WAGTX Commentary (Q1 2023)
April 2023
OVERVIEW
The first quarter of 2023 was not dull on headlines, with the largest bank failure in the US since the 2008 crisis, forcing the Fed to reverse its tight monetary policy. The ramification for international investors is that as the Fed goes, so do the rest of the central banks. The markets seem to be debating whether the pivot is permanent or temporary, and whether the Fed fund’s rate is peaking or if there’s more to go. However, when looking at performance of the markets and of the fund, Q1 was quite tame, with the fund returning 5.7%, beating the benchmark by just under 1%. 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 3/31/23 | WAGTX | MSCI ACWI Ex-USA Small Cap Index |
|---|---|---|
| Quarter | 5.67% | 4.70% | 1 Year | -18.18% | -10.37% | 3 Years Annualized | 8.74% | 15.04% | 5 Years Annualized | 0.65% | 1.72% | 10 Years Annualized | 6.09% | 5.06% |
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, 2024. This agreement is in effect through January 31, 2024, may only be terminated before then by the Board of Trustees, and is reevaluated on an annual basis.
DETAILS FROM THE QUARTER
The quarter was characterized by a mild “risk-on” environment: the growth component of our benchmark outperformed the value component by 1.7%. The rotation towards growth in the market was favorable to our style of investing. We think this was driven by three factors: the perception that we are approaching peak interest rates in the US, allowing the market to focus on what’s next; the weakening of the dollar against a basket of major currencies since its peak last September; and the fact that Europe’s mild winter minimized the much-feared deterioration of economic conditions there. Consistent with the risk-on environment, the best performing sectors in Q1 were IT and industrials. Risk on indeed. There is a lot of debate about the sustainability of this rally and the imminence of a global recession. Regardless, we continue to focus on bottom-up stock selection, with the belief that quality companies with a strong competitive advantage will accelerate market share gains, even in an economic downturn.
We think that the current recovery we’re seeing is rooted off into the future. We also suggest that the roots of the recovery are firmly planted in the belief that central banks/monetary policy will be there to catch any market stumble. It has been just three months since our last letter, and with the regional banking crisis in the US, we are already seeing this dance play out.
There is no disagreement from us that the banking system is foundational, and thus a reaction was necessary to avoid a systemically risky situation. And it is with little surprise to us that the go-to solution was a new form of quantitative easing (QE), opaque as it may be. Within a week of the first murmurs of banking stress, the Federal Reserve created a special vehicle offering additional funding to banks that would allow them access to enough capital to cover the entirety of their collateral. To avoid any further bank-specific runs, the offer was extended to all banks – stressed and sound alike. Within a couple more days, the Fed’s solution had reintroduced half the capital that was painstakingly sucked out of the system over the past year. The most simple and best framing we’ve heard is that the US economy is now driving down the road with one foot on the gas (QE) while the other is firmly on the brakes (high interest rates). Inflation is being handed out with one hand, while the other is taking it away.
We won’t predict how the scenario will unfold, but with the markets moving higher in the face of distress, two generic determinations are that the Fed IS there for us, and that the shakiness in the banking sector has brought us one step closer to the end of the high interest rate period. We agree with the first belief, but retain the memory that the Fed led us down this primrose path. The second conclusion is where we remain very cautious. Inflationary tailwinds are currently the Fed’s number one adversary. We don't believe a “silly” banking crisis is cause for a shift; what we do believe is that economic contraction remains the only catalyst for erasing the inflationary pressure, and contraction will ultimately be the driver of bringing down rates in a meaningful way. The year so far has shown us the too-familiar cycle where bad news yields a stronger market. We are skeptical of the “the sooner the economy breaks, the sooner we find salvation from the Fed” theme. It has worn thin over the past decade. Although the Fed now holds the reins of the market, economic reality will ultimately take back the controls. We don’t see a shortcut around tougher times ahead.
Though we look down the road, we hold tight to the fact that, while headlines can influence a day, the market ultimately moves at a much slower pace. The art of our business is seeing the forest through the trees. We see challenging times ahead with broad economic growth difficult to come by. Nevertheless, there are plenty of companies that will still show solid growth through the current environment, so attention to valuation will prevent blindly overpaying for growth. During the first quarter we began to see cracks in the expensive growth stocks that drove much of the market rebound over the past six months. Despite their high quality, valuations are beginning to be challenged as the pace of future growth comes into question. As always, we seek-out undiscovered GARPy companies with earnings as-close-to-certain as possible, and valuations that make sense for the type of business and company prospects. Fortunately we hold, and continue to find, many companies that fit into this bucket. With the belief that earnings drive stock prices, we expect that our style of investing will be rewarded.
