WAGTX Commentary (Q1 2020)

Q1 2020

The decline in the stock market in the first quarter of 2020 was large but not unprecedented. It was the pace of the correction that was so shocking. Starting on February 19th it took just 22 trading days for the market to drop over 30%, a world record. By definition, it’s hard to be prepared for a once-in-a-lifetime global pandemic and economic lockdown. Bear markets, on the other hand, are a normal part of the stock market cycle. Most investors plan for them ahead of time when markets are calm. The crux of most plans was deftly summed up by Warren Buffett: “Be fearful when others are greedy… and greedy when others are fearful.” But most investors quickly abandon the plan in the face of the intense volatility and emotions of an actual bear market. Indeed, most investors get fearful when others are fearful. Best intentions to dollar cost average or rebalance portfolios are abandoned precisely when stocks are cheaply priced and primed to boost long term returns. Good investors, on the other hand, have a plan for a bear market, and they stick to the plan. And great investors are good investors that get a little bit lucky! We attempt to be good investors and stewards of your hard-earned savings, and then we hope for a little luck.

These are the performance figures for the bear market so far: The Fund was down -24.18% during the March quarter, an unwelcomed loss. But, we generated almost 5 percentage points of outperformance relative to our closest benchmark, the MSCI All Country World Ex-USA Small Cap Index. We have continued to outperform after quarter end; as of April 17th the Fund was down -14.04% for the year, more than 10 percentage points better than the benchmark’s -24.24% decline.

The chart below displays our track record over short and long term periods:

Periods ended 3/31/20	WAGTX	MSCI ACWI IMI Index	MSCI ACWI Ex-USA Small Cap Index*
Quarter	-24.18%	-22.44%	-29.00%
Year	-17.32%	-12.73%	-21.18%
3 Years	0.77%	0.76%	-4.89%
5 Years	2.81%	2.45%	-0.81%
10 Years	8.19%	5.80%	2.79%

*the MSCI All Country World Index Ex-USA Small Cap is a commonly used international small cap benchmark

Data shows past performance. Past performance is not indicative of future performance and current performance may be lower or higher than the data quoted. For the most recent month-end performance data, visit www.sevencanyonsadvisors.com. Investment returns and principal value will fluctuate and shares, when redeemed, may be worth more or less than their original cost. The Advisor may absorb certain Fund expenses, leading to higher total shareholder returns. The Advisor has contractually agreed to reimburse Total Annual Operating Expenses in excess of 1.75% and 1.55% for the Investor Class Shares and the Institutional Class Shares  respectively until at least January 31, 2021. This agreement is in effect through January 31, 2021, and may only be terminated before then by the Board of Trustees, and is reevaluated on an annual basis.

OUR PLAN

The following is an outline of our bear market plan and how we executed it during the quarter:

The first and preeminent rule: Stay in the Game

At the bottom of a bear market one cannot be greedy when others are fearful without cash or liquidity available. Most of the work has to be done before a bear market starts. For example, we tend to hold a bit more cash in the bank than our peers–usually about 5-10% of the portfolio. Cash drags on performance during a bull market, but keeps us in the game when a bear appears. The companies we choose to invest in are even more important than our small cash buffer, especially as small cap investors. Small-cap stocks are less liquid by nature. In a bear market, a small cap stock with a deteriorating business and bad balance sheet can quickly be labeled a distressed asset and shares can’t be sold at any price. We buy high-quality growth businesses with net cash balance sheets as opposed to deep value companies with lots of debt, or underperforming businesses that look “cheap.”

At the end of the December quarter of 2019, in calmer times, the Fund was relatively well prepared to face a bear market, although we were not predicting one. To be specific, the portfolio had 6.6% in cash. The quality of our portfolio companies was strong. The key metrics we track registered as follows: the one year revenue growth rate was 16.8% for the Fund (compared to 6% for the benchmark); the gross profit margin was 54.7% (benchmark 29.2%); the return on assets was 7.4% (benchmark 3.9%); and the net debt to equity was negative 6.1%, meaning our companies had net cash balance sheets (benchmark positive 25.4%). We were also overweight the traditional defensive sectors, health care and consumer staples, at 26.6% (benchmark 13.5%). And well underweight the most cyclical sectors, with no investments in the energy and materials sectors (benchmark 13.3%), 1% in financials (benchmark 10.4%), and 9.2% in industrials (benchmark 19.6%).

In February we started to suspect that the COVID-19 pandemic might lead to a bear market, and we made some last minute adjustments. Early in the month we sold Taiwanese tea shop La Kaffa and Taiwanese beauty salon Chlitina, both are good businesses rapidly expanding locations in mainland China. Surprisingly, even after the Wuhan lockdowns had been announced, the shares had not sold off much. We thought that perhaps the total lockdown would be short lived. Even so, we realized cautious customers might avoid tea shops and salons for a while. With little upside in 2020, we preferred to hold the cash. We also made small across-the-board trims to our most illiquid positions, which included several tech companies based in Australia and the UK. By February 19th, the 1Q market peak, our cash balance had grown to 11.0% and our sector weights remained about the same. We remembered the first rule: have some extra cash on hand, stay in the game.

The second rule: Two Wrongs Don’t Make a Right

Investors who come into a bear market poorly positioned, loaded up on lower quality cyclicals with little cash reserved in the bank, often compound their first mistake by making a second one. They hold a fire sale on the worst performing stocks near the bottom of a bear market in order to buy quality companies in defensive sectors or to build up a big cash pile–a reaction which only locks in losses. And worse, it is the perfect set up for a second round of underperformance when the market inevitably rebounds.

