WAGTX Commentary (Q4 2018)
Q4 2018
Volatility returned to global stock markets with a vengeance in 2018; that's the obvious headline. The December quarter put an exclamation point (or three) at the end of that statement. Consider this, in all of 2017, there were only 8 days where the S&P 500 moved up or down by more than 1%, that happened 64 times in 2018 and 9 times in December alone. More of the big moves were down than up, and most global stock markets declined. The Seven Canyons World Innovators Fund was down 10.35% in 2018, a whisker away from the 10.08% decline registered by its benchmark, the MSCI All Country World Investable Markets Index. For the quarter ending December 31, the Fund was down 15.27% versus the benchmark’s 13.28% decline.
This was a frustrating period for us, not least because we don’t like losing money for our shareholders. But it felt even worse because for years we’ve been preparing the Fund to face choppier markets. The following conditions call for added vigilance: global asset valuations and debt to Gross Domestic Product (GDP) levels are high, and interest rates are low relative to historical averages. None of these factors will necessarily cause stock market declines, but taken together they create a lot of surface tension that could break as rates start to rise.
We have implemented a few common-sense strategies to insulate the portfolio. First, most of our companies have cash on the balance sheet and little or no debt. Second, as rates rise, financed purchases are less affordable, so we favor companies that sell daily staples rather than big-ticket items like cars, houses, or capital equipment. And finally, we have reduced investments in companies running the Silicon Valley land grab business model, characterized by spending more than one makes in order to get to scale first. Unlike diehard value investors, we are not fundamentally opposed to the Silicon Valley strategy, but as debt and equity financing conditions tighten we expect the business model to face more scrutiny.
A good metric that illustrates our efforts to insulate the Fund is the debt to EBITDA ratio. More profit per unit of debt on the balance sheet signals a safer more stable company. The portfolio's median debt to EBITDA ratio hovered between 0.7 to 1.0 in 2016 and 2017. Our edits to the portfolio this year prioritized stable cash flows and strong balance sheets. Today the portfolio's median debt to EBITDA ratio sits at 0.3 versus the benchmark's median of 2.2.
Sounds great, right? Then why didn’t we outperform the market in a down year? Fair point. It is our view that the return of volatility is a recent phenomenon that hasn’t fully played out. In moments of panic, investors tend to throw the baby out with the bathwater, not taking the time to consider individual business fundamentals. In our opinion, the market has yet to settle down, but as stronger companies report positive earnings, slowing economy or not, investors will rally back to them first.
A good example of this phenomenon was the rapid sell-off of emerging market (EM) stocks early in the year. Concerns regarding foreign currency-denominated debt in Argentina and Turkey triggered a comprehensive derating of most EM assets. Good companies and bad companies; safer countries and riskier ones; baby out with the bathwater. Our investment team has lots of experience investing in EM equities, and better prices demand more of our attention. So we brushed up on the investment cases of our favorite names on the watch list; screened for new ideas; hopped on planes and traveled to Indonesia, Malaysia, South Korea, Thailand, and India to visit companies in person. The Fund started the year with only 2.48% of the portfolio in EM stocks, by mid-year we had 5.23%, and at the end of December, exposure stood at 10.49%. Our agile response to buy good companies at discounted prices paid off. During the fourth quarter, EM stocks in the benchmark were down 7.93%, beating the developed market cohort by a full six percentage points. Our EM stock picks did even better, increasing 31 basis points.
The December quarter produced another "baby out with the bathwater" moment impacting video game assets. We happen to like the industry and own several video game companies. Sony, Nintendo, Take-Two, and Game Digital were among our top 10 holdings. The video game industry had compounded growth of 11% over the past five years and is the fastest-growing segment in the entertainment sector. (Cinema grew 4.5%, TV 3.6%, music 2.2%, and print declined 1.1%.) Our video game stocks followed the lead of the FANGs and the Silicon Valley cash burners; each of their share prices dropped over 20%. And yet our investments are profitable growth businesses that can easily fund investments internally. We suspect holiday sales were strong, and when the results for the quarter are made public, they should provide share price support. We remain overweight the sector.
DETAILS FOR THE QUARTER
Not many stocks went up this quarter, although we did have at least one standout performance. One of our top 10 holdings, Sarana Menara Nusantara Tbk (SMN), increased 43%. SMN is the largest owner/operator of cellular towers in Indonesia. The company's rental income should grow as its telco customers extend mobile coverage to Indonesia's thousands of islands and over 260 million people. We originally added this company to the portfolio after discovering it on a visit to Indonesia in Q1 of 2018. The stock struggled out of the gate. Its largest customer, Hutchison Group, had paused spending in Indonesia, and some investors feared they might pull out of the country altogether. However, SMN has other large clients with whom business has grown steadily. We also felt the 70%+ valuation discount to global competitors more than compensated for this risk, and so we added to our position. When new management at Hutchison started signing leases again in November, showing their commitment to the country, the stock reacted positively. We think the shares remain undervalued at 8.8x EV/EBITDA versus 16.5x for the global peers, and it remains a top 5 position.
The only other company with a meaningful positive contribution to performance was Bandai Namco Holdings, up 11.55%. The company is an entertainment conglomerate, a bit like a Japanese Disney. They produce video games, toys, movies, TV, and live shows in the Japanese Anime style. Earnings have grown consistently along with the popularity of Anime around the world, and the stock price is up too.
The rest of the top 10 positive contributors did not add meaningful returns, but we found it interesting that 5 of them were companies based in emerging markets.
The biggest detractors to performance were Roku, Nintendo, Game Digital, Gamma Communications, and Sony Entertainment. These companies have two things in common: 1) they are some of our highest convictions and largest holdings, so naturally, the movement of their stock prices has an outsized impact on performance; and 2) their recent earnings reports have been very good. Our read is that they were caught in non-fundamental sentiment reversals. We remain committed and invested in every one of them.
OUTLOOK
We outlined some of the defensive measures we've taken as volatility returns to global equity markets. We believe a weakening US economy - already evident in housing and auto data - will slow the Federal Reserve's interest rate path in 2019 and translate to a weaker US dollar. This should provide a tailwind for our growing emerging market exposure. At the same time, ongoing trade uncertainty is no friend to many emerging market export-driven economies, which is why we are focused on paying attractive prices for domestic demand-driven stories with the ability to take market share. The sharp sell-off in Q4 was indiscriminate. We believe investors will start to be more selective about the assets they choose as they adjust to newly tighter financial conditions. We think the Fund is set up for a strong 2019 due to our tactical defensive measures and our ownership of innovative companies that take share throughout the economic cycle. As always, we thank you for your trust and investment with the Seven Canyons team.
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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 a one hundredth of one percent
EV (Enterprise Value) is calculated as follows: EV = market capitalization + preferred shares + minority interest + debt - total cash
EBITDA is earnings before interest, taxes, depreciation, and amortization
MSCI All Country World Investable Markets Index is a market capitalization weighted index designed to provide a broad measure of equity-market performance throughout the world
S&P 500 is the abbreviation for the Standard & Poor's 500, an American stock market index based on the market capitalizations of 500 large companies having common stock listed on the NYSE or NASDAQ
CAGR (Compound Annual Growth Rate) is the rate of return that would be required for an investment to grow from its beginning balance to its ending balance assuming the profits were reinvested at the end of each year of the investment’s lifespan.
PE Ratios (Price-Earnings Ratios) are the ratios for valuing a company that measures its current share price relative to its per-share earnings
Valuation Multiple are financial measurement tools that evaluate one financial metric as a ratio of another, in order to make different companies more comparable.
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