WAGTX Commentary (Q3 2021)
SEPTEMBER 2021
OVERVIEW
Market conditions have been unkind to the World Innovators Fund in 2021, creating sector and style headwinds that have weighed on the share prices of our investments. Value stocks have outperformed growth stocks. Commodity sectors have outperformed. And numerous COVID winners, many of which we owned, have had flat or down share prices this year, as even the strongest results often haven’t been enough to meet lofty expectations and support valuation multiples.
For the most part, these trends continued during the third quarter. Most COVID winners sold off, despite reporting strong business results. The two strongest sectors were Energy +8.29% and Financials +2.67%, which are mostly composed of companies we avoid because they sell commoditized products and services. We were overweight the two weakest sectors, Healthcare -3.28% and Consumer Discretionary -3.96%. We are structurally overweight these sectors because they produce an abundance of companies with unique products and business models. On the balance, the fund faced some headwinds from market conditions during the quarter, but they were relatively mild.
Frustratingly, this means it was our stock selection that created the majority of the 7.00% underperformance relative to the benchmark. We had an unusual number of companies lower earnings guidance for 2021 for a variety of reasons—mostly due to external events they couldn’t control. The one commonality is that several companies reported COVID-related supply chain issues that went from bad early in the year, to worse in the third quarter. For example, AO World, a UK company, mentioned a truck driver shortage and associated wage increases due to Eastern European drivers returning home to sort out Brexit-related visa issues, then getting stuck there as a result of COVID. Asetek had production temporarily shut down due to localized COVID lockdowns in China, closing production facilities. Maisons du Monde had a similar issue in Vietnam. Avon Rubber had big orders to fill, but were having a hard time hiring because of the UK government’s temporary unemployment benefit boosts.
We do not think we have a systemic problem with the companies we own. Even great companies occasionally face some bumps in the road, but those bumps tend to look insignificant when a company consistently grows sales by double-digits for over a decade. Honestly, we think most of the quarter’s underperformance is a normal side effect of high-quality active management. We aim to generate significant long-term outperformance for our shareholders, and a critical part of any strategy aiming for significant outperformance is to run a high conviction, highly concentrated portfolio. Of the 4000+ companies in our benchmark, we own a total of 57. Our top 10 holdings account for ~40% of the portfolio. It is this highly concentrated structure that enabled the fund to outperform its benchmark by 53% in 2020, and to significantly beat its benchmark over the last 3, 5, and 10 years. But this structure also means short term periods of underperformance are normal—all it takes is for a few owned companies to simultaneously hit bumps in the road.
Chart: WAGTX performance vs. its benchmark
| Periods ended 9/30/21 | WAGTX | MSCI ACWI Ex-USA Small-Cap Index |
|---|---|---|
| Quarter | -7.00% | 0.00% | YTD | -5.45% | 12.23% | Year | 13.92% | 33.06% | 3 Years Annualized | 17.44% | 10.28% | 5 Years Annualized | 17.84% | 10.33% | 10 Years Annualized | 14.91% | 9.44% |
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, 2022. This agreement is in effect through January 31, 2022, may only be terminated before then by the Board of Trustees, and is reevaluated on an annual basis.
DETAILS FOR THE QUARTER
Our investment strategy is to purchase companies that are growing sales rapidly and taking market share from the competition thanks to dramatically better products and services. We select companies with large TAMs (total addressable markets); a large TAM is industry shorthand meaning the opportunity is big. Companies in industries with large, growing TAMs can grow sales double-digits for at least a decade. For example, our current largest holding is Nordic Entertainment (NENTB SS), the company behind Viaplay, a streaming service in the Nordics, second-only to Netflix. Viaplay is still growing fast in its home markets and is in the process of being launched across Europe, where it holds one of the best portfolios of live-sports streaming rights. The global TAM for paid streaming services is north of $40Bn and is expected to more than triple in size by 2026. We want to buy small-caps like Nordic Entertainment, which we think will eventually attain market caps of $10Bn+.
The largest individual positive contribution during the quarter was from German company Basler AG. Basler sells factory and warehouse automation products that make supply chains more reliable. Both sales and order-book growth have come in higher than the market expected, which seems appropriate given all of the supply chain disruptions the world currently faces.
