WAGTX Commentary (Q1 2024)

April 2024

OVERVIEW

By the end of the first quarter of this year, international small-cap stocks generally showed little movement, with the fund lagging the benchmark by 4.78%. While this is certainly disappointing from a shorter-term perspective, we remain optimistic about the current opportunities represented in the portfolio. Our approach continues to focus on a robust screening process involving detailed due diligence including screening, extensive dialogue with senior company management, and modeling our assumptions to create a roadmap for what we believe the future will hold. We look for growth in earnings, improving profitability (ROA), and solid balance sheets coupled with what we believe are reasonable valuations.  

DETAILS FROM THE QUARTER

Japan is the largest country-weight in the benchmark at 22%, and is currently at 12% weighting in the portfolio. It is a huge market with thousands of small-cap public companies lending to a relatively inefficient market in the small-cap space and a vast opportunity to execute on our process. Numerous companies demonstrate rising ROA, growing sales, margins, and business models that resonate with our analysis. Our performance in Japan was challenged in Q1, accounting for over 50% of total portfolio underperformance. Several underperformers were SaaS (software as a service) business models, a model characterized by large upfront development and marketing costs, followed by dynamic positive effects as the revenue line grows. When successful, dramatic improvement in profitability and income generation result as the upfront costs are leveraged. We think the companies we target in that space have superior products and a large untapped market, so we are willing to invest prior to the inflection point in their profitability. On average our Japanese companies grow sales at 33%, yet the two largest weights are still unprofitable. We believe that when profitability emerges, the market will reward those stocks. Given the nature of the industry and our confidence in their ability to grow into a large addressable market, we see them as great opportunities that are currently mispriced. 

Let's look at three examples: FREE, SpiderPlus, and Kaonavi. Our biggest Japan weight is FREEE (4478 JP), a small business accounting software firm, similar to Intuit in the US, with 56% market share in Japan. Notably, FREEE has only a $1.3B market cap versus Intuit at $176B. FREEE has two major tailwinds going in its favor. First, Japan remains far behind in adoption of accounting software with only 25% penetration of cloud accounting. Second, FREEE’s 100% cloud-based software puts it on the cutting edge, avoiding messy transitions from on-premise software that “legacy” software companies have to endure. It has grown subscription sales at a 41% per-year rate over the last three years yet is currently unprofitable as they are aggressively reinvesting into growth. We believe it will reach profitability next year, with on-going dramatic acceleration. FREEE’s balance sheet is also solid, with $240M of net cash, compounded recurring revenues at 35% CAGR, and increasing dominance in the market. FREEE is now trading on EV/2024 sales of 6x (compared to Intuit at 11x) – relatively inexpensive, although since it has not yet reached profitability it cannot be valued on current earnings. Another large Japanese SaaS position in the portfolio is SpiderPlus (4192 JP), offering subscription-based construction management cloud software in Japan. They are by far the largest player with approximately 10% market share in a nascent, under-penetrated market. SpiderPlus has delivered a three-year revenue CAGR of 28%, though the stock has been largely flat since the start of 2023, even as the revenue growth rate accelerates. We believe they will reach the profitability inflection point in Q3 of 2025, and expect subscription revenues to continue to grow 30-35% per year thereafter. It trades on an attractive EV/sales multiple of 5.2x 2024 compared to similar construction management companies elsewhere such as Procore (PCOR) in the US at 9x, and Smartcraft (SMCRT NO) in Norway at 8.8x. Finally, there is Kaonavi (4435 JP), one of two leading HR SaaS players in Japan. Kaonavi has compounded its recurring revenues at a 45% annual rate over the last five years and recently hit profitability, delivering a 12% operating margin last quarter. Despite this incredible progress, the stock declined by 34% since the start of 2023. Kaonavi trades at 2.4x 2024 EV/sales (much lower than similar companies), and 40x P/E, an elevated earnings multiple that reflects the early stage of profit generation.   

