WAGTX Commentary (Q2 2020)
June 2020
OVERVIEW
The first half of 2020 was an unimaginable, once-in-a-lifetime event--a rare black swan, nay, a dodo bird event. The simultaneous shutdown of nearly all commerce, all schools, and government institutions, and all office buildings everywhere -- all at the mercy of a highly contagious new virus -- changed life on the planet earth as we know it. The future of the economy is opaque at best, and stock markets react to uncertainty with volatility. In Q1 we witnessed the fastest peak-to-trough bear market dive on record for US stocks, followed by the best quarter in more than 20 years in Q2. For professional investors, this short four month window has been a unique chance to prove their value.
Our small-cap international benchmark, the MSCI ACWI Ex-USA Small-Cap Index, was up 22.83% in the June quarter. The Fund more than doubled the high bar set by that benchmark, returning a 48.00% increase. We are proud of the way we performed in an exceptional time. More importantly, we think it validates the Seven Canyons brand of investing: we target the inefficient small-cap niche of equity markets, we specialize in secular growth companies, and we are nimble decision-makers and allocators thanks to a small experienced team and early AUM caps on our funds. We think this formula provides a long term structural advantage over our competition that should lead to better performance for our shareholders.
The chart below displays our track record over short and long term periods:
| Periods ended 6/30/20 | WAGTX | MSCI ACWI Ex-USA Small-Cap Index* |
|---|---|---|
| Quarter | 48.00% | 22.83% | Year | 19.39% | -4.34% | 3 Years Annualized | 11.58% | -0.17% | 5 Years Annualized | 10.49% | 2.50% | 10 Years Annualized | 13.29% | 6.05% |
DETAILS FROM THE QUARTER
We executed our bear market strategy well. The fund was prepared before the market crashed with ample cash and liquidity, double-the-benchmark weight in traditional defensive sectors, and one-quarter-the-benchmark weight in cyclicals. We didn’t “panic sell” near the bottom in March. And critically, we played offense when everyone else retreated to defense, and rotated out of fairly priced assets and into severely mispriced ones.
To that last point, we recognized early in the COVID-19 lockdown that the prospects of many companies would be changed forever. In our own portfolio, we held several companies where the investment thesis had been dramatically accelerated, while others faced permanent impairment. This disruption was perhaps the most obvious in the Consumer Discretionary sector of the economy. The doors of brick and mortar retailers everywhere were locked and gathering cobwebs, while online retailers remained open 24/7. We have played the theme of shifting from physical to online retailers for decades, so we know most of the key online pure-plays around the world and owned several of them coming into 2020. Two of our favorite online retailers, Naked Wines (WINE LN) and AO World (AO/ LN), gave very positive updates early during the lockdown.
Naked Wines is the largest online DTC wine seller in the UK and the USA. On April 15th the CEO Nick Devlin tweeted, “COVID-19 is rapidly accelerating the trial of online models by American wine lovers. With online wine sales reported to be up [441%]... a quick bit of math shows online share of category going from ~7% pre-crisis to up to 25% in some recent weeks...The lesson from other categories is clear. Once consumers understand online options and become familiar with (them) the channel migration tends to run in one direction.”
And on a May 12th trading update, John Roberts, Founder and CEO of AO World, the leading online appliance store in the UK, wrote, “In terms of online shopping behaviour, I believe we have seen five years accelerate into only five weeks and we will plan to cement that change as we impress more new customers than ever with the AO Way.”
On the other hand, we also owned several companies that were founded before internet retail took off and thus have large legacy store bases. For example, we owned Pets at Home (PETS LN), a leading brick and mortar pet supplies retailer in the UK, and Fenix Outdoor (FOIB SS), which is like REI for the Nordic countries. These are quality companies with strong brands that lag online, but have been methodically investing in the internet channel. We think this methodical investment was enough in 2019, but online retail went into warp speed in 2020 and left them abruptly far behind.
Pets at Home’s May 21st trading update struck a somber, defensive tone: “In light of uncertainty around the duration of lockdown, disciplined management of cash and prudent allocation of capital became increasingly important. In addition to welcoming certain Government-led initiatives, we implemented specific measures internally to preserve near-term cash flow...deferring capital and marketing spend and agreeing a temporary 20% reduction in remuneration across our Executive Management Team, Non-Exec leadership team.”
Later in that same update, the company’s outlook was murky: “While online sales have remained at materially elevated levels, matched by improved capacity and good product availability, they are, in isolation, unable to mitigate the reduced level of in-store sales, and their weighting towards food, together with an additional £5m of costs relating to our initial response to COVID-19, has had an adverse effect on profits, margins and cashflow...It remains difficult to make a clear assessment of how consumers will react as we emerge from lockdown and we, therefore, do not feel it is prudent to provide full-year guidance at this stage.”
