WAGTX Commentary (Q2 2022)
June 2022
OVERVIEW
The second quarter of 2022 follows the previous quarter as 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 17.55%, while World Innovators dropped 24.30%, trailing the benchmark by 6.75%. Our short-term underperformance this year is extremely disappointing, but as active, bottom-up, long-term investors, we are aware that our approach to investing will occasionally expose us to bouts of strong underperformance. 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 6/30/22 | WAGTX | MSCI ACWI Ex-USA Small Cap Index |
|---|---|---|
| Quarter | -24.30% | -17.55% | Year | -38.46% | -22.45% | 3 Years Annualized | -1.36% | -2.94% | 5 Years Annualized | 2.23% | 2.55% | 10 Years Annualized | 6.74% | 6.22% |
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
This quarter can be described as “more of the same, but worse” as the Q1 sell off of perceived Covid beneficiaires continued. The growth component of the benchmark lost 19.6% in Q2, underperforming the value component by 4.2% as growth companies continued to fall from grace. But this was also a unique quarter, defined by the start of a major war in Europe for the first time since World War II, with many ramifications yet to be seen. The initial effects were clear: a more difficult environment in Europe due to spiking energy costs, accelerating inflation, and need for much higher military investment which will put additional strain on budgets. There was an immediate and negative impact that led to European markets selling off significantly in Q2. Germany, the largest economy in Europe, sold off by 22%, with other major European markets largely following in lock-step. Europe accounted for 58% of our portfolio weight, with the two largest weights, Germany and the UK, amounting to 38% of our portfolio. The Germany and UK portion of our portfolio posted a decline of 27% in the quarter. Even though most of our German and UK companies have global revenue streams with significant sales and earnings coming from outside of Europe, the market chose not to differentiate, thus illustrating a knee-jerk reaction to global events.
Key drivers of WAGTX’s underperformance came from individual stock underperformance in a few of our high conviction stocks in Germany and the UK, which also happened to be the weakest markets in Q2. These high conviction European stocks benefited from the Covid pandemic and have structural growth drivers that we expect to propel the stocks in the long term. Unfortunately, these names continued to underperform the market due to a combination of persistently elevated inflation, rising interest rates and input prices, and the risk-off environment where investors “turn off” risk by running away from more expensive, higher growth stocks to find shelter from falling stock prices.
The biggest detractor was Va-Q-Tec (VQT GY), a core long-term holding, which corrected by 44% during the quarter. VQT is a German-based innovative manufacturer of thermal insulation containers used to transport pharmaceuticals and other temperature-sensitive products. VQT benefited from Covid vaccine distribution, but also has broad end-markets in pharmaceutical, construction, appliance, and automotive industries. The company has a phenomenal track record, compounding sales by 24% per year over the last five years while generating positive operating profit, and gaining market share from legacy solutions as VQT’s products do not require electrical connection. It is a founder-led company that is disrupting a massive market where a legacy player was just purchased for 28x EBITDA, compared to VQT’s valuation of 13x EBITDA. While their latest quarter demonstrated slowdown in growth coupled with temporary margin pressures, we were surprised by the severity of VQT stock price correction in Q2 given that their solution is as relevant as ever and there are no changes to their long-term growth trajectory. We are using this opportunity to increase our position in VQT as the market seems to be overly discounting their future.
