WAGTX Commentary (Q3 2019)

WAGTX

Q3 2019

“Same, same but different!” A common refrain heard when we visit companies in Thailand which means that the product a street hawker is trying to sell you is similar but not quite exactly what you're looking for. This saying comes to mind when reflecting on third quarter action in global equity markets. Ever since early 2018 when quantitative tightening (QT) started to weigh on investor sentiment and trade spats intensified, we've come to expect heightened market volatility and the outperformance of both large-cap and US stocks. During the past quarter, there were 14 days where the S&P registered big moves up or down (>1% on the day). Recall that there were only eight days with big moves in all of 2017! The S&P 500 returned a positive 1.70% during the quarter, outperforming the MSCI All Country ex USA Small Cap Index by over 3%, and the Russell 2000 by over 4%. And since the beginning of 2018, the S&P 500 is up 15.27% and has outperformed the international and domestic small-cap indices by more than 18% and 14%, respectively.

There was one big difference in global equity markets this last quarter that may have important future implications: US tech stocks, the highest of all highfliers during this protracted bull market, stumbled relative to other shares. 2019 has been rife with high-profile, poorly performing tech initial public offerings (IPO) - Uber, Lyft, Peloton - culminating in last month’s spectacular implosion of the WeWork IPO. We do not think this means the end is nigh for US tech. We think these are symptoms of QT; there is simply less capital to go around. For years, investors have been playing the game of sardines, all trying to squeeze into fast-growing cash-burning US tech companies. This game will likely turn into a game of musical chairs because there’s not enough capital to support everyone. In the near term, we expect investors to demand clearer, shorter paths to profitability. We think this may put a cap on some of the insanely high and rising price-to-sales multiples being used to value tech companies. We also think the sentiment pendulum will swing back to favor companies that can internally fund growth. WAGTX is primarily invested in international tech companies which have always been held to a higher standard when it comes to cash flow generation and sustainable growth. We think they will benefit from the change in sentiment.     

DETAILS FOR THE QUARTER

The Seven Canyons World Innovators Fund declined by 2.30% in the third quarter, underperforming the 0.06% decline of the MSCI All Country World Investable Markets Index. Unfortunately, the trends that have favored large-cap US stocks for two years have not rewarded the Fund's penchant for investing in off the beaten path high-quality international companies trading at significant discounts to US counterparts. So, for example, we own one of the largest tea and coffee chains in China, La Kaffa International (2732 TT) rather than Starbucks (SBUX). La Kaffa has a market cap of $180M USD, a 27% five-year revenue compound annual growth rate (CAGR), and trades on a price-to-earnings ratio (PE) of 22 times. Starbucks is a 103B USD market cap company with an 11% five-year revenue CAGR and a 32 times PE. We also own NFON AG (NFN GY) the largest enterprise voice over internet protocol (VoIP) in German-speaking countries, but not RingCentral (RNG) the largest enterprise VoIP provider in the United States. NFON has a $159M USD market cap and a three-year sales CAGR of 27% compared to RingCentral’s $14B USD market cap and 32% three-year sales CAGR. Both companies are investing heavily and running just below break-even, so we look at sales multiples to compare valuations. NFON trades on 2.5 times sales, while RingCentral is valued at a hefty 18.3 times its revenue. As our holdings demonstrate, we think the entry price you pay is a very strong determinant of an investment’s return over the long run. In contrast, many short term investors are crowding into expensive US stocks, and ignoring high-quality small international companies, despite much more attractive valuations abroad. 

The Fund’s current positioning is significantly different from its benchmark. There are structural reasons that will keep the Fund heavily weighted toward international small caps. Electronic trading and regulatory pressures have eviscerated profits from the international equity brokerage business, therefore most banks have significantly downsized their research departments and dropped coverage of small caps with low trading volume. To make matters worse, Security and Exchange Commission rules introduced last year have forced US mutual funds to reduce their investments in small caps with lower liquidity, (Many US mutual funds started preparing to comply with this rule over three years ago by selling small and micro caps.) These factors make international small caps prime hunting grounds for nimble, active managers like Seven Canyons Advisors.