Asetek was the largest detractor from performance. Asetek is the world leader in liquid cooling components for the fast-growing niche of high-powered PCs used primarily for gaming. The company has flagged supply chain headaches all year, and finally had to lower sales and profit guidance when a large supplier stopped production due to a citywide COVID lockdown. For perspective, Asetek has grown revenues by 3x over the last five years. Despite the guidance cut, it still plans to grow 10-20% this year. We confirmed with management that the brand and business remain strong, so we continue to own Asetek.
The other large detractor from our results was Marley Spoon, an Australian-listed online meal-kit retailer. The company grew sales 36% year-over-year in the first half of 2021. That was on top of the 89% growth it reported during the same period the prior year. However, supply chain disruptions, caused by US labor shortages and food price increases, mean the company will lose money in a year when analysts were expecting a small profit. But in our opinion, the supply chain issues should pass, and the company has already implemented price increases that should support margins, so we continue to own this company.
The charts below show some of the simple key metrics we track on a quarterly basis to ensure that the fundamental characteristics of our portfolio align with our long-term investment goals. They illustrate how wide the gap is between our average company’s sales growth, margins, and balance sheet quality compared to the average company in the benchmark.
Source: Bloomberg
Consistent double-digit sales growth is the most important metric in the search for small-caps that can graduate to mid- and large-caps one day. This metric accelerated nicely due to the world’s economies opening up thanks to the COVID vaccine rollout. We track gross profit margins because we think high gross margins signal leading products for which customers are willing to pay high prices. We track balance sheet leverage (debt-to-equity) because we think a good balance sheet is the easiest way to mitigate unexpected risks. It also implies that a company’s growth is likely organic and not fueled by debt-funded acquisitions.
The current portfolio metrics are solid, confirming that we are following an investment strategy which should lead to long-term outperformance. The economic rebound that followed the COVID-induced collapse is starting to fade, and growth will slow for businesses selling commodity products and services. However, market-share-gaining secular growth companies will continue to report much faster growth rates than the average benchmark company, and eventually investors will notice and buy up shares.
OUTLOOK
As the gravity of the COVID pandemic started to become apparent last year, governments around the world acted fast with stimulus measures to ensure that lack of demand for goods and services wouldn’t crash the economy. So far, these measures, along with the human ability to adapt to changing conditions, have worked pretty well. It turns out the supply-side of the economic equation is the longer lasting problem. New COVID variants leading to waves of local and regional shutdowns are partly to blame. And when workers do come in to work at warehouses and plants, COVID safety measures like social distancing reduce capacity, slow down production, and add costs. In addition, the unintended consequence of government stimulus is that workers continue to stay at home, especially when the other option is a low-paying job where they might be exposed to COVID. These are the main factors that have impaired global supply chains and caused delayed products and sharp shipping-price increases. For now, we think these issues may bleed into 2022, but will mostly pass as vaccines are widely distributed and temporary government-stimulus packages expire and compel people to go back to work.
COVID has exposed that the global supply chain is fragile, and that long-term factors, such as geopolitical squabbles (China vs. USA) and climate change-related weather events, could cause major disruptions. The silver lining to all this is that good operators are now acutely aware of supply chain risks, and are accelerating efforts to make their supply chains more robust. Several of our management teams are investing in production that is closer to home and more automated. We want to invest in well-managed companies that are planning for disruptions and, as a result, will deftly navigate them when they come. We have likewise made several direct investments in companies selling products that enable automation using robots, drones, machine vision, and software.
After making what seemed like all the right calls to adapt to COVID’s impact on stock markets in 2020, some of our investments have struggled with the new set of problems the virus has presented for companies in 2021. Even so, we believe that we own great companies which may emerge much stronger than their competition from this ongoing crisis. We also remain confident in our high-conviction, high-concentration investment strategy and its ability to beat the benchmark in the long term.
For a list of current top ten holding and performance charts, please click here.
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. There is no guarantee that the Fund will meet its investment objective.
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 us at +1 (833) 722-6966. Read the prospectus carefully before investing.
Seven Canyons Funds are distributed by ALPS Distributors, Inc.