Another large detractor was Future PLC, a digital media and ecommerce company based in the UK. This company has assembled a leading portfolio of digital publications such as PC Gamer, MarieClaire, TechRadar, Guitar World, and many others, demonstrating ability to grow a global user base, increase relevance, and improve monetization of these sites. Led by an experienced management team with an excellent track record, Future PLC has a strong balance sheet and the ability to drive growth globally, independent of market conditions. When we sit back and ask ourselves if Future PLC is in worse or better shape now than pre-Covid, it becomes quite apparent that it’s a much stronger business: it was a beneficiary of lockdowns and online users have increased nearly 50% since the pandemic; the value of their digital properties to advertisers has increased significantly since privacy changes limiting collection of personal data by third parties went into effect; and they expanded their portfolio by acquiring nine digital properties since the start of the pandemic. Nevertheless, their stock price declined by 38% during the quarter due to a combination of market concerns over sustainability of their user gains, and this year’s market trend of selling Covid winners (Future PLC returned 156% from pre-Covid levels to end of last year). Despite the recent downturn, the company continues to execute profitably and is continuing to grow both revenues and profits, albeit at a slower pace. And though there may be valid concerns about the state of the UK economy, only 16% of Future’s user base is from the UK, with more than half the users now in the US. Given the long-term promise of the company, we believe Future was a victim of "throwing the baby out with the bathwater.”
On the other hand, with market turbulence we find exciting opportunities to deploy capital. In Q2 we initiated a position in the leading German online pharmacy, Shop Apotheke (SAE GY). Despite a strong revenue growth trajectory and large addressable market, the stock has been battered due to lack of profitability coupled with regulatory delays. However, as the market for prescription drugs gradually shifts online, SAE stands to benefit immensely thanks to its established infrastructure and customer base. We also took advantage of the market sell off to initiate a position in Atoss Software (AOF GY), a leading workforce management software provider in Central Europe where there is large headroom for penetration growth. Although AOF has been delivering consistent revenue and earnings growth, the stock corrected nearly 45% from the start of the year, making it a well-priced acquisition with excellent future growth potential.
OUTLOOK
With the widespread market decline, we naturally step back and look at how our portfolio companies are performing. The weighted average sales growth of companies we own is still strong – 21% year-over-year as of the last reporting period available. While it’s quite possible this growth rate will slow as a result of potential recession, this number does indicate that our portfolio companies are continuing to aggressively gain market share even in this difficult environment. Unfortunately, we are also seeing margin dilution, with the 21% sales growth only translating to 12% EBITDA growth. We feel this margin dilution is temporary for several reasons. First, commentary from management teams indicates that the sudden nature of inflationary shock that began last year surprised many companies and they were late to respond by raising prices on their products and services. The companies we invest in have strong pricing power driven by their unique and relevant products or services, thus we have little doubt about their long-term ability to increase prices to restore margins. At the same time, we are observing a correction in a number of commodity prices which seems to indicate at least a temporary pause in the cadence of input cost inflation. Second, the war in Ukraine was equally sudden and unexpected, and resulted in temporary shock among the European corporates, so some business was postponed as companies digested the newsflow. Lastly, the logistics challenges that occurred in 2021 exacerbated inflationary pressures, but are now close to resolution. So as we look a year or more into the future, we have confidence that the current margin shock will subside.
The world seems full of negative news including war, inflation, political instability, economic uncertainty, etc. In easy times, when cost of capital is nearly free and the market is clamoring for growth at all costs, waves of new competition tend to emerge, chipping away at incumbents. But in times of turbulence, only structural winners gain market share. With rising cost of capital, high risk aversion, high inflation, supply chain disruptions, and many additional challenges, the competitive pressures tend to recede as weaker players exit the field. When capital becomes scarce, those without a strong balance sheet are forced to pull back on spending to preserve cash, and that helps restore normalcy to markets. We believe we are entering such a period. Thus owning high quality companies, with leading market shares in their niches and strong balance sheets, becomes absolutely paramount. Many of our companies are leading players in their markets and we think the silver lining to the current downturn is that as competition decreases, it will become easier for our companies to gain market share.
In addition, we are continuing to see that the trend towards increasing efficiency is as relevant as ever. Customers want a more efficient way of doing things, whether that relates to automating their payroll and accounting, shipping medicines in cheaper and more reliable ways, or enabling remote work conditions. Arguably, in periods of economic stress, doing things more cheaply and efficiently becomes even more relevant. We think that the majority of our companies are playing into this trend, which leaves us optimistic about the ability of our owned companies to overcome the hurdles of our current market environment. Thank you for your continued confidence, especially during this on-going market correction.
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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