WAGTX Commentary (Q3 2023)
October 2023
OVERVIEW
At the close of each quarter we pan out in order to better see the forest (economy) vs. the trees (portfolio companies). The goal of this task is to ensure that the fund is well-positioned for the current environment, with a secondary objective of fleshing out a well-articulated view to communicate to our investors. Without fail, the exercise leads us down a path into global economics. And although we meander with high hopes of finding a clear path this time, without fail, we exit the forest with some great historical quotes, and resignation to hope for the best, yet plan for the worst.
The third quarter was defined by the relentless climb of the 10-year yield, ending near 4.6%, the highest level since 2007. Both the level and magnitude of the increase are notable and unkind to international small-cap investing, but what’s more important is the resulting shift in market expectations from peak rates and inflation, to the “higher for longer” mindset. The factors driving the 10-year yield higher are complex – higher oil prices, a stronger labor market in face of consistent rate hikes, and a more regulatory-heavy political environment. This leads to a stronger dollar, and re-directs global investment towards the U.S. and away from international markets. Negative cross-currents galore. The macro remains challenging, and it seems like the bottom is yet to be reached.
We don’t have much to add to these discussion points beyond what’s already being reported. This conclusion was supported by a recent Bloomberg quote from Epictetus: “First learn the meaning of what you say, and then speak.” All of the aforementioned financial realities are facts. Collectively they are symptoms of a debt cycle. We are decades into a well-understood developed market (DM) debt cycle. There are plenty of history books that can enlighten us as to what has happened in past debt cycles. Spoiler alert: it’s not pretty. It begins with printing money, peaks with printing more money, and ends with enormous wealth gaps and frustration (to put it lightly) from the masses. As we sit within a present-day cycle, the challenge is more about timing and patience than worrying about the ultimate outcome. We’ll humor readers with a reminder of the definition of cycle: a series of events that are regularly repeated in the same order. What’s most relevant for investors today is simply accepting that we are indeed in a cycle, and that there is a pattern to it.
The trouble with accepting this anticipated pattern is that, at best, we can tell everyone else is accepting it as well. This dynamic makes for high market volatility, since corporates to consumers have been trained to lean on government support as soon as any real pain registers. For example, over the last few days alone we have seen a market that rejoices in both economic weakness and economic strength. To us this is irrational behavior, as it telegraphs that any outcome is a win.
As an advisor that prides itself in discovering and aggregating portfolios that offer some of the smallest market-cap companies available to investors, this makes for an extremely tough market. Behind the scenes of generally solid global index returns, we have seen wildly different performance between small caps from region to region. It’s very clear that the US interest rate path is dictating investor appetite in developed markets, whether that makes sense or not. It is certainly frustrating from our perspective to endure environments where fundamentals don’t matter. The silver lining is that many high-quality companies are on sale right now.
In contrast to DMs, emerging markets (EM) have performed very well through the year. In our recent shareholder letters we alluded to the superior balance sheet positioning and better ability to endure inflation that most EMs exhibit. This has been rewarded in 2023. But we shouldn’t assume that the economies of the world operate autonomously. They don’t.
So how are we reacting to the current environment? With (or without) the current backdrop, every investment we make is hinged on determining whether or not the business in question is a “real growth” business of quality with competitive advantage. The environment that we are in today makes this question more relevant than ever, given that the free-flowing money of the past decade has effectively been shut off – for now. We have always maintained the same strategy and objective, and plan to continue through all the cycles that come and go.
DETAILS FROM THE QUARTER
The chart below displays our track record over short- and long-term periods:
| Periods ended 9/30/23 | WAGTX | MSCI ACWI Ex-USA Small Cap Index |
|---|---|---|
| Quarter | -5.54% | -1.70% | Year to Date | -4.71% | 5.03% | 3 Years Annualized | -14.24% | 4.01% | 5 Years Annualized | -2.15% | 2.58% | 10 Years Annualized | 3.51% | 4.35% |
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.
