WAGTX Commentary (Q2 2023)
July 2023
OVERVIEW
The second quarter of 2023 brought a few unwelcome surprises to the fund. We underperformed the benchmark by 6.6%, and the fund showed a negative total return for the quarter, which is disappointing to say the least. The driver of the fund’s underperformance in Q2 is attributed to two things: a steep decline in one single stock in the portfolio, and broad pressure on faster-growing, lower-profitability small-cap stocks which comprise a notable portion of the fund’s portfolio. The recent environment for fundamentals-based, growth-oriented stock pickers like us has been extremely difficult, and any whiff of a hiccup, however short-term it may be, has been severely punished. Despite the fund’s poor performance in Q2, we are encouraged by the fact that companies owned by the fund are demonstrating strong fundamentals. The portfolio had a weighted average sales growth of 20% and EBITDA growth of 35%, which speaks to dynamism of the companies held in the fund.
The chart below displays our track record over short- and long-term periods:
| Periods ended 6/30/23 | WAGTX | MSCI ACWI Ex-USA Small Cap Index |
|---|---|---|
| Quarter | -4.54% | 2.05% | 1 Year | 3.19% | 10.93% | 3 Years Annualized | -6.04% | 8.15% | 5 Years Annualized | 0.20% | 2.62% | 10 Years Annualized | 5.01% | 5.75% |
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 Great Disconnect. We’ve determined this short phrase to be the most apt description of the year, and particularly the second quarter. The markets are jammed with cross-currents: equities vs. bonds, large cap vs. small cap, US vs. China, manufacturing vs. services, and AI vs. non-AI. This jockeying simmers on the surface of the perennial debate about whether US rates have peaked and whether the US will avoid a severe recession following the steep interest rate hikes. Meanwhile the music played on for most markets in Q2 with the S&P returning 8.74%, the MSCI World Index rising 6.99%, the MSCI ACWI Ex-USA grinding higher by 2.63%, and the MSCI Emerging Markets Small Cap delivering 6.50%.
The overall macro environment paints a fairly clear picture with most data around the world directionally softening. Here in the US the manufacturing ISM hit the lowest point since 2009, and across the sea in China, the long-awaited economic recovery following draconian Covid lockdowns appears to be flagging. Even so, market participants are scratching their heads as they parse through the conflicting economic data, the expectation of even higher rates ahead (as communicated by the US Central Bank), and the screaming yield curve that’s telling investors that although rates may be high today, they may soon be much lower. These are not the conditions one would expect to produce some of the strongest equity performance in decades, as we saw in H1.
Common sense would dictate that the double shock from an unprecedentedly rapid increase in US interest rates coupled with poor post-Covid recovery in China would, at a minimum, lead to significant weakening of global demand, or at a maximum, to a severe global recession. While either scenario may yet happen, we are comforted by the fact that the companies we own are structural market share gainers, and economic weakness can serve them well in the long term by washing away weaker competition. As we wait to see the coming economic cards, it is worth mentioning that the market is still in the mode of the past decade, where negative economic news results in a positive market response. On the surface, a positive response is somewhat rational considering that tackling spiraling inflation seems to be requisite for rates to begin their drop. But as we’ve stated in past commentaries, we don’t find the shift as simple as the markets seem to be making it. The past year has shown us that downshifting the economic engine is no simple task. The Fed has essentially pulled the emergency break, yet momentum has propelled us forward for much longer than anyone anticipated. The effort to get things moving again at a safe speed is apt to be equally as challenging.
We are mindful of the macro backdrop, but keep our attention more closely fixed on what our companies are telling us. Thus far, we are still hearing that revenue trends remain robust. While we wait to see how this plays out, we have confidence that none of our companies “let a good crisis go to waste.” Over the past year, nearly every company we own has optimized and rationalized their cost and/or supply structure to some degree, improving the quality of their operations. So while we do not discount the probability of recessionary headwinds across our universe, the general sense from our owned companies is that they are continuing to grow, and are now in a better position from a profitability perspective.
