WAGTX Commentary (Q4 2020)
December 2020
OVERVIEW
Most equities across the globe rose double-digits during the December quarter. The news that two COVID vaccines were deemed safe, effective, and ready for mass distribution understandably generated relief and optimism about the future. While strong equity returns look like a continuation of the trends that started last March, when stocks rebounded from COVID-panic lows, a significant reversal of market leadership actually took place. During the second and third quarters, companies that benefit from COVID-lockdown conditions led the way—streaming services, meal kits, video calls, and diagnostic and pharmaceutical companies making products to test for and treat the virus. Generally, these were secular growth companies found in Tech, Healthcare, and Consumer sectors. But in the fourth quarter, companies that benefit from a return to normalcy took the lead—think travel and transportation stocks, and the oil companies that fuel them. Value outperformed growth. Commodities and cyclicals beat defensives. International small-cap led US large cap. In summary, the laggards became the leaders.
Going into the final quarter of 2020, the Seven Canyons World Innovators Fund was primarily invested in long-term COVID beneficiaries. Most such companies saw a dramatic boost to sales during lockdown and, more importantly, should benefit from permanent changes to work and consumer habits far into the future. We knew a change in market leadership would inevitably come, and consequently the Fund, committed to investing in the world’s best small, secular growth companies, might suffer a period of underperformance. So we were pleasantly surprised on December 30th when markets closed and the Fund was up 20.49% for the quarter, ahead of the benchmark’s 18.56% gain. The Seven Canyons investment style generates portfolios with high active share and low correlation with broader markets. This is how the Fund was able to outperform in both a secular growth-led market during the first nine months of the year, and a cyclical, value-led market during the final three months. This is a small win; one quarter in the hundreds it takes to build a great long-term track record. The chart below displays the Fund’s performance over the last 10 years compared to its international small-cap benchmark.
| Periods ended 12/31/20 | WAGTX | MSCI ACWI Ex-USA Small-Cap Index* |
|---|---|---|
| Quarter | 20.49% | 18.56% | Year | 67.92% | 14.24% | 3 Years Annualized | 21.93% | 4.59% | 5 Years Annualized | 19.78% | 9.37% | 10 Years Annualized | 15.33% | 5.95% |
A fund’s performance for very short time periods may not be indicative of future performance. Data shows past performance. Past performance is not indicative of future performance and current performance may be lower or higher than the data quoted. The gross fee for the fund is 1.98% for both retail and institutional. 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.
DETAILS FROM THE QUARTER
Over the last decade, secular growth stocks have driven markets to all-time highs, leaving value, cyclical, and commodity counterparts in the dust. That trend continued this year until early September. During that month, a growth versus value tug-of-war broke out. Value prevailed, and has led markets into the new year.
Sector data provides evidence of a significant leadership change. Healthcare and Technology were the strongest sectors in our benchmark for the first nine months of the year, up 21% and 12% respectively, while cyclical and value sectors remained in negative territory. Energy tanked, down 43% through September! That all changed during the December quarter. Energy led the way, rallying 33%. Materials, Industrials, and Financials each had over 20% gains. Safety sectors, Healthcare and Consumer Staples, were up single-digits.
In a similar fashion, underperforming geographies rallied during the quarter. Brazil, where the oil price is an important economic input, went from worst out of 64 countries in the benchmark (down 42% through September), to second best (up 32% during the December quarter). And the UK, a nicely diversified economy temporarily slowed by Brexit, jumped in the performance table from the bottom three to the top three.
In spite of the significant market reversal, the Seven Canyons World Innovators Fund chose not to chase hot segments of the market, yet still managed to outperform. Technically, we were in the right sectors but the wrong geographies during the first three quarters of the year, and the wrong sectors but the right geographies during the final quarter. However, bottom-up stock picking in under-researched small-caps, and high concentration in top ideas, yields low correlation with sector, geography, and overall index averages. In other words, our active management and high active share won the quarter and the year for the Fund.