From the perspective of international small-cap markets, growth underperformed, with the growth portion of the international small-cap index declining 3.6% vs the value part appreciating 0.5%. This is a continuation of the year-to-date trend of growth underperforming value. We think this is a reflection of the macro environment of slowing growth and rising interest rates worldwide. The macro indices are continuing to indicate deterioration in global fundamentals – both US and Eurozone composite purchasing managers’ indices deteriorated, while the US, Eurozone, and Japan 10-year yields moved upwards in a consistent pattern. Oil prices also increased significantly from Q2 lows. Markets are realizing that the going is getting tougher for the foreseeable future – the next card is not any better than the previous card.
One divergence that we observed this quarter is that benchmark performance was led by India, an EM that has become the third-largest country exposure in the benchmark, carrying a 7% weight. We think this is reflective of a slow but steady shift of more economic activity to India from both China and the developed world, and illustrates how the engines of global growth are shifting. India has always been an important market for us given its breadth of high-quality small-cap growth companies, and India has become one of the fund’s largest weights. It's interesting to observe that India was a solid performer both in the fund and in the benchmark, returning 12.5% in the quarter and 28% year-to-date, while the other two large benchmark weights of UK and Japan generated a negative return. What stands out to us is that Europe continues to struggle, with quarter benchmark returns for Sweden at -12%, Germany at -9%, France at -7%, and the UK at -2.5%. From a high-level perspective this makes sense: countries with faster structural growth are becoming more attractive destinations, and are being rewarded as more capital flows their way.
Despite the tough macro, mergers and acquisitions (M&A) are a continuing bright spot in our universe, implying that valuations are compelling enough for long-term-oriented investors to make big bets on companies. The fund has a history of owning companies just prior to their being bought out. This quarter added two more. Ergomed (ERGO LN) and Instem (INS LN) both announced that they were going to be taken over by private equity funds specializing in healthcare tech. Unfortunately our weightings in these companies were relatively small: Ergomed was a 1.5% average weight during the quarter, and Instem was a 0.5% weight. We owned Ergomed for about a year, which resulted in an average-sized position. Instem was a recent addition for us, thus we did not have enough time to increase our confidence and position size. We think the continuation of the M&A trend is indicative of the fact that valuations of small-cap growth companies are compelling to long-term investors.
PERFORMANCE
The fund underperformed the benchmark by approximately 4% this quarter. Almost all of that underperformance came from our two biggest markets: Germany and Japan. As a large and innovative country with a plethora of compelling quality small-cap stocks, Germany has been a significant exposure. Furthermore, it is a market where we have been deploying incrementally more capital over the last year, responding to opportunities arising from its severe market dislocation due to the inflationary impact of the Ukraine war, and corresponding increases in interest rates and declines in industrial exports. Over the last year, we have added Hypoport (HYQ GY) and Patrizia (PAT GY), which are both high-quality platform businesses catering to industries experiencing cyclical dislocations. While we found the valuations compelling, but the market continued to punish those stocks this quarter, sending them down 26% and 33% respectively. Our other German holdings were also impacted by the near 9% decline in the overall German small-cap market, retracting all of its positive performance for the year. Overall, we think the volatility we’re seeing in German small caps is reflective of the continuing difficult near-term economic outlook in Germany. We are investing for the long term and are unperturbed by the near-term fluctuations, as we view these companies as resilient long-term investments.
Japan has been another area of weakness for the portfolio. While the Japan market performed in a fairly resilient fashion for the quarter, our Japan portfolio declined by 11%. We showed significant underperformance in our healthcare segment, driven primarily by Linical (2183 JP), which declined 20% this quarter while remaining a sizable weight in the fund. Linical is a well run Contract Research Organization that scaled up its business significantly right before COVID impaired demand for their services, leaving them with an elevated cost base and no access to the human-patient population required to run their studies. Fortunately, the US exposure, added right before COVID lockdowns, is now going strong, whereas their core Japanese business has yet to return to normal. The company has been reducing labor costs through COVID, and our expectation is that as the world normalizes further, demand will pick up and the company will demonstrate significant margin expansion towards the end of this year.
