results came out, we made the determination to notably cut the weight. Selling shares was a tough pill to swallow given the competitive position the company was in when we first met. Ifirma was the largest online tax accounting company in Poland with dominant market share. We often compared their opportunity to Fortnox (FNOX SS) in Sweden or Intuit (INTU US) in the US. Fortnox is a $3.7B market cap company that serves a population of ~27M in the Nordics. Intuit is a $180B market cap company that services the US. The Polish market on the other hand has a population just shy of 40M with less than 10% of the market having shifted from brick and mortar to online accounting. We discovered Ifirma at a sub $20M market cap. As of the middle of last year, the market dynamics changed when the number two player was bought by a large Norwegian company willing to burn lots of cash in order to develop the market and capture market share. While we are not disappointed in Ifirma’s three-year earnings CAGR of 65% and overall stock performance, we are concerned about management's apparent willingness to cede market leadership, behaving along the lines of: “The market is large enough to be #2.” We agree that the market is large enough for both players to thrive, but felt it prudent to trim our exposure as the company navigates the evolving competitive landscape. The long-term prospects remain extremely compelling given the fundamentals of the business and headroom in the market. After the correction, the stock is trading on an 18x TTM P/E ratio, and we continue to anticipate double-digit earnings growth in 2024. And even if ‘24 growth proves slower than the past three years, we are glad to own a well-positioned business that steadily generates a return on asset north of 30% and pays us a 4%+ yield as we wait for the dust to settle.
As for opportunities, we continue to find an abundance. Our most notable additions this quarter are Segyung Hitech (148150 KS), Solum (248070 KS), and Time Technoplast (TIME IN).
Segyung Hitech (148150 KS) is a specialty optical film manufacturer. The growth engine supporting their business is the adoption of foldable phones and organic light-emitting diodes (OLED) displays, a more efficient light source than electronic. Samsung (005930 KS) is the largest foldable phone manufacturer in the world, and Segyung has a three-year exclusive tie up with them ahead of a concerted push to accelerate their foldable phone roll-out. While only a projection, on a base of 15M units sold in ‘23, the outlook for foldable phone volumes are estimated to be 23M in 2024, 33M in ‘25, 43M in ‘26, and 73M by 2027. On the OLED side, Apple (AAPL) is in the early innings of shifting to OLED for their tablets and PCs, and given the larger screen sizes, Segyung stands to benefit via increased volume requirements. Playing the product cycle is not something we love, but we know that the key to any manufacturing business is maintaining high utilization. We are seeing the benefits of utilization increases with margins starting to jump exponentially over the prior year. With company-wide utilization ending 2023 at 49% and a strong pipeline in 2024, we expect another year of exponential earnings growth as utilization moves higher and dollars drop to the bottom line. What makes the stock so attractive is that when we purchased the shares they were trading at 2.2x EV/EBITDA. It appears that the stock has been forgotten over the years when excess capacity and weak demand muted earnings. We expect the company to get noticed this year as fixed cost utilization drives earnings higher. We never bake-in valuation expansion as part of a thesis, but do believe there is ample room for a rerating on top of strong earnings growth.
Solum (248070 KS) is an electronic price-tag manufacturer with number two global market share behind Vusion Group (VU FP). Electronic price tags are exactly that. What makes the product so compelling to a retailer is that adoption allows for immediate price adjustments from a single computer, rather than manually modifying every tag. As we sit somewhere in the midst of an inflationary cycle, the power of instant price-tweaking is very relevant to every retailer. It is not really a question of if, but when. To date, adoption is higher outside of the US, with the EU at ~20% versus the US at ~1%, but the wave is coming to the US and Solum is prepared to fulfill it with their recently opened plant in Mexico. While Vusion has gained global visibility, Solum has quietly been taking significant market share. Back in ‘20 the market share split between the two was 40% Vusion/20% Solum. At the end of ‘23 the market share had shifted to 35% Vusion/30% Solum. We expect Solum to displace Vusion as the leader in the near future in a market that is still growing rapidly. What’s more compelling is that Vusion trades at 40x forward earnings while Solum trades at <8x forward earnings for a multi-year 20%+ EPS growth business.