The most notable aspect of Q1 is that almost all our outperformance came from stock selection. The less encouraging aspect of Q1 is that the fund was only firing on one of two cylinders – outperforming in the information technology (IT) sector while underperforming in health care. The majority of outperformance was driven by our technology stocks, which benefited in the sector-wide rebound from a weak 2022. Conversely, the healthcare sector was a sizable detractor. In addition to the general market rotation away from defensive sectors (such as healthcare), a few of our healthcare stocks experienced company-specific challenges. The fund continues to be positioned consistent with its long-term history of being overweight IT and healthcare, sectors where we see a lot of opportunities to invest in secular growth companies. We remain underweight in cyclical industries (such as commodities and industrials).
It was a bittersweet quarter as one of our biggest holdings, GKS Software (GKS GR), was acquired by a private equity fund. GKS was one of our top positions, and the announcement led to a 40% increase in the stock price. While we are happy to book the gain, and appreciate the validation of our thesis on GKS, it is somewhat unfortunate to have this name taken private at a fairly early stage in its life cycle. This is the second major holding of ours to be privately acquired in the last six months (Va-Q-Tec was taken out last December). We think these take outs demonstrate that there is a bid for high-quality smallcaps in Europe, and that valuations fell too far in the 2022 sell-off. Additional contributions to our Q1 outperformance came from Appier (4180 JP), another one of the fund’s top weights, returning 23%, and EMRO (058970 KS), a supply chain logistics software company that returned 107%.
The biggest detractor this quarter was I-Energizer (IBPO LN) which declined 17% and is one of our top weights. IBPO is a back office and customer support outsourcing company based in India. We are surprised by the decline in IBPO’s stock price as there have been no changes in the underlying business, and the stock is now on 9x earnings, yielding nearly 8% in dividends, delivering 15% sales growth, and improving margins. IPBO benefitted from COVID restrictions, but continues to enjoy a secular growth theme due to the increased outsourcing of low-wage labor by high-cost countries. As recessionary conditions tighten around the developed world, the demand for low-cost solutions should increase as companies focus more on cost reduction. In the current macroeconomic conditions, we think IPBO is more relevant rather than less.
Another significant detractor to the fund’s Q1 performance is Polypeptide Group (PPGN SW), declining by 26%. PPGN is a strong contender in a complex, very high-barrier-to-entry industry with only a few players globally. Yet when PPGN’s long-term CEO recently left and was replaced by an outsider, a host of management issues led to subpar execution from the company. We initiated the position under the assumption that all the negative impacts from management changes were behind them, and that the company would resume its growth. Unfortunately, during a quarter of rapid growth in the industry, more management issues became apparent, and the stock price reacted accordingly. The company has just appointed a new CEO after dismissing the prior one, so we think this should right the ship and put them back on a growth trajectory. We remain positive on the long-term outlook for PPGN given the rapidly growing industry in which it operates, and the strong competitive advantage of the company.
During the quarter the fund made a few changes, adding a number of high-quality beat-up names that we found through our bottom-up screening process. These names included Pensionbee Group (PBEE LN), a leading defined contribution pension aggregator in the UK. This was a classic case of a “busted” IPO from the early-2022 tech bubble, falling 65% from IPO price when the bubble popped. The business, however, is on a solid trajectory, progressing closer and closer to profitability and demonstrating strong revenue growth. We initiated a position in QT Group (QTCOM FH), a Finnish company that is a global leader in providing a code depository for programmers. We also added TGS Nopec (TGS NO), a leading global multi-client seismic data provider. Pason Systems (PSI CN) relies on similar data to TGS, but we chose to exit PSI because its growth trajectory is challenged by the end of rig count recovery in North America since nearly all relevant oil and gas rigs are fully deployed. TGS, on the other hand, does not face the same limits to growth, as it collects data in all major offshore oil/gas basins globally, and rig unavailability in one basin is offset by rig availability in another.
OUTLOOK
We are encouraged by strong revenue and EBITDA growth metrics of our portfolio companies. Per the latest reporting period, weighted average year-on-year sales growth of companies in our portfolio was 22.5%, which is similar to growth rates seen through 2022 and well above growth rates seen in 2019 and 2020. EBITDA growth accelerated to 20% year-over-year, almost double the growth rate our portfolio companies were seeing a year ago. As bottom-up stock pickers, these are the metrics on which we are most focused. We acknowledge the difficult macro backdrop and expected capital flows resulting from potential global economic turbulence, yet our focus remains on finding businesses that will thrive through the current, and hopefully any, macro environment. There is downward pressure on global growth right now, yet we remain confident that the companies that are able to grow through the pressure will be rewarded. As always, we are grateful for your trust.
Sincerely,
The World Innovators Fund Management Team
DEFINITIONS
EBITDA (Earnings before interest, tax, depreciation and amortization) is a measure of a company's operating performance.
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.
An investor should consider investment objectives, risks, charges, and expenses carefully before investing. To obtain a prospectus, which contains this and other information, visit www.sevencanyonsadvisors.com or call +1 (833) 722-6966. Read the prospectus carefully before investing.
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