Even though our brick and mortar retailers saw sharp declines in their share prices, we deemed them fairly valued given the uncertainty they face, and therefore sold shares. As investors in growth and innovation, we did not then reallocate into deep cyclicals whose shares had declined the most. Instead, we invested in our favorite secular growth companies whose futures had become brighter much more quickly than expected as a result of COVID-19, leaving the shares severely mispriced in our opinion. We doubled down on Naked Wines and AO World. We also added to many other COVID-19 beneficiaries, including several global leaders in the meal kit subscription space: Hellofresh (HFG GY), Marley Spoon (MMM AU), and OISIX Japan (3182 JP). We agree with Nick Devlin that once consumers try online retail options, very few will ever go back.
At the beginning of the quarter, the Fund was overweight Consumer Discretionary stocks with more than 25% of the portfolio invested in the sector. Our rotations led to stunning results--our Consumer Discretionary stocks rose 96% on average during the quarter. Across the portfolio, we methodically rotated out of COVID-19 victims and into beneficiaries. And across sectors and industries, we outperformed our benchmark.
OUTLOOK
The Fund is composed of high-quality secular growth companies. Around half of our holdings directly benefit from the disruptions caused by COVID-19. The remainder of the portfolio is mostly long term structural winners that took a temporary hit during the lockdown and should come out stronger than the competition. A small fraction of the portfolio, around 5%, is invested in high-quality cyclicals whose businesses and stocks have been hit hard this year. With the global economy shrinking and the future direction very much in doubt, we want to keep the majority of the portfolio in innovative secular growth companies rapidly gaining market share, which enables them to grow even when GDPs are shrinking.
We believe there is a strong, objective case to be made that our positioning in growth companies is the right place to be in the current macroeconomic environment--oft dubbed “The New Normal” or “Japanification”. The foundational characteristic of most economies today (that locks them in a vicious cycle) is record levels of indebtedness. This forces central banks to keep interest rates low so that borrowers can repay debts and make lenders whole. An economy focused on loan repayment leads to underinvestment in innovation and productive assets, and slower GDP growth. Prior to 2020, the global economy was already on this slippery slope of indebtedness, and COVID-19 just gave it a shove in the back, accelerating the slide.
On March 23rd the US announced $2.0T worth of treasury and agency mortgage-backed securities purchases. The stock market bottomed. Soon after, Europe, Japan, and the UK announced similar central bank asset purchase programs valued well into the trillions of dollars. And initial programs were followed up by second and third rounds of massive monetary and fiscal stimulus, and there will be more to come. The speed and size of the government stimulus is many multiples larger than the response was to the 2008 Global Financial Crisis. These programs have softened the near-term economic hit from COVID, but extended the future period of low rates, debt servicing, and low economic growth from long to longer.
Japan started down this path of extreme indebtedness in response to the Asian financial crisis over three decades ago and remains on that path today--which means we’ve seen this movie before and we can learn from it. From an investment standpoint, we have been doing bottom-up stock picking in the country for nearly two decades and the recipe for success is clear--find, buy and hold high-quality growth companies. Slow GDP growth is not made up of all companies growing precisely 0-2% per annum, it is the average of all the company’s growth rates. In Japan, the majority of companies do seem to grow 0-2%, but a small cohort of well managed, progressive companies exist that consistently grow 10%, 20%, or even 30% a year. Japanese growth companies cannot rely on a booming economy to lift outcomes, they must innovate and offer customers dramatically better solutions to convince them to change old habits. In other words, they take market share, lots of it, in order to grow sales double-digits. Investors in Japanese growth companies have been handsomely rewarded with stock prices lifted by compounding sales and earnings growth with an added benefit: because growth companies are scarce, market participants tend to crowd into them, leading to valuation multiple expansion that endures over time.
We didn’t form Seven Canyons in anticipation of “Japanification”. It happens to be the way history played out. We have spent our careers perfecting the process of finding and investing in the best secular growth companies around the world. And this experience just might give us an advantage in the current high-debt low-growth economic backdrop. We think we have the right team and the right low-AUM business model to successfully beat the market for our investors.
Thank you for the opportunity to manage your money.
DEFINITIONS
Global Financial Crisis (GFC) refers to the period of extreme stress in global financial markets and banking systems between mid 2007 and early 2009
Gross domestic product (GDP) is a monetary measure of the market value of all the final goods and services produced in a period of time, often annually or quarterly.
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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