The last notable addition is Time Technoplast (TIME IN). Time is the global leader in plastic drums and the number two player in composite cylinders. Plastic drums are displacing steel drums, just as composite cylinders are displacing steel tanks. To frame the benefits of a composite cylinder, think about a propane tank for your BBQ that is ⅓ the weight and is non-explosive. Time is a company that we have known for over a decade and owned in the fund in the early years. Their challenge was always that the founder was a visionary inventor but not a businessman. He was always focused on the next new product rather than harvesting on the products they had already created. When he tragically passed away a couple years ago, there was uncertainty of what would become of the business. The CFO took over and has been operating the company flawlessly via optimizing the product mix and selling off non-core assets. Under his tenure, they intend to become a debt-free company in two years while also accelerating adoption of their higher value/margin composite cylinders. The stock trades at 14x forward earnings for 20% + earnings growth over the coming two years. We thankfully started with a heavier weight than usual because of our experience with the company, and are grateful because we have seen the stock move 30% higher over the past month.
OUTLOOK
Last night we did a call with a small holding of ours that’s listed in Hong Kong. Euroeyes (1846 HK) is a company that has compounded earnings at 34% over the past four years, and we expect it to achieve 30% growth once again in 2024. The stock now trades on 12x earnings and a 4.5x EV/EBITDA multiple after closing out 2023 with 44% earnings growth. Post-reporting last month, the stock didn't budge on the earnings release. While only a guess, we’d argue that a business compounding earnings at 30% while maintaining a non-cash return on asset of 20% would trade well north of 30x EPS here in the states. In fact, US Physical Therapy (USPH US) is a company from our past that lines up reasonably well with Euroeyes as a healthcare services business, and the stock trades on 32x TTM earrings, and 15.5x EV/EBITDA on the heels of a 4% EPS CAGR over the past four years. Why is this important? As our conversation with management was concluding, we were asked whether or not we thought it was a good idea for the company to list in the US. Having been approached by bankers and private equity over the past year, Euroeyes is pondering any solution that would help accurately reflect the value being created by their efforts. While the answer is no – we think it makes no sense to list a business in a country where there are no operations – the skew of where dollars are being jammed is apparent around the world. The point of this example is that this real-world case highlights a dramatic distortion in capital allocation. Taking inflation into account, US Physical Therapy (USPH US) actually did not grow over the past four years, while a foreign company had 30%+ real growth, yet trades at one third the valuation. Yes, the past few years have been hectic, and the impacts of geopolitics and policy decisions remain clearly evident in the markets around the world. Yet we do not believe that the resulting value distortions will endure. Unlike many of our past write ups, we will not comment on the next macro twist, but instead will close with this illustration of the deep distortion of the market’s willingness to pay.
DEFINITIONS
CAGR (compound annual growth rate) is a measure of average annual growth over a given period.
EV/EBITDA is a ratio that compares a company's Enterprise Value (EV) to its Earnings Before Interest, Taxes, Depreciation & Amortization (EBITDA). The EV/EBITDA ratio is commonly used as a valuation metric to compare the relative value of different businesses
TTM (Trailing Twelve Months)
The MSCI Emerging Markets Small Cap Index includes small cap representation across 27 emerging markets countries. With 1,693 constituents, the index covers approximately 14% of the free float-adjusted market capitalization in each country. The small-cap segment tends to capture more local economic and sector characteristics relative to larger emerging markets capitalization segments. An index does not charge management fees or brokerage expenses, and no such fees or expenses were deducted from the performance shown.
This report was prepared by Seven Canyons Advisors, a federally registered investment adviser under the Investment Advisers Act of 1940. Registration as an investment adviser does not imply a certain level of skill or training. The oral and written communications of an adviser provide you with information about which you determine to hire or retain an adviser. Neither the information nor any opinion expressed it so be construed as solicitation to buy or sell a security of personalized investment, tax, or legal advice.
The mention of specific securities and sectors illustrates the application of our investment approach only and is not to be considered a recommendation. The specific securities identified and described herein do not represent all of the securities purchased or sold for the portfolio, and it should not be assumed that investment in these securities were or will be profitable. There is no assurance that the securities purchased remain in the portfolio or that securities sold have not been repurchased. For a complete list of holdings please contact your portfolio adviser.
The information herein was obtained from various sources. Seven Canyons does not guarantee the accuracy or completeness of information provided by third parties. The information in this report is given as of the date indicated and believed to be reliable. Seven Canyons assumes no obligation to update this information, or to advise on further developments relating to it.
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