WAGTX Commentary (Q1 2022)
March 2022
OVERVIEW
The first quarter of 2022 was one of the toughest quarters in the fund's long-standing history. Our small-cap international benchmark, the MSCI ACWI Ex-USA Small Cap Index, was down 6.52%, while World Innovators dropped 18.70%. Our short-term underperformance is extremely disappointing. Nevertheless, the operating metrics and long-term trajectories of our portfolio companies continue to point in the right direction.
The chart below displays our track record over short- and long-term periods
| Periods ended 3/31/22 | WAGTX | MSCI ACWI Ex-USA Small Cap Index |
|---|---|---|
| Quarter | -18.70% | -6.52% | Year | -27.18% | 0.03% | 3 Years Annualized | 9.12% | 10.22% | 5 Years Annualized | 9.97% | 7.89% | 10 Years Annualized | 9.39% | 7.28% |
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 Fund Operating Expenses in excess of 1.76% and 1.56% for the Investor Class Shares and the Institutional Class Shares respectively until at least January 31, 2023. This agreement is in effect through January 31, 2023, may only be terminated before then by the Board of Trustees, and is reevaluated on an annual basis.
DETAILS FROM THE QUARTER
Historically World Innovators has stayed ahead of the benchmark, but the fund's performance over the last year has diluted our strong track record and begs a close examination of our holdings. Two obvious questions come to mind: Why the current underperformance? And is it temporary or structural?
First, it helps to look at how growth performed versus value within our international small-cap universe. In Q1, the growth component of our benchmark lost 10.3% versus the value component of our benchmark, which lost 2.5%. By virtue of investing primarily in growth companies, the fund was facing the same headwinds as the growth companies in the index, which accounts for a significant portion of the under-performance of the fund during the quarter.
However, when looking at the stock-level performance, we had a few large detractors during the quarter. Fevertree Drinks was the largest detractor, costing the fund 2.1%. Other larger holdings, including Nordic Entertainment, Va-Q-Tec, Gamma Communications, GK Software, and Advanced Medical Solutions, roughly detracted 1% each. Most of these stocks are domiciled in the UK and Germany, where markets significantly underperformed the benchmark in Q1. These main detractors also happen to be our core long-term holdings, where we have significant conviction in management, track record, and path forward. Per the latest reporting period of December 2021, the health of these companies was sound. Fevertree posted 14% sales growth, one of their highest growth rates over the last three years. Nordic Entertainment’s sales growth was 12% (also one of highest rates over the last three years), with 22% growth in the high-value streaming platform business. Va-Q-Tec grew quarterly sales 63%, close to an all-time record. The aggregate average year-on-year sales growth of companies in our portfolio was 20%, which is on the high side of the historical range. Despite the lackluster Q1 performance, these companies are growing largely in line with our thesis and are continuing to gain market share. Their fundamentals look good. We remain positive on the long-term potential of our owned companies given their strong market position, track record of gaining market share, and solid balance sheets. They have successfully managed challenging times before, and we believe they will successfully manage the current macroeconomic turbulence.
The common factor driving underperformance of the names above is valuation. Fevertree’s valuation contracted from 50-60x PE in 2021 to approximately 40x. Va-Q-Tec went from trading at 25x EV/EBITDA to 18x. Nordic Entertainment derated from 40x EBITDA to 35x. Gamma went from 25x PE to 20x in the course of this quarter. The picture looks similar for many names in our portfolio. Significant de-rating during the quarter was the main driver of our underperformance. While we did selectively trim names that appeared expensive going into this de-rating, in retrospect we realize that we should have been much more aggressive.
The silver lining is that our portfolio became cheaper and thus more appealing. Currently the portfolio trades at the cheapest level in two years on a variety of valuation metrics. We believe that all of our companies will generate great returns for years to come. Despite periodic bouts of significant volatility, the long-term charts show these stocks bouncing back stronger because they continue to grow revenues and earnings, thus becoming more valuable over time.
With the turbulence in the market, we are seeing many opportunities to buy quality growth companies at attractive valuations. One region of particular interest is Japan. Historically Japan has been a tough market for small-cap investors, as growth stocks tend to trade at very high multiples relative to the rest of the world. We have seen this reverse somewhat over the last year as many industry-leading software-as-a-service (SaaS) stocks have come back down to more reasonable valuations. During the quarter we added FREEE KK (4478 JP), a leading SaaS payroll services provider to small-and medium-size businesses in Japan. The company had an IPO in late 2020, tripling its stock price the following year. But in 2022 their stock roughly returned to its IPO price after a 60% decline from its peak, despite solid execution through Covid (which provided us with additional conviction). The fund purchased this stock at 12x sales–less than half the valuation it was trading at just a year ago. We really like this business as it tends to have high barriers to entry once scale is established, and there is a lot of room to grow sales to existing clients through rolling out additional features. We also added CI Medical Group (3540 JP), a leading digital distributor of dental supplies. CI Medical has a great track record of taking market share from legacy distributors, who still account for 90% of the dental distribution market. For a company with massive headroom, 15% annual sales growth, and 20% annual EBITDA growth, the company is trading at just 19x PE. This temporary slowdown in sales growth gives us an appealing entry point.
OUTLOOK
With the global economy undergoing inflationary stresses unprecedented in recent memory, and the future direction of the global economy very much in doubt, we want to keep the majority of the portfolio in innovative secular growth companies that continue to rapidly gain market share, enabling them to grow even when real GDP shrinks.
Inflationary environments present a challenge to higher-multiple stocks because higher inflation levels tend to lead to higher interest rates which reduce the discounted value of future cash flows. The companies we invest in are valued at higher multiples precisely because of the growth they can generate in the future. From a valuation perspective, this is an unfavorable environment for growth stocks. We don’t know if and for how long inflation will persist, nor how high interest rates will ultimately go. But we do know that the value proposition driving the sales growth of these companies relative to their competitors has not changed, so we expect our companies to continue to innovate and grow by taking market share. We also know that from an operational perspective, the vast majority of the companies we own do not need to raise capital since they are largely self-funding with strong balance sheets. This is why, despite the unfavorable environment, we remain confident.
We have made minimal changes to the portfolio by prioritizing companies we believe will grow. Market volatility has led to valuation declines in companies across the board. However, this decline in growth stocks has created very appealing reinvestment opportunities, allowing us to acquire equity in companies we like, but were previously hesitant to buy due to their high valuations. So while on the margin we have been redeploying capital judiciously to where we have higher visibility and more appealing valuations, we continue to be excited about our current portfolio of high-quality secular growth companies.
Sincerely,
The World Innovators Management Team
DEFINITIONS
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.
EBITDA (Earnings before interest, tax, depreciation and amortization) is a measure of a company's operating performance
EV (Enterprise Value) is calculated as follows: EV = market capitalization + preferred shares + minority interest + debt - total cash
PE Ratios (Price-Earnings Ratios) are the ratios for valuing a company that measures its current share price relative to its per-share earnings
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