WAGTX Commentary (Q4 2023)
December 2023
OVERVIEW
In what has become a common refrain, the tug of war between rising v. falling expectations of inflation and interest rates has become the defining feature of the post-Covid market landscape. The market is desperately trying to understand what the “new normal” looks like. Are we reverting to the near-zero percent interest rates of the past decade, or are we facing a new inflationary reality, implying higher rates for longer? The implications are immense, and the international small-cap asset class is subject to the most volatility due to its sensitivity to interest rates, USD moves, and overall economic growth. Fortunately, in Q4 the debate shifted firmly, though perhaps temporarily, into the “near-zero rates'' camp, which triggered strong results for this asset class. Following a benign US inflation print, the US 10-year yield, (which international investors consider the engine that moves global markets), declined from 4.6% at the start of the quarter, to 3.9% by quarter end. This was a significant move down, reversing the Q3 yield spike. Correspondingly, the dollar sold off by 4.6%, reversing a strong Q3 rally. The market responded with euphoria: the international small cap index, MSCI ACWI ex-USA Small Cap Index, was up 10.12% in Q4, contributing the majority of the full year’s return of 15.66%. The fund performed largely in line with the index, returning 10.65% for the period.
Reflecting on the year that passed, we still lack the answer to what the “new normal” looks like. We do not know whether we’re in for another inflation-fraught decade like the 1970’s, or back to the post-financial crisis free money. Arguments can be made in both directions. Yes, the Consumer Price Index is falling, but proponents of either camp can point to data that argues each way. Currently we’re in a strange mixture, with some parts of the global economy very deflationary, while some are quite the opposite. Why? There’s a growing list of moving pieces: rent, food, gold, supply chains, wars, elections. Happily, the worst fears of run-away inflation have not materialized. Temporary or not, inflation does seem to be declining around the world. But this does not end the debate, it just puts a pin in it for now.
While the macroeconomics may seem dominant and overwhelming, at Seven Canyons we spend our time searching for businesses with real growth and sustainable competitive advantage – companies that can chart their own destiny rain or shine. We try to get there first, finding such companies before our competitors do. We also spend a lot of time speaking to management teams of companies we own and companies on our get-to-know list. Through these efforts, we assemble a unique mosaic of indicators, which currently are quite positive. We continue to see that prudently run companies with an innovative offering are growing and winning market share. The portfolio metrics for Q4 look solid: weighted average year-on-year revenue growth of 19.7% and EBITDA growth of 18% demonstrate that, regardless of macroeconomic uncertainties, our portfolio companies are continuing to grow profitably.
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 | 10.65% | 10.12% | Year to Date | 5.43% | 15.66% | 3 Years Annualized | -16.59% | 1.40% | 5 Years Annualized | 3.30% | 8.03% | 10 Years Annualized | 3.91% | 4.97% |
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.
The fund rallied along with the market in Q4, in what turned out to be a strong quarter in an otherwise difficult year. Because of this, performance in Q4 felt more like a rebound after a correction, rather than a sustained rally – indeed, the assets that rallied most seemed to be the ones most oversold.
Country weights did not account for much difference in fund performance. Developed countries led the rebound, outperforming emerging countries during the quarter. Ironically, countries mired in economic doldrums led the rebound. The UK and Germany were up nearly 13% in the quarter, with some smaller developed geographies rallying 20% or more, such as Finland (+20%) and Sweden (+29%). Larger weights in the benchmark, such as India and Taiwan, had fairly even performance, while Japan and South Korea lagged a bit. But the big picture is that of a broad rally.
More interesting is the performance of individual stocks in the portfolio. The largest contributor was FlatexDegiro (FTK GR), which is also our largest weight and a long-time holding of the fund. This company originated from a merger of two leading online brokers in Europe: Flatex, one of the leaders in Germany, and Degiro, the largest online broker in a number of other European countries. The merger occurred in 2020 and formed a leading digital brokerage in continental Europe, a massive market that resembles the US in the 1990s, before the wave of digital brokers in the US transformed the industry. Online brokerage is a very attractive business when you are the leader – the majority of operating costs are fixed, and scale leads to low unit costs thus begetting more scale and leading to market dominance over time. As of today, FTK has 2.7M customers and is the largest digital player in continental Europe, so the opportunity is immense. The stock market rally in the midst of Covid juiced all the metrics of FTK and sent the stock parabolic, with a post-Covid hangover that dragged out into a six-quarter slowdown in new customer acquisition and revenue metrics. However, great companies shine during downturns, and FTK has gradually gained market share in the post-Covid era, while unprofitable competitors have scaled back. This tumult played to the benefit of FTK, which has maintained high profitability, significantly reduced marketing costs, and has continued to grow their client base at a 13% annualized rate. Meanwhile, other key performance indicators of the company have reached a floor and are now pointing up. In Q4 the market recognized the strength of FTK’s business model as well as its strong performance in a difficult environment, and the stock began to rerate from a historically low valuation. Our analysis implies that FTK can become a much larger company with a customer base multiples of what it is today. We appreciate that the company was battle-tested in the 2022/23 downturn and came out ahead.