We deliberately recommitted our research efforts to seeking out the best secular growth companies this quarter. We are about two-thirds of the way through the most comprehensive global secular growth screen we've executed since the inception of the Fund. This is not a strategy change but rather our response to recent volatility offering better pricing on fast-growing innovators. On top of that, we think growth companies, as opposed to value, will be the best segment of the market going forward. In fact, we think we've seen this movie before in Japanese stocks. Since the Asian financial crisis in 1997, the Japanese economy has been dragged down by excessive levels of debt. Japanese equity investors have been willing to pay a premium to own growth stocks while ignoring value companies with flatlining sales and profit growth. We think the sequel has begun to play out around the rest of the globe, and we have the fund positioned to benefit. Faster sales growth than peers has always been a key metric used by the World Innovators Fund because faster growth is a hallmark of innovation and market share gain. The median revenue growth rate of companies we own has consistently been 50% higher than the benchmark's median. As a result of our global secular growth screen, we are finding new higher growth companies to invest in. The median sales growth rate for the portfolio jumped to 13.3% in the third quarter, up from 9.4% in the prior quarter, and 8.8% in the third quarter one year ago. 

Three of our holdings made meaningful positive contributions to the Fund’s performance this quarter. We define “meaningful” as more than 50 basis points of positive (or negative) contribution. The biggest contribution came from Zozo Inc., the leading independent online fashion retailer in Japan. Yahoo! Japan agreed to buy 50% of the company at a 20% premium over the stock price, and the shares rose 23.4% during the quarter. The other meaningful contributors were MNF Group in Australia and Avon Rubber in the UK. MNF is a telecom services provider whose stock was spurred by the growth in internet protocol voice services. Avon, the leading supplier of respiratory protection systems for the world's military, law enforcement, and fire markets, rose due to its acquisition of 3M’s ballistic protection business.

Two of our holdings detracted meaningfully from performance. Abcam (ABC LN), one of our longest holdings with a very good track record of innovation, hurt the most. The Cambridge UK-based company is the largest online retailer of antibodies and biotech tools used by lab researchers. The company is in the midst of an IT investment cycle in order to build stronger foundations for future growth. Organic sales growth has stayed the same as always, right around 10%, but increased investment has weighed on margins for longer than expected, and the stock sold off in response. We remain loyal shareholders. The other large detractor was Loopup Group (LOOP LN), an enterprise software-as-a-service conferencing solution provider. The company had to cut its guidance for the year as its UK-based professional services customers (law firms, investment banks, and consultants) suffered from the never-ending Brexit anxiety depressing the economy. Despite economic headwinds, the company continues to grow organically and take market share. Loopup is priced at an attractive discount compared to global peers.         

OUTLOOK 

We think our portfolio of faster-growth companies trading at reasonable prices is well-positioned for the future. That said because small, international stocks are currently out of favor, their valuations are increasingly appealing. What will turn this widening valuation dispersion around? We can't say in the short term, but in the long term, we believe earnings drive stock prices and the entry price paid determines the magnitude of returns. Our research team is mining data, calling, and traveling to meet companies, working tirelessly in order to find the world's best sustainable growth stories. We are patient investors who are willing to wait for sentiment to turn in our direction and lead to outperformance over the full market cycle.

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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 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. 

For a current list of top ten holdings and performance charts, please click here.

DEFINITIONS

ACWI Index (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.

Basis Points (bps) are a one hundredth of one percent.

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.

Price-to-earnings (PE) is the ratio for valuing a company that measures its current share price relative to its per-share earnings.

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

Revenue Growth Rate measures percentage increase in revenue over a given time period.

Russell 2000 is a small-cap stock market index of the bottom 2,000 stocks in the Russell 3000 Index. 

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