PERFORMANCE
As mentioned, the fund’s underperformance primarily resulted from a steep drop by one single security that was one of the fund’s largest weights – iEnergizer (IBPO LN). In April, iEnergizer fell 82% following the announcement of the boards’ determination to delist the shares “in the best interest of shareholders.” We disagreed with their determination and assumed the founder (who is also CEO, a board member, and owner of 83% of the shares) would simply vote against the proposal in order to stop the delisting process. We’ve met with IBPO on-site in India and interacted with them over a dozen times in the three years we've held the security. Like the founder, we’ve long felt the shares were undervalued, and have written about it in our quarterly letters. When we heard the news, we immediately contacted the founder, hoping to encourage a rational vote and other shareholder-friendly corporate actions to correct the course. Over numerous calls the CEO lamented his ~$500M equity loss and expressed the same shock and disappointment that we felt. But he went on to mention the possibility of better access to capital as a private company and a reduction of expenses related to the public listing. His logic felt unsound and his lament insincere. Ultimately, he voted in favor of the proposal, and after 12 years of public trading, IBPO has been delisted. No one on our team, nor our brokers, clients, nor market confidantes have ever seen anything like this. We can only guess why the founder made the decision he did, and though we did our due diligence, the move feels suspect. While some shareholders, including WAGTX, were able to keep their stake in the soon-to-be private company, the decision led to forced selling by many others.
Another notable detractor in the quarter was Kaonavi (4435 JP), another of the fund’s top weights, which suffered a 25% decline in its stock price. We’ve owned Kaonavi for a few years now as it is a high-quality software company holding roughly 30% market share in Japan’s nascent talent-management software business. Currently, software penetration is only 13% among Japanese middle-market companies that form the bulk of demand for Kaonavi’s software. For a pure SaaS business with subscription revenue growth in the 30% range and minimal client churn, the valuation has always looked appealing at the 3-4x EV/sales multiple at which it typically trades. Unlike most SaaS software companies, Kaonavi is profitable in a meaningful way, aspiring to achieve a 10% operating margin this year. Despite a strong trajectory of fundamentals, the company announced a reduction (from 30% to 20%) in its expected five-year medium-term operating margin target. We feel Kaonavi stock was priced appropriately for the 20% long-term operating margin. The market reacted rather violently however, sending the stock down 25% over the course of the quarter. We followed up with management and remain confident in the company’s continuing trajectory of reliable revenue and profit growth.
CI Medical (3540 JP) also had a negative impact on our performance, with the company’s stock suffering a 27% stock decline during the quarter. It is a leading digital and catalog distributor of dental supplies to dental offices in Japan. Based on numerous touches with management, we consider CI Medical to be the dominant player in Japan, with associated pricing power. Because CI Medical imports most of its products from outside of Japan, the recent yen depreciation has put significant pressure on their gross margin. Given the company’s dominant position, we expected CI Medical to increase prices to offset the hit to their gross margin from yen depreciation. However, the company did not increase prices materially, and suffered a significant margin decline. We asked the company repeatedly why they are not increasing prices to protect their margins, but did not receive a clear answer. With our confidence in the company’s competitive advantage now waning, we decided to exit this position.
During the quarter we continued to take advantage of market dislocations presenting us with attractive opportunities to buy high-quality growth businesses at reasonable prices. One such example is Keywords Studios (KWS LN), a service provider to video game publishers. We have known this stock for a long time, but have been concerned about valuation as the stock always carried a high multiple. Given the AI-related market gyrations of recent months, Keywords Studios de-rated massively as many feared its services would be replaced by AI. However, we believe KWS should be able to leverage AI to improve its service offering – an outcome overlooked by the market’s knee-jerk reaction. We also added LT Foods (LFTO IN), the second largest branded basmati rice company in the world, and the leading branded player in the US and Europe. The company has both a domestic and an export business that each have considerable headroom. Within India only 30% of the rice sold is branded, and as the country develops we see packaged rice continually gaining market share. In the export markets there are more regions to penetrate, and as the company moves towards more rice-based packaged goods and higher-value organic offerings, the margins should march higher. LT Foods is a company that has grown sales at a 12% CAGR over the past decade, and earnings at a pace of 19% per annum. The headroom remains large enough that we believe the pace of growth will continue for some time. We have high confidence in the business and were able to purchase our shares for under 10x trailing earnings.
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 20%, which is similar to growth rates seen through 2022 and well above growth rates seen in 2019 and 2020. EBITDA growth accelerated to 35% year-over-year, significantly above 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 the 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
CAGR (Compound annual growth rate) is a measure of average annual growth over a given period.
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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