Fortunately, we were relatively well positioned heading into the bear market. This allowed us to be in the game, relaxed, and not chasing from behind. Avoiding the first mistake dramatically improves our chances of avoiding the second mistake. Currently (April 17th) our cash balance sits at 7.1% and the quality metrics of the portfolio remain well ahead of the benchmark.

The third rule: Rebalance; if Everyone is Playing Defense, go on the Offense!

We believe that it’s always a good time to invest in high-quality growth companies. But equity markets can occasionally get prices wrong, either overpricing or underpricing a company. The stresses of a bear market cause most companies to be mispriced all at once. Many, many babies are thrown out with the bathwater. We have high conviction that smart investors must respond to the current market conditions. Even though it feels counterintuitive, perhaps even a little bit scary, we believe long term investors will be handsomely rewarded for selling some top performers near the bottom of the market and rebalancing into shares offered at deep discounts. We think it is best to operate methodically, making small changes over weeks and months and avoid the temptation to try to bottom tick the market. We look for companies with strong market positions selling great products for a premium because customers love them. We look for companies with safe balance sheets that don’t risk being put out of business by a recession. And we look for discounts, shares that are 50% off (or more) compared to pre-bear market prices.

For example, towards the end of the quarter we initiated positions in two Mexican airport operators: Grupo Aeropuerto del Pacifico (GAPB MM); and Grupo Aeropuerto del Centro Norte (OMAB MM). Both run airports that cater mostly to locals. GAPB has a five-year compound revenue growth rate of 23%, OMAB’s five-year growth is 17%, and both airports have net-debt-to-EBITDA (Earnings Before Interest, Tax, Depreciation, and Amortization) ratios below 1. Naturally, passenger traffic has dropped significantly during the COVID lockdown and so have their shares prices. We bought both companies at more than a 50% discount off peak prices. We think the long term trend for Mexican business and leisure travel to shift from buses to low-cost airlines will reassert itself as the lockdown eases and these businesses will experience strong rebounds.

The COVID-19 pandemic has created another rotation trade unique to this bear market. A small cohort of companies directly benefit from people locked down, working, studying, or just killing time at home. And no, we are not hoarding toilet paper manufacturers. We are more interested in buying companies that we think will benefit in the short term and long term from changed habits. The poster child for this trend is the video conferencing company, Zoom (ticker ZM). Now that we have all used it–me, my friends, my wife, my kids, you, your friends, et cetera, Zoom has cemented itself in pop culture. There is no turning back. Video conferencing is here to stay. We do not own Zoom, it is too large for our small-cap focused Fund. However, we do own V-Cube (3681 JP), the market-leading enterprise video conferencing solution in Japan. A couple of the other COVID beneficiaries we own include: the Korean molecular diagnostics company Seegene (096530 KS), the first to produce commercial volumes of a COVID test available globally, and the US/UK online wine retailer Naked Wines (WINE LN). We owned all three of these companies long before COVID-19 existed. (We got a bit lucky!) Once we realized they would benefit from the crisis, we added to our positions. During the quarter Seegene’s shares increased 246%, V-Cube’s rose 83% and Naked Wines shares were up 4%. And we think these companies will only get more than a short term bump from COVID conditions. We believe they have great products that delighted customers will continue to use once economies open back up. At this time we have rotated at least 50% of the portfolio into companies we think will benefit from shifts caused by COVID and will register sales growth in 2020 and beyond.

OUTLOOK

In front of the March earnings season we are cautious. So far most companies are saying the same thing, essentially that business was good in January and February, but fell off a cliff in March and the ground is nowhere in sight. They are pulling their guidance for 2020 because they don’t have any conviction where financial figures will land. We think this could put the market rally in late March and early April at risk.

Thus, for now, we remain overweight in companies that benefit from pandemic conditions whose share prices have already performed well. As they report strong earnings, we think their shares will continue to lead the market. We think wise investors, however, should take advantage of the opportunities presented in a bear market and rebalance. We have already started to sell some shares of defensive healthcare companies to fund the purchase of cheap high-quality cyclicals.  Over the June quarter we will likely rotate more of the portfolio out of COVID beneficiaries and into high-quality companies selling at large discounts. That is our plan.

At Seven Canyons Advisors we are committed to true small cap investing. We prioritize performance over asset gathering. We will cap our funds early to remain structurally more agile than our competition. We think that we have the experience and the right business model to deliver market beating returns for our shareholders over the long term.

Thank you for giving us the opportunity to manage your money.

DEFINITIONS

Earnings before interest, tax, depreciation and amortization (EBITDA) is a measure of a company’s operating performance

Net Debt-to-EBITDA ratio is a measurement of leverage, calculated as a company’s interest-bearing liabilities minus cash or cash equivalents, divided by its EBITDA

The World Innovators Fund seeks to provide long-term capital growth by investing primarily in domestic and foreign growth companies that we believe are innovators in their respective sectors or industries.”

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.

Past performance is not indicative of future performance and current performance may be lower or higher than the data quoted. The gross fee for the fund is 1.95% for both retail and institutional. For the most recent month-end performance data, visit www.sevencanyonsadvisors.com. Investment returns and principal value will fluctuate and shares, when redeemed, may be worth more or less than their original cost.

For a current list of top ten holdings and performance charts, please click here.

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