WAGTX Commentary (Q3 2022)
October 2022
OVERVIEW
The third 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 8.37%, while World Innovators dropped 15.28%, trailing the benchmark by 6.91%. 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 9/30/22 | WAGTX | MSCI ACWI Ex-USA Small Cap Index |
|---|---|---|
| Quarter | -15.28% | -8.37% | Year | -51.87% | -28.93% | 3 Years Annualized | -5.66% | 0.38% | 5 Years Annualized | -2.20% | -0.56% | 10 Years Annualized | 4.36% | 4.44% |
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, 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 slow motion market capitulation as the selloff of international stocks entered an indiscriminate phase. The growth component of the benchmark underperformed the value component by only 90pbs as both growth and value declined in Q3. All sectors of the index were down, and all major developed countries fell at similar rates except Japan, which declined less. A big headwind to international markets was a robust US dollar, strengthening by 6.7% against a basket of international currencies (DXY) in Q3. The positive message, if any, is that capitulation-type market environments tend to overshoot to the downside and are typically followed by stabilization. While the headlines are consistently negative – ongoing war, persistent inflation, and interest rate increases – markets tend to hit bottom before economies do. Are we there yet? Who knows, but we’re certainly closer to the bottom than a quarter ago.
The fund has underperformed the benchmark this year, which we view as an unfortunate but necessary attribute of concentrated, high active-share management. At the start of the year the fund was positioned largely in expensive stocks where sales and earnings growth accelerated during Covid, setting a high comparison base for earnings growth in 2022 – positioning that served us poorly. Looking back at the last nine months, we have rotated out of stocks where the post-Covid investment case was less clear. This has been a good adjustment. However, we continued to hold a number of stocks where the long-term growth trajectory remained strong but the valuations were too high in the context of a higher-interest-rate world. While these companies have executed well, the high valuations have been a major source of underperformance this year. We were also positioned heavily in the worst performing countries. Our biggest country overweight is Germany, where we have 14% higher weight than the benchmark, and which was one of worst-performing markets in the quarter, falling by 19% vs an 8% decline for the benchmark. Our three biggest weights in Germany were also our biggest detractors; va-Q-tec, JDC, and GK Software were each down around 20% in Q3. In all three cases the companies continue to report quarterly data consistent with our expectations, and we are highly confident in the strong prospects of these companies despite the negative news associated with European energy issues and inflation. We believe the negative investor sentiment around the German economy is having a detrimental impact on stock prices of these companies, without any visible impact on their fundamentals.
As a matter of fact, the fundamentals of most of the companies in the portfolio continue to remain healthy. As of the latest available period, average year-on-year sales growth of companies in the portfolio was 22%, which is in line with our expectations and with the growth rate seen in the first two quarters of this year. This sales growth is almost 2x the average growth rate for benchmark companies (14%). Average EBITDA growth for companies in our portfolio was 13% – below the aforementioned rate of sales growth, but well above the 10% average EBITDA growth for the benchmark. So portfolio companies are continuing to grow sales and EBITDA ahead of the benchmark, despite margin compression.
We believe that in current tough economic times, companies are looking for ways to become more efficient. Thus suppliers of efficiency with a demonstrable return on investment for their customers will stay relevant and continue to grow even in environments where companies are looking to cut costs. With this in mind, we started a position in Appier (4180 JP), a leading Japanese software player for automating online marketing. Clients can improve returns on marketing spend by 20% on average by using Appier software rather than relying on in-house staff, while at the same time saving employee costs by reducing the number of employees needed to oversee marketing expenses. Appier is successfully taking their software outside of Japan and is demonstrating notable gains in the US. The company IPOed just over a year ago. Since then the stock has declined over 60% from its IPO price, allowing us a great entry point.
OUTLOOK
The economic conditions in the international markets continue to remain difficult, and there is a lot of macroeconomic noise that makes it difficult to have a clear picture of various trends. The more cyclical parts of the global economy, such as housing, are starting to show visible strain as sectors respond to rising interest rates. Consumers seem to be under extreme pressure across the developed world, and it's hard to see that pressure letting up soon given rising interest rates and persistently high energy prices. On the positive side, we are starting to see pressure ease on supply chains as freight rates plummet: the composite index of container freight rates is down 65% from peak. Crude oil seems to have declined from peak levels as well, and copper prices are down 25% from peak and are only slightly higher than the prior peak they reached in 2018. We are not macroeconomists and can’t predict the direction of economic trends, but we can see that input-cost pressure on companies across the globe should start to ease, which is a welcome tailwind in an otherwise difficult environment.
From a bottom up perspective, we are seeing that companies in our portfolio are continuing to gain market share, as is evidenced from healthy revenue growth rates. We monitor this metric carefully and we believe these market share gains will continue regardless of the direction of the economy. The structural growth drivers of increased relevance of technology will continue. And our companies have strong balance sheets and have little reliance on capital markets for additional funding. In this difficult macroeconomic environment, we expect the strong to get stronger and eventually be rewarded by the market.
Our portfolio is trading near a three-year low price-to-sales ratio (P/S) of 2.9x after hitting a peak valuation of 5x early last year. While P/S as a valuation metric has its limitations, we think it’s a quick and consistent way to gauge portfolio valuation across periods, and view it as much more reasonable as a result of the ongoing market correction. At present, we are in an environment where the market is preoccupied with macroeconomic noise, but there will come a time when the focus will shift back to underlying fundamentals of companies. Current valuation levels position the fund favorably for when this shift occurs, as our companies continue to realize market share gains on the back of strong revenue and earnings growth.
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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