An investment we’ve mentioned in several past letters that demands another round of applause is UK-based online appliance retailer AO World (ticker: AO/ LN). We’ve liked and owned the company for years thanks to its superior customer proposition. An online “storefront” means they can offer more appliances and more information on those appliances than any brick and mortar retailer in the world. But what really sets AO apart is its obsession with customer service. AO realized early on that for an online retailer of appliances, the moment to win over a customer for life is with a seamless delivery. So AO decided to build a countrywide last mile delivery network, something only the largest online retailers in the world have done. For the customer, vertically integrated logistics means that a desperately needed replacement refrigerator shows up on time, in the hands of two friendly delivery people dressed in clean uniforms, who install the new fridge, then remove and recycle the old one. It's a business tailormade for the 21st century, but few customers (and even fewer investors) realized it until COVID-19 changed the world. We think AO’s business became an essential service under lockdown conditions, and we would argue that new customers who have now experienced the AO way will never ever go back to the old way. The stock was our largest position in the fourth quarter and rose 101%; in 2020 the shares increased an astonishing 759%.
The second biggest contribution during the quarter came from another UK-based online retailer that we’ve also mentioned before—Naked Wines PLC (ticker: WINE LN). As the name suggests, they sell wine. Despite their UK listing, the company's largest, fastest-growing, and most profitable market is right here in the USA. Prior to COVID, most Americans were either unaware it was legal, or too set in their ways to buy wine online. During a period of about two months when most states were locked down, the share of wine sold online saw a step change from 5% to 25% of the total market. Already established as a market leader in all 42 states where online sales are legal, Naked was in prime position to benefit from the sudden shift to online purchasing. Naked Wines was our second largest position during the fourth quarter, and shares rose 61%.
Finally, there is one stock we must mention due to its negative impact during the quarter. The LoopUp Group (ticker: LOOP LN) provides web-based conference call services, including video calls. They charge by the minute, like the legacy telcos they compete with, and with everyone suddenly working from home, the business boomed. It turned out to be a temporary boost however, and the company had to lower guidance in November. The stock fell 50%. We are concerned the business could face intense competition in the future, not from their traditional foes, the old European telcos, but from Microsoft Teams and Zoom. For that reason, we took the loss and exited the position.
OUTLOOK
At Seven Canyons we are committed to buying the world’s best small growth companies, specifically those taking market share thanks to innovative products and services. As bottom-up investors, this unintentionally aligns us with sectors and countries where one finds the most secular growth companies. We have long-standing overweight positions in Technology, Healthcare, and Consumer Discretionary; underweight positions in Financials and Industrials; and rarely any investments at all in Energy and Materials. From a geographic standpoint, we end up in countries with well-diversified economies, strong universities, and entrepreneurial, innovative cultures, such as the UK and Australia. We are also drawn to export-led economies that specialize in innovative high-value-added products, such as Japan, Germany, and Sweden (which also happen to have reasonably well-diversified economies).
This alignment with secular growth segments of the market means that we have been operating under tailwind conditions for most of the last decade. And it also means that a sustained market reversal—where commodities, commodity-producing countries, and value stocks lead the way—would mean headwinds for the Fund. The December quarter proved that our uncorrelated style can still produce market-beating results.
If the new market leadership persists, however, outperformance may become more difficult. Fortunately for our shareholders, our expectation is that the value rally will be short-lived. We think the reigning macro driver of the last and the next decade is global Japanification—with most developed markets (and some emerging markets) exhibiting historically high debt levels, low interest rates, low inflation, and low growth rates. These conditions have led to a long cycle of outperformance by innovative growth companies that don’t rely on broad economic growth to act as a tide that lifts all boats. It is true that current valuations for growth stocks are rich and in some cases extreme. We avoid cases of extreme valuation, but as a group, we think consistent growth companies will receive and hold valuation multiples. This is exactly what happened in Japan over the last three decades under similar macroeconomic conditions. We believe we can find growth companies while they are small, undiscovered, and valuations are reasonable. As they grow and get on the radar of institutional investors, we think multiples could re-rate and benefit our investments.
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