The picture in Japan is such that we own tomorrow’s winners – the names above are dominant or close to dominant in their niches, have winning business models, and are growing in a way that makes it clear they’re continuing to gain market share. It does not take much analysis to see these companies will be worth multiples of their current value. Relative to comparable business models in the US and Europe that achieved similar dominance in their markets, our Japanese holdings are trading at significant discounts, but Japan is not different enough to warrant such discounts. Demonstrating consistent recurring revenue growth north of 30%, and improving margins and narrowing losses on the way to near-profitability is an attractive position to be in. As quality oriented, ROA and earnings-focused investors, we sometimes make the decision to invest in companies where we know ROA will grow in the future despite a low ROA in the present. This is akin to buying Amazon in its earlier phase of going public. We don’t shy away from such investments, but the flipside is more volatility in performance, requiring more patience from investors.

Though India only had a small impact on performance in Q1, its weight in the fund is second only to Japan, and given the breadth and depth of opportunities we are seeing in India, we think it is worth a brief discussion. The fund’s Indian small-cap stocks returned 50% last year. The Indian stock market regulator triggered a small-cap correction in Q1 by attempting to dissuade domestic fund managers from increasing their small-cap exposure. We have seen corrections in India before, and historically they have proven to be short lived since the country’s economic growth is on very steady footing. We took this correction in Indian small caps as an opportunity to add to high conviction ideas and trim those with frothy valuations. The 50% return last year was excellent, and the future of our India holdings remains bright. Our positions are consistently profitable, have improving ROA, and are compounding earnings at an average annual rate of 17%.These holdings trade at a reasonable P/E multiple average of 24x this year’s earnings (compared to the Indian index trading at 21x this year’s earnings for 14% earnings growth). Our India holdings also demonstrate excellent profitability and returns metrics as evidenced by their average non-cash ROA of 18% and near-net cash balance sheets.  

We continue to position the fund towards innovative, high-quality growth companies trading at reasonable valuations. One such idea that we added in Q1 is Fabasoft AG (FAA GR). Fabasoft is a German software company with a two-speed story: half of the revenues come from government digitalization contracts (which the market dislikes), and the other half of revenues come from SaaS data structuring for large organizations. The latter revenue stream has led to margin expansion and acceleration of earnings growth over time, and a shift towards more SaaS. In addition, Fabasoft has been in investment mode over the past year to support the growth of its SaaS software business, reaching the point of operating leverage where future sales growth will be faster than increases in operating expenses. Fabasoft is trading at a very reasonable valuation of 9x EX/EBITDA for what is increasingly becoming a very valuable SaaS business.

POSITIVE CONTRIBUTORS TO PERFORMANCE

The largest contributor to the fund’s performance in Q1 was NextVision Stabilized System (NXSN IT), returning 47%. NextVision is the global market leader in sub 2kg cameras and gimbals used for drones. The company is rapidly gaining share in the extremely fast-growing military drone market as a result of their offering being “lighter, better, and cheaper.” When comparing the NextVision products to their closest competitors, their offering stands head and shoulders above on every metric. On top of these attributes, the company has designed their product to be a “plug and play” solution for any drone manufacturer. The performance of the business speaks for itself, with revenues growing north of 80% over the past three years, and earnings up five fold. What’s most compelling about the opportunity is that adoption remains in the first innings. Military budgets are just now starting to shift from large and extremely expensive drones to small and cheaper drones. Furthermore, the US is currently only ~15% of their revenue, yet it is where the bulk of global military spend derives. The company is just now gaining a toe-hold in the US and they anticipate it to ultimately be their largest market. The stock has performed very well, but still trades at a reasonable 18x forward earnings with an expected 65% earnings growth in 2024.

