WAGTX Commentary (Q3 2018)
Q3 2018
OVERVIEW
During the 3rd quarter as of September 30, 2018, the Seven Canyons World Innovators Fund was up 6.36%, beating its benchmark the MSCI All Country World Investable Markets Index (up 4.40%) by almost 200 basis points. The narrative in the markets was more or less the same as it has been since the pullback in February, with US technology stocks and domestically focused US stocks, especially small caps, rallying, while almost everything else around the globe flatlined or was steadily sold off. Two exceptions were Argentina and Turkey, where concerns surrounding high foreign currency denominated debt levels led to sell offs in both their stock markets and currencies, and a 50% loss of value in 2018. Other emerging markets countries that rely heavily on US denominated debt have triggered investor concerns as well as the US currency increases buoyed by rising interest rates. In the few emerging market stocks which the Fund does own, business fundamentals remain fine while stock prices have suffered from weak investor sentiment. Fortunately emerging markets only make up 6.4% of our portfolio and ood stock picking elsewhere has more than compensated.
Given the volatile backdrop we are pleased with the result this quarter. It is a nice feather in our cap. However, this is not the biggest news of the quarter by a long shot, vastly more important for our shareholders was the announcement that Fund was transferred from its original home at Wasatch Advisors to our new firm, Seven Canyons Advisors. We believe this change will have a lasting beneficial impact on Fund performance — an outcome well worth the increased levels of anxiety your managers faced in starting a company from scratch.
Now is an appropriate time to give a brief introduction to the new firm. First and foremost, we are a small family-run investment boutique, and we intend to keep it that way. We believe that being small has its advantages. The five founding partners are: Sam Stewart, the founder of Wasatch Advisors: his sons Josh and Spencer, both long time portfolio managers and seasoned international stock pickers; Sam's son-in-law, COO Eric Moessing; and family friend Wes Golby, an experienced portfolio manager and technology investment specialist. The partners funded the business out of our own pockets. We plan to make the vast majority of investment decisions as a group. We believe in quality over quantity; we won't be able to recreate the volume of research output by our larger peers, but we believe our tightly-knit team and above-average investment IQ will be able to make quicker better investment decisions. We also plan to cap assets long before liquidity in the small companies we invest in becomes a problem. In short, we have set up Seven Canyons Advisors to be an exceptionally nimble firm, which we believe will put us in a position to navigate dynamic stock markets and seek to generate better results.
DETAILS FOR THE QUARTER
While the Fund's home has changed, the strategy, which we developed in the aftermath of the 2008 global financial crisis, has not. In late 2009, we, like most market participants, were recovering from the crushing, painful losses over the prior year and asking questions: What just happened to us? What can we learn from it? What can we do now to prepare for the next crisis? We observed that while most companies and their employees suffered mightily, a select few sailed right through the recession, growing sales into the double-digits and hiring all the way through. After knee-jerk sell-offs in the early days of the market panic, the stock prices of these seemingly recession-proof companies dramatically out performed through the remainder of the crisis period. Investors quickly rallied back to these special companies as they reported positive results quarter after quarter in spite of the general economic mayhem. We looked closely at this group of companies and concluded that what they had in common was not industry or geography or size, but rapid sustainable market share gains. They sold products and services that were so dramatically superior to the alternatives that they replaced the legacy competition fast enough to grow even amidst a full blown recession.
Ever since this epiphany we have populated our portfolio with companies that we believe to be this special recession proof breed which we call “World Innovators”. Our top 10 World Innovators over the last 10 years are: Abeam,
Alphabet (Google), Cognizant, Visa, Mastercard, Wirecard, Take Two Interactive, Sartorius Stedim Biotech, Diasorin and Apple. We continue to own Take Two and Sartorius today, the others have been sold and put on a watch list for now. When it becomes market consensus that a company is “special” and prices are pushed up to new valuation ranges with little margin for error we take our profits. Fortunately our process includes a constant search for new ideas so when a great company gets extremely expensive, we put it on the waiting bench until prices are more favorable and fill empty slots with new companies that we've screened and vetted where we think we are ahead of the crowd.
One of these newer additions to the Fund is over-the-top (OTT) streaming television enabler Roku, the biggest contributor to our performance this quarter and for the year thus far. Roku is innovating how we consume television by providing a menu of 5,000 channels via an internet connection. Between Roku boxes and Roku powered TVs the company is the market share leader in OTT in the U.S. with 22 million users, up 6.9 million in the last twelve months. Roku is now moving to monetize that audience and the company has turned profitable ahead of plan. People ask us how Roku can compete with Google and Apple in TV, and it's a fair question. It's our view that Roku's competitive advantage is independence as a neutral third party working with hardware vendors and content owners. Our early recognition that Roku is a disruptive market share gainer — something that other investors are now recognizing — put us ahead of the masses.
