AEC Commentary (Q2 2024)
July 2024
OVERVIEW
We are pleased to report that AEC returned 9% in the second quarter vs 6% for the MSCI Emerging Market Small Cap Index (M1EFSC). With the first half of the year behind us, the M1EFSC has finally achieved new highs, surpassing levels last seen in September of 2021. Reaching new highs isn’t a shocking feat, but with heavy outflows hampering the asset class for three years running, it’s a notable achievement. Meanwhile, the bulk of global equity flows have continued to pour into US large cap stocks with the artificial intelligence theme propelling the “The Magnificent Seven” and consequently the S&P 500 to new highs as well. While making money is the name of the game (and we applaud investors that have benefited from the US large cap rally), to us the trade today appears to be a concentrated momentum bet that makes less sense as each day passes. Over the past decade the S&P has produced an annualized return of 12.75% with P/E expansion (valuation) making up 3.7% of that annualized return. The move higher in valuation has left the current S&P valuation 45% higher than it was a decade back. Stripping out the “Mag 7” from the S&P 500 performance reduces the total return by 40% over the decade, with the annualized return of the remaining 493 companies falling to 10.4% with a greater than 3.7% impact from valuation uplift. Conversely, over the same period the EM small-cap index has seen lighter returns of 5.15% per annum, yet has been impacted by a P/E contraction of 30%. Suspending reality for a moment by pretending that earnings is all that matters, these numbers would indicate that EM small caps have put up superior earnings results versus 98% of the S&P constituents, and have gotten cheaper in the process. Returning to reality, we believe that the earnings outperformance in EM small caps will continue, and the data suggests the same. Expectations are for the S&P to trade at a 19x multiple in two years, with 10% earnings per share (EPS) growth per annum over the period. In the meantime, the EM small-cap market is expected to trade at an 11x earnings multiple, for an expectation of over 20% EPS growth over the same timeframe. We love this setup. Paying less for higher- and longer-duration growth is what we seek out every day. And it’s with satisfaction that we manage a portfolio of high quality companies that match this profile. We remain confident that tides will turn and rational heads will direct capital to where returns are more lucrative.
| Periods ended 6/30/2024 | AEC | MSCI Emerging Markets
Small Cap Index |
|---|---|---|
| Quarter | 8.94% | 5.94% | 1 Year | 9.75% | 20.06% | 3 Years Annualized | 2.45% | 2.54% | ITD Annualized | 9.99% | 5.29% |
Data shows past, net of fees performance. Past performance is not indicative of future performance and current performance may be lower or higher than the data quoted.
PERFORMANCE
As with last quarter, India was the driving force behind fund performance. Our results this period showed a strong recovery, with the fund returning 27% in India vs 20% for the benchmark. Our overweighting and reshuffling of India last quarter led to an outsized contribution of +9% to performance vs +5% for the benchmark. While it’s a stretch to label the drawdown we saw in India through Q1 a “crisis,” we did not let the opportunity presented by a sharp non-fundamental pullback go to waste. A flurry of management calls prompted by the correction in March led to major portfolio repositioning. Six position exits were more than offset by adding weight to five high conviction holdings. Four months have passed, and our results are very satisfying. In aggregate, the stocks we exited returned 6.5% since we sold them, versus a 42% aggregate return for the stocks that were added. To our satisfaction, statistics don’t lie. The range of performance of the stocks we sold is -13% to +17%, whereas the range of performance of the stocks we added is +16% to +63%, with three of the five returning over 50%.
These results give us both validation and pause. A lifetime ago I worked as a stockbroker at a US small cap equities firm. Most of my clients appreciated the access to management that we facilitated. Conversely, a handful of industry veterans claimed that communication directly with management was misleading and led to mistakes and biases. To avoid management bias, those bygone clients relied on sell-side coverage for their analysis. This luxury does not exist in the EM small-cap world we traffic. There is little-to-no research available. We do the research. Our sources are the women and men who run the companies in which we invest. Having met with thousands upon thousands of companies over the decades, the ability to understand people and personalities is a critical aspect of our business — it takes arduous work to make sure that the agenda of management isn’t obscuring important details. Admittedly, those jaded US investors who lacked trust weren’t totally incorrect, but we view the management relationship differently; the businesses we own are all byproducts of the people who operate them, and building relationships of trust is essential to every investment we make. Our outcome over the past few months clearly validates the high-touch process that we employ.
We also take pause after seeing such an outcome. At the time of reshuffling, there was an air of urgency that demanded action. One of the core philosophies that was taught to us early on in this business is that there is no such thing as a “hold” – every stock is either a “buy” or a “sell.” When there was acute pressure, the team leaned into this discipline and we were rewarded. This is a reminder of the importance of making hard decisions and only allowing high conviction “buys'' into the fund. We made correct decisions under pressure, and seek to avoid that level of pressure in the future by staying disciplined. With so many gems in the EM universe, there is no room for passionless “hold” positions in our portfolio.
The Philippines was our number two contributing geography, adding +1% to our + 9% performance. The entire 1% was driven by Philippines Seven Corporation (SEVN PM), which rocketed 64% in the quarter. Given the iconic status of the 7-11 brand here in the US, Philippines Seven really needs no introduction. Within the Philippines, the brand maintains dominant share in a convenience store market that is far from penetrated. Currently the largest player in the market, (with nearly three times as many stores as the number two), SEVN PM is still able to grow store count at a 10% clip. Our investment with SEVN PM has proven wise, yet there have been some bittersweet moments along the way. This company was a darling prior to Covid, carrying a P/E range between 45-75x all the way back to 2011. It has always been a great company and was valued as such. Covid was bad for business, and the stock corrected by nearly 70% from peak to trough. We began buying last summer when the earnings exceeded pre-Covid levels, despite traffic still 20% below historical patterns. Operational results like these highlight just how well managed the business is. The kicker is that, when we started buying, the stock was trading at 20x earnings. Over the course of the three following quarters the valuation fell to 17x as earnings grew and the stock remained flat. In April we determined that the valuation/performance mismatch had become extreme and decided to double our weight. Unfortunately, others came to the same conclusion at the same time and the stock blasted off with only 10% of our order completed. We are glad we made our move, but would have preferred to capitalize on the position even more.