Kinx (093320 KS) was another large contributor to the fund’s performance. Although it’s a recent addition to the fund, we have closely followed this stock for four years and owned it previously. Kinx is an independent (i.e. not owned by Google or Amazon) data center in Korea. As the world moves more online, and data shifts from on-premise servers to the cloud, data centers benefit from rapid volume growth, so much so that Kinx ran out of capacity in their data center in 2021 and was using higher-cost, margin-dilutive third-party data centers to accommodate the growth. At the same time, they began construction of a new data center that would take nearly three years to build, but would increase their owned capacity over fourfold. We sold the stock a few years ago based on concerns that the massive new data center would hit classic large-project potholes: cost overruns, delays, and extended ramp up. But we continued to follow the stock and recently checked in as they approached the end of the data center buildout. We learned that the project was running on time and on cost, and demand for data center space was so strong that it should take just one year to get to 80% utilization, rather than the original three year estimate. We bought back the stock now that the project execution risks are behind them. We think Kinx is still largely undiscovered by the US institutional investor community, making the stock look very reasonably priced at 12x 2024 PE.
Another big contributor was Trustpilot (TRST LN), a leading European independent review aggregator with a toehold in the US. In a nutshell, it's a great recurring revenue business that chose to sacrifice profits to accelerate revenue growth, and hit EBITDA breakeven in the second half of 2023. This reflects a bigger picture: this year many previously unprofitable companies have successfully pivoted to profitability. Historically the choice to prioritize growth over profitability has been rewarded by the market – unprofitable but rapidly growing stocks enjoyed a generous valuation based on a multiple of sales (a dubious metric which tends to be favored during boom times). Such stocks have struggled for the last two years as the market shifted focus from rewarding “growth at all costs'' to rewarding profits. The fund holds a number of unprofitable innovative software names where management historically chose to prioritize aggressive growth over profits. Over the course of 2023 we have seen a number of these names hit profitability marks, Trustpilot and Pensionbee (PBEE LN) being the two standouts. The market has rewarded this shift to profitability as these stocks returned 51% and 47%, respectively, during the quarter. The ones that are still enroute have been tougher. For example, FREEE (4478 JP), a leading SaaS accounting software for small and midsize enterprises in Japan, is at maximum cash burn. While it rallied 9% in Q4, it lost 3% during the year. We think FREEE will earn its reward too, but with a cash-rich balance sheet, it can afford to invest. It is encouraging to see management teams deliver profitability in a tough environment without sacrificing growth – a testament to a quality company. We’re confident that the currently unprofitable names we own will reach profitability; the timing will vary, but the trajectory seems clear.
The fund avoided major detractors in Q4 – the market rally lifted all boats, thus there was no clear geographic or industry trend driving underperformers. The worst performing names are a smorgasbord of companies that downgraded guidance or experienced company-specific issues. The largest detractor was Linical (2183 JP), one of the larger weights in the fund. This company is a leading contract research organization in Japan, administering trials for prospective new drugs. Most of the business is in Japan, but they have been diversifying geographically by building out a global platform. Although this should be a great business, it requires scale. Their US business is scaling well and growing rapidly, but Japan and Europe have not followed the same path. Linical has been struggling in Japan due a longer than expected downturn in funding for new drugs. We believe this is a function of Japanese bureaucracies slowly adjusting to post-Covid realities. The biggest surprise to us is the scale of the slowdown in their European business. While they are making progress on bringing their cost structure in line with new realities, our confidence in the business is shaken, and we are working to understand whether the long-term trajectory that we forecasted has been impaired.
The fund’s philosophy remains the same: an unrelenting focus on reasonably-valued, high-quality, innovative growth companies with clear moats and bright futures. We do not make portfolio decisions based on how we expect countries to perform; we invest in companies we find attractive, and the country weightings in the fund are a byproduct of that. As mentioned earlier, country weights did not dominate fund performance. It is nevertheless worth mentioning that over the past year we shifted some of the fund weights towards geographies where we are seeing more of such companies at reasonable valuations. For example, the weight of Indian companies in our portfolio and in global benchmarks is going up as the Indian economy undergoes rapid growth fueled by strong domestic demand, growing IT exports, and manufacturing jobs shifting over from China. We have added Indian companies that demonstrate high but sustainable revenue and profit growth – a rarity in a slowing GDP world. One such company we added to the fund is Caplin Point (CLPL IN). Caplin Point is a generic drug manufacturer in India that has built up a large export business in Latin American markets, and is now expanding to the US market. This business requires manufacturing excellence, strong historical reputation, local distribution expertise, and strict compliance with drug inspection bodies from various countries – this is not an easy business. Caplin Point has an enviable track record of execution as well as finding both new generic drugs to manufacture, and new markets to profitably send them to. The stock has consistently delivered revenue and profit growth in the mid to high teens, and even after returning 121% last year for the fund, the stock trades at 21x PE, which is quite reasonable given their earnings growth trajectory.
Over the year as India’s weight in the fund increased, the weights of other geographies came down. This has not been a top-down decision, it’s a result of cautious redeployment of capital. Throughout the year we had a couple of our UK and German holdings taken out by private equity. In Japan, we reduced the weights of a few of our larger holdings when they prioritized sales growth, pushing out profitability timelines. Japan, Germany, France, and the UK continue to be important geographies where we see compelling opportunities, but their relative weighting has come down.
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 19.7%, which is a slight deceleration from growth rates seen throughout 2022, but well within our targeted range. EBITDA growth was consistent with the prior quarter at 18% year-over-year, and 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.
PE (price to current year earnings per share ratio)
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 US.
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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