The highlight of the fund’s performance has been India. This country has the two ingredients that drive long-term returns: a deep market, and structurally sound economic growth. As the developed world remains stuck at the tail end of a long-term debt cycle, suffering from stagnant, debt-driven economic growth, and as China decouples from the global supply chain, India stands to benefit. With the world short on economic growth, India’s economy is being turbo-charged by its deep and under-penetrated market, and the shift of export-oriented industries from China. The fund is carrying a 13% weight in Indian stocks, making it the third largest country exposure.
During the quarter, we added a few high-quality long-term compounders at attractive valuations. Two additions stand out: we added Epsilon Net (EPSIL GA), a leading small business accounting software company in Greece, with a long-term track record of strong organic growth and a history of accretive acquisitions. EPSIL has 75% market share of small- and medium-sized entities’ accounting software in the country. As digitalization continues, (accelerated by EU development funds), Epsilon Net will layer in additional software solutions such as e-invoicing on top of their existing dominant reach. While Greece is a fairly small market of 10mm people, there is still significant room for increasing software penetration and improving monetization of this software. In H1 2023 the company reported 25% organic revenue growth while doubling its operating profit, with a medium-term objective of doubling its revenue by 2025. The company is also demonstrating excellent operating leverage with its EBITDA margin increasing from 22% last year to 29% this year. We are paying 25x this year’s earnings for this combination of strong revenue and profit growth, and at a market cap of $500mm, this company remains undiscovered by sell-side analysts.
Kinx (093320 KS) was another sizable addition. Kinx operates a defensive yet fast growing data center business in Korea. A few years ago we had sizable ownership in Kinx, but exited upon the announcement of a massive capital expenditure (CapEx) investment. The timing of our sale in 2021 was good, and thus far the timing of our return to the company has also been good. Our view on the expansion has changed given the demand the company is seeing for the yet-to-be completed data center. When they announced the CapEx program in 2021, they hoped to achieve full utilization within three to four years of the launch. When we spoke to them this August, they communicated that current demand is 3x the announced capacity, which means they now expect to achieve full utilization within a year of completion. The importance of full utilization lies in their ability to maintain margins post investment. With strong demand teed up, we see earnings doubling within 24 months. The stock currently trades on 16x trailing earnings even after a 30% move over the past three months.
In the third quarter we exited Ergomed and Instem due to the aforementioned pending take-out offers. We also exited a fairly large holding for the fund, Mitra Adiperkasa (MAPI IJ). It is a leading foreign-brand retail store operator in Indonesia. Their stores account for 30-40% of retail space in major malls there, including Zara, Skechers, Converse, and Starbucks. We knew this company to be an excellent operator, and two years ago we noticed that their shares were unduly punished due to the negative impact of lingering COVID lockdowns in Indonesia. The stock has more than doubled as Indonesians have returned to mall shopping, propelling Mitra Adiperkasa’s revenues well above pre-COVID levels. However, we think that the challenging inflationary environment will lead to tougher consumer discretionary spending, and the ability of the company to grow long term is challenged by the lack of new mall construction in Indonesia. When the valuation multiple became fully reflective of the current state of the business, we exited this stock to take advantage of better opportunities elsewhere.
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 19%, which is similar to growth rates seen through 2022, and well above growth rates seen in 2019 and 2020. EBITDA growth was consistent at 19% 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
EBITDA (Earnings before interest, tax, depreciation and amortization) is a measure of a company's operating performance.
MSCI ACWI Ex-USA Small Cap Index is an index representing 22 of 23 developed market countries (the United States is the excluded country) and 24 emerging market countries, covering roughly 14% of the global equity opportunity set excluding the U.S.
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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