Taiwan and Poland were our biggest detractors. Taiwan pulled 1.7% from performance and Poland was a 55 basis point drag. We remain very light in Taiwan, at ~4% of the portfolio, and our return was -5.5% vs +6% for the benchmark. We own three semiconductor-related companies, and all were down through the quarter without notable company-specific news to point to. We still like the positions, but in our correspondence with management we have not yet found cause to press the positions harder. Our Poland exposure sits at 8.5% – far above the 1.25% positioning of the benchmark – and on the whole, declined 3% in the quarter vs the benchmark allocation returning +9%. Unlike our Taiwan positions, the industry exposure in Poland is diverse, yet nonetheless most of our positions were down marginally. Again, there is nothing specifically negative to point to regarding individual company fundamentals.
Our sector allocation has held steady, with tech and consumer staples remaining our top two allocations. Our total return was nearly double the benchmark in tech, and almost 5x better than the bench in consumer staples. We had a lot of big winners in the consumer staples sector. Philippines Seven (SEVN PM) was our top stock performer, returning 64%, and Manorama (MANORAMA IN) was our second best performing stock, with a 59% return in the quarter. LT Foods (LTFOODS IN) and Corporativo Fragua (FRAGUAB MM) returned 37% and 28% respectively, and both are top ten weights.
Our industrials exposure was the biggest drag to performance. It was the best performing sector within the benchmark, and also carries the largest weight disparity, at 18.5% vs our 10% allocation. We put up a -1% return vs +11% for the bench. Interestingly, the entirety of the industrials weakness stems from our geographic exposure in Latin America. Mills Estruturas (MILS3 BZ), Group Aeroportuario del Centro Norte (OMAB MM), and Controladora Vuela Compania de Aviacion (Volara MM) were all down double digits. The weakness in our Mexican airline holdings follows the election of Claudia Sheinbaum, a left-leaning president who may impose greater regulations and tariffs on the transportation sector, where the two positions reside. We believe that these risks are overstated, and continue to favor the theme of greater airline usage in the years ahead. The correction in Mills, (a construction equipment rental company), appears to be tied directly to the slower pace of rate cuts that surprised the market in early May. The stock dropped 30% in response to a quarter point trim vs the anticipated half-point cut. We view Mills as a long-term secular share gainer that remains underappreciated by the market due to its small-cap status. On top of that, the company maintains a strong balance sheet and enviable cash flows. We increased our position size materially in mid-June; we believe the nominal rate miss holds little bearing on the potential of the investment. Thus far we have been rewarded for our purchases.
CONCLUSION
After reviewing the results of repositioning India earlier in the quarter, we were reminded of the recent Dartmouth College commencement speech given by Grand Slam Champion Roger Federer, in which he noted that he played 1,526 matches over his career, winning almost 80% of them. Federer went on to ask the audience what percentage of points he won in those matches. After a brief pause he divulged the answer: 54% – a stark contrast to the 80% of matches won. In fact, because tennis matches are decided in sets of games, you can actually win the match with fewer than 50% of the points. With one of the best tennis players only winning about half of his total points, it is clear that a winning strategy depends on crucial moments. To bring the comparison full circle, there are times when EM funds will lose “points” relative to competitors, yet as active managers, our fund is able to recoup by capitalizing on crucial “points” that passive strategies cannot.
Looking forward, we don’t see any events that are likely to disrupt our course. We are on the tail-end of a restrictive monetary policy regime, and have seen stable outcomes from three recent presidential elections (Taiwan, India, and Mexico). The skies appear clear, and the current positive chatter coming from banks, brokers, and advisors surrounding the EM asset class is astounding even to us. The touted attributes of: relatively faster economic growth in EM’s vs DM’s; superior pace of earnings growth; lower valuations; diversification from US equities; and low investor positioning, match the message we’ve been sharing since we opened our doors. Yet, these arguments only address the surface-level valuation, under-allocation and growth gap between different asset classes. There is no mention of the abundance of quality companies that are available where we traffic. Our underdog asset class comprises the bulk of economies and people around the world and is typically perceived as risky and irrelevant. Perhaps this is because of the effort it takes to really dig into EMs and identify winners. And that is what makes AEC standout. Not only do we know that EM valuations are better and EM earnings growth is faster (and accelerating) relative to DM, but we have taken the time to identify quality companies. WIth global monetary policy beginning to ease, EMs will enter a favorable climate for investors looking to diversify by pioneering into under-owned but vetted and promising EM companies. This is an exciting time to be in EM small-cap investing as the market winds appear to be shifting. We look forward to continued partnership with our investors and appreciate your trust in us.
The MSCI Emerging Markets Small Cap Index includes small cap representation across 24 emerging markets countries. With 2,031 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.
All investing involves risk. Investments in securities of foreign companies involve additional risks, including less liquidity, currency-rate fluctuations, political and economic instability, and differences in financial reporting standards and securities market regulation. Investing in small and micro-cap funds will be more volatile and loss of principal could be greater than investing in large cap or more diversified funds.