WAGTX Commentary (Q3 2024)

October 2024

OVERVIEW

In the third quarter of this year, international stocks finally ripped upward, with the benchmark returning 8.7% and the fund following its footsteps. The theme du jour was interest rate cuts, with the Fed delivering its first rate cut this cycle, and a large one to boot. In June, the Eurozone, a significant portion of the fund’s universe, kicked off the interest rate-cutting trend, and followed with another cut in September. The markets cheered, with a strong move up after largely going sideways for the first half of the year. Interestingly, international small caps outperformed the S&P in Q3. Is this the start of a catch-up trade? Perhaps. Yet, international small caps remain a heavily out-of-favor asset class, with many companies sporting a massive valuation disconnect versus their US peers.

One other theme to emerge was the impact of the Chinese market. After a capitulation-level sell-off in Chinese stocks, the Chinese government finally announced a sizable stimulus, and the heavily oversold Chinese market rallied hard. China was one of the best performing markets in the quarter, returning 18.5% – a reflection of the stimulus-triggered excitement. Although it comprises a de-minimis portion of the benchmark (2.6%), when China makes big moves, they tend to reverberate globally. WAGTX does not have any exposure in China, as it is a market where our process has not worked well; we thrive on companies with earnings visibility, and in China we have not been able to find such visibility despite years of trying. Nevertheless, the global impact of the Chinese stimulus is quite positive. Having another region of the world shifting from a restrictive to a more accommodative stance is a tailwind to global demand. Whether that lasts, we shall see.   

The strength in international small cap markets was fairly broad-based: major markets like the UK, Japan, Canada, Sweden, and Australia were up low double digits, and India rallied 9%. China was a standout, rallying 18%. Not everything was green though – laggards included Germany and France, returning only 3% as their economies sputtered, and South Korea and Taiwan, which returned negative single digits. Mexico was down a whopping 12%, as that market digested the election impact. So while the general mood was up, it was not universal. 

Lower US interest rates will likely boost international small caps, but as bottom-up investors, our focus remains primarily on company fundamentals. The stocks in our portfolio are selected for their ability to grow and take market share in any macro environment.  

DETAILS FROM THE QUARTER

Fund performance during the quarter was solid across all countries, with the notable exception of South Korea. Looking at the fund’s largest country exposures, performance in the four top markets (UK, Germany, India, and Japan) has been quite strong. Canada, while a smaller weight, was also one of the top contributors to our outperformance. The main detractor was South Korea, where our stocks declined an average of 23% during the quarter. It’s hard to find a common theme within our South Korean names, other than that South Korea tends to be a very volatile market, thus performance can vary greatly from quarter to quarter.

The largest contributor to WAGTX performance during the quarter was Blackline Safety Corp (BLN CN).  Blackline is a leading manufacturer of wireless safety monitoring devices for the oil and gas industries – workers wear the device that automatically detects the presence of dangerous gasses. This company differentiates itself by selling services on a subscription basis, thus the majority of its gross profit is recurring. We have a long history of investing in this company. While Blackline Safety has continued to gain market share over the years, the stock price has been very volatile, declining 81% in 2022 from its 2021 peak, when high interest rates took a bite out of the valuation of this yet-to-be profitable company.  The company’s execution has been quite robust though, and the stock price has been recovering since a trough in late 2022, but it still has a ways to catch up to its prior peak. This is the background for a strong rally the stock had in Q3 when they finally reached maiden adjusted EBITDA profitability. The stock reacted well to achieving that milestone, jumping 36% over the course of the following weeks. 

The second largest contributor in Q3 was JDC Group (JDC GY), another long-time stalwart of the fund and the current top individual weight. In a nutshell, JDC is the leading insurance platform in Germany, used by the majority of insurance companies to empower their agents to manage customer insurance contracts. While JDC has a solid growth trajectory, growth decelerated in 2023 as a result of general macroeconomic weakness in Germany. This year the weakness reversed, and JDC showed accelerating revenue and earnings growth along with new operating leverage. Q2 revenue growth was the highest it has been in four years, and EBIT margin doubled albeit the small base. When sales growth accelerates and operating leverage kicks in, stocks tend to react with gusto, which is what we observed in Q3 as the stock responded to the accelerating fundamentals.

The largest detractor in Q3 was Next Vision Stabilized Systems (NXSN IT), a leading camera manufacturer for small drones. This company has experienced rapid revenue and earnings growth driven by accelerating demand for small drone cameras both from growth in the underlying end markets, and from a shift in demand towards smaller drones (where Next Vision has a strong platform). The stock performed very well through Q2 of this year (returning 91% year-to-date), but corrected 26% in Q3. We think this is a technical correction, and continue to believe that the business is fundamentally strong.

Another sizable detractor was Arman Financial Services (ARLF IN), a regional microfinance lender in northern India. At one point this was one of the fund’s top positions, but we began exiting this position over the course of the year as we became concerned that the company is running out of headroom in its core microfinance business. Additional concerns surfaced more recently regarding excessive lending in the micro-lending industry, which has seen tremendous growth over the years, attracting a significant amount of new capital. Because of our gradual exit, we felt the 19% Q3 stock correction.

OUTLOOK

As bottom-up stock pickers, our focus is on the fundamental performance of the companies in our portfolio. While the optics suggest that lower interest rates will help international stocks, and international small caps in particular, we do not hang our hope on the direction of interest rates, nor do we pontificate on where they may go. We are bottom-up investors focused on company fundamentals, and the fundamentals of the companies in our portfolio have remained strong, demonstrating that regardless of macroeconomic uncertainties, our portfolio companies have continued to grow profitably. We believe combined earnings for our investments can follow a mid- to high-teens trajectory over the long term. At Seven Canyons we search for businesses with real long-term growth driven by sustainable competitive advantages, and the attractive opportunity set presented by international small caps allows us to invest in such companies early in their growth cycle. As in the past, we intend to devote time to speaking with the management teams of companies we own, and of companies on our get-to-know list – companies that often have little to no coverage by the street or our competitors. Doing so will enable us to assemble a mosaic of indicators about the true nature of these businesses, their opportunity sets, and the likelihood that they can achieve their goals. Our goal is to purchase businesses that demonstrate an ability to thrive through the majority of macro environments, with the potential to reward our investment. We are grateful for your trust, and welcome your feedback and questions.

DEFINITIONS

EBIT (Earnings before interest and tax)

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