The second largest contributor was Boku Inc (BOKU LN), returning 37% in Q1. BOKU is a largely-undiscovered payment processing company historically focused on facilitating the billing of digital transactions to the customer’s mobile phone bills – a profitable but fairly mature and niche market. Over the last few years the company has worked to leverage its relationship with global merchants such as Sony and Amazon to connect them to emerging local payment methods such as electronic wallets. Boku focuses specifically on Asia, where electronic wallets are becoming a payment norm. The challenge with connecting disparate electronic wallets across many countries is that connection protocols and regulatory friction complicate the process. Nevertheless, over the last two years we have seen strong tangible progress in penetrating electronic wallets, with such transactions now contributing 22% of revenues. The strategy was also validated by inking a long-term deal with Amazon, in which Amazon acquired warrants to the tune of 4% of Boku’s capital, illustrating the importance of Boku to Amazon’s business. Despite such progress, the stock was range-bound for most of last year, but performed better in Q1 as they released a business update showing the currency-neutral revenue growth rate accelerated to 34%. On the back of continued strong execution, the company finally began to receive well-deserved attention from the market.

DETRACTORS TO PERFORMANCE

The largest detractor was Linical (2183 JP), declining 30% in Q1. Our original thesis was that Linical is a well-run contract research organization that scaled up its business significantly right before Covid. This impaired demand for their services, leaving them with an elevated cost base and no access to the human-patient population required to run their studies. Fortunately, the US exposure, added right before Covid lockdowns, is now going strong. Unfortunately, their core Japanese business has yet to return to normal. The company reduced labor costs, and our expectation was that as the world further normalized demand would pick up and the company would demonstrate significant margin expansion by the end of this year. However the case for margin expansion has not materialized, and business pressures in Europe and Japan have not abated, which raises concerns about the credibility of management. We decided to exit this position in recognition of the fact that our expectations were too optimistic. 

The second largest detractor was Ray Co (228670 KS). Ray is a global manufacturer of oral imaging equipment, and we view it as a highly innovative company. We have known Ray for about four years and spoken with the founder multiple times. This innovative style led the company into the mask business in response to Covid. This move was a capital-destructive diversion that led to a writedown of that investment, and distracted the management from expanding their China operation. This distraction proved significant because other Chinese players began rolling out low-end products to compete with Ray. This increasing competition in their core market forced us to question our belief in their ability to differentiate their products long term, and our confidence in management was reduced. We exited our position in Ray Co as a result of these concerns.  

OUTLOOK

At Seven Canyons we spend our time searching for businesses with real long-term growth driven by sustainable competitive advantages. The nature of our approach and the attractive opportunity set presented by international small caps often allows us to invest in companies early in their growth cycle. We spend a lot of time speaking to management teams of companies we own and companies on our get-to-know list. These are companies that often have little to no coverage by the street or our competitors. Through our efforts, we assemble a unique mosaic of indicators about the true nature of these businesses, their opportunity sets, and the likelihood they will achieve their goals. Metrics for Q1 continue to look solid with our portfolio-weighted average EBITDA growth of 15%. This demonstrates that regardless of macroeconomic uncertainties, our portfolio companies are continuing to grow profitably. We expect combined earnings for our investments to follow a mid to high-teens trajectory over the long term. As bottom-up stock pickers, these are the metrics on which we most rely. Our focus remains on finding businesses that will thrive through the majority of macro environments and will ultimately reward our investment. As always, we are grateful for your trust, and we welcome your feedback and questions.

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 1.70% and 1.60% for the Investor Class Shares and the Institutional Class Shares respectively until at least January 31, 2025. This agreement is in effect through January 31, 2025, may only be terminated before then by the Board of Trustees, and is reevaluated on an annual basis.

DEFINITIONS

ROA (Return on assets)

CAGR (Compound annual growth rate)

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

P/E (price to current year earnings per share ratio)

MSCI ACWI Ex-USA Small Cap Index is an index representing 22 of 23 developed market countries (the United States is the excluded country) and 24 emerging market countries, covering roughly 14% of the global equity opportunity set excluding the US.

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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Seven Canyons Funds are distributed by ALPS Distributors, Inc. (ADI)