Sodastream has been a strong contributor to Fund performance for years. During the September quarter it made the second largest positive contribution to our return. The sparkling water niche has a tailwind as more and more people kick the sugary soda habit and replace it with just water and bubbles. Sodastream's small appliances used to make sparkling water at home have enabled the company to steadily take market share and achieve mid-teens sales growth. New customers are attracted for a variety of reasons including: saving money, reducing plastic bottle waste, and avoiding extra trips to the supermarket. The key reason we invest in the stock is the company’s large recurring revenue stream coming from the ongoing sale of high margin carbonation canister refills, which accounts for over 60% of the company's revenue. When we first accumulated a position, we thought the razor-razorblade business model should fetch a much higher valuation multiple than the approximate lx sales the shares traded on. Several quarters of strong sales and earnings per share growth drove the re-rating we were looking for. This quarter it was announced that PepsiCo will buy the company at a multiple of approximately 5x sales, delivering a handsome return to our shareholders.
Another large positive contributor to the quarter was Malaysia-based e-government portal technology provider MyEG. It's a company we've known for years at our prior firms and one that we believe, despite being based in a country classified as an emerging market, offers some of the most sophisticated citizen to government online transaction portals in the world. In fact, we wish the state of Utah would hire them so we would never have to step foot in the DMV again! When Malaysia held parliamentary elections in May and the outcome unexpectedly put the opposition party and a new prime minister in power, the stock sold off nearly 75%. Investors speculated that the new government’s attempts to shake down contractors, and put its fingerprints on immigration and tax policy would hurt current and future business. Seven Canyons Advisors team members had visited in March and we gained an appreciation for the resilience of MyEG’s services. For example, there is no physical DMV in Malaysia — no building, no state employees at counters, and no ticket dispensers. The website powered by MyEG is the only way to register your car. Additionally, MyEG services collect fees and generate revenue for the government. For these reasons we were confident that risks had been overblown and more than priced into the shares. After checking in with management again in June, we started accumulating a position. The stock quickly rebounded, more than doubling off the bottom, and after such a vertical recovery we have taken some profits.
The largest detractor from returns was UK-based Game Digital. The company is the largest brick and mortar retailer of video games in the UK and has a sizable footprint in Spain. Not surprisingly its traditional retail roots are threatened by online retailers selling and shipping physical copies of games, as well as digitally delivered and cloud-based games. To put it bluntly, the outlook for the original business model is bleak. Flowever, we believe management has found a solution to remain relevant and grow profits well into the future: video game arenas. The company is squarely focused on opening new sites and converting appropriate older stores into video game arenas where gamers can come to play with friends, join leagues, and play in tournaments that feed into big money professional esports. The stock is relatively unknown. Most UK-based investors know the brand for what it was historically and quickly label it “just another threatened brick and mortar retail business” and move on. We dug in and listened to their new story. We believe we have found a World Innovator that will manage to parlay its expertise in video game customers to deftly step out of the headwind-laden retail industry, and into the tailwind-rich esports market. However, as we witnessed this last quarter, during the transition and investment period profits will be sporadic and the stock volatile. We believe that as early adopters of a company on the cusp of incredible growth, we can confidently ride out the short term wiggles.
There were no other large detractors to performance during the period.
OUTLOOK
Looking forward, we have a sense that macroeconomic events (such as central bank policy) or political events (such as a trade war or chunks of the EU falling away) could start to dominate returns. The set up of historically high equity valuations combined with historically high corporate, government, and consumer debt levels in most parts of the world doesn't help. That said, the world has always been a dynamic place. At this point it is clear that the valuation discrepancy between US and international equities is high relative to historical averages, and conditions for business in the US aren’t dramatically better. In these conditions we would expect some reversion to the mean. With that in mind we are looking overseas, and in emerging markets in particular, with more intensity than usual. We are checking in with management teams we have met in the past, as well as screening for new businesses that we believe are recession resistant, market share gaining, and have business models with disruptive products. This is not to say that we expect to make geographic overhauls to the portfolio. We tend to recycle profits taken from great innovators that have become expensive back into newly found or better priced market share gainers. We also swap out investments that are not tracking to our thesis for better options. This may gently tilt the portfolio into overweights in certain countries or sectors but it happens one company at a time. Given current valuations in emerging markets, if we find the companies with the sort of “all weather” characteristics we seek — rapid market share gains, low or no debt, and the ability to generate strong free cash flow — shareholders can anticipate seeing our portfolio-weighting in these regions slowly tick up through the end of the year.
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.
Past Performance does not indicate future results.
For a list of current top ten holdings and performance charts, please click here.
DEFINITIONS
Basis Points are one-hundredth of one percent
Earnings Per Share are the portion of a company's profit allocated to each outstanding share of common stock.
Valuation Multiple are financial measurement tools that evaluate one financial metric as a ratio of another, in order to make different companies more comparable.
An investor should consider investment objectives, risks, charges, and expenses carefully before investing. Click this link to obtain a Prospectus, which contains this and other information, or call us at 1-801-349-2718. Read the prospectus carefully before investing.