WASIX Commentary (Q1 2023)
April 2023
OVERVIEW
The first quarter showed continued strength, with the fund returning 6.85% vs 4.25% for our global benchmark. While two quarters doesn’t yet make a trend, we are happy to see that after a dramatic year of macro-driven market action, our portfolio companies are again being rewarded. We understand the tailwinds for our positions, yet are leery of the updraft behind most indices. In the fund we saw one of our positions acquired (GKS Software - GKS GR) and another re-rate exponentially (Emro - 058970 KS). Both companies were misunderstood and mispriced by the markets. We view the remaining 65 positions in our portfolio as similarly misunderstood/mispriced. But these are few among thousands. Here in the US, the S&P rose 7.5% and the Nasdaq 17% through the first quarter, while the Russell 2000 only mustered 2.75% and, as of today, has retreated back to flat for the year. We view the Russell as more indicative of a current status quo, in which the outlook is murky given our down-shifting economy paired with investors who remain focused on potential Central Bank measures.
The chart below displays our track record over short- and long-term periods
| Periods ended 3/31/2023 | WASIX | MSCI ACWI
Small Cap Index |
|---|---|---|
| Quarter | 6.84% | 4.24% | 1 Year | -4.40% | -9.57% | 3 Years | 17.92% | 17.93% | 5 Years | 5.00% | 4.21% | 10 Years | 6.24% | 7.15% |
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 1.40% 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.
In our most recent letter we covered a few simple tenets of market psychology including the forward-looking and optimistic nature of investors. Consequently, we suggested that the current recovery we’re seeing is rooted off into the future. We also suggested that the roots of the recovery are firmly planted in the belief that central banks/monetary policy will be there to catch any market stumble. It has been just three months since our last letter, and with the regional banking crisis in the US, we’re seeing this dance play out.
There is no disagreement from us that the banking system is foundational, and thus a reaction was necessary to avoid a systemically risky situation. And it is with little surprise to us that the go-to solution was a new form of quantitative easing (QE), opaque as it may be. Within a week of the first murmurs of banking stress, the Federal Reserve created a special vehicle offering additional funding to banks that would allow them access to enough capital to cover the entirety of their collateral. To avoid any further bank-specific runs, the offer was extended to all banks – stressed and sound alike. Within a couple more days, the Fed’s solution had reintroduced half the capital that was painstakingly sucked out of the system over the past year. The most simple and best framing we’ve heard is that the US economy is now driving down the road with one foot on the gas (QE) while the other is firmly on the brakes (high interest rates). Inflation is being handed out with one hand, while the other is taking it away.
Ahem... We won’t predict how the scenario will unfold, but with the markets moving higher in the face of distress, two generic determinations are that the Fed IS there for us, and that the shakiness in the banking sector has brought us one step closer to the end of the high interest rate period. We agree with the first belief, but retain the memory that the Fed led us down this primrose path. The second conclusion is where we remain very cautious. Inflationary tailwinds are currently the Fed’s number one adversary. We don't believe a “silly” banking crisis is cause for a shift; what we do believe is that economic contraction remains the only catalyst for erasing the inflationary pressure, and contraction will ultimately be the driver of bringing down rates in a meaningful way. The year so far has shown us the too-familiar cycle where bad news yields a stronger market. We are skeptical of the “the sooner the economy breaks, the sooner we find salvation from the Fed” theme. It has worn thin over the past decade. Although the Fed now holds the reins of the market, economic reality will ultimately take back the controls. We don’t see a shortcut around tougher times ahead.
Though we look down the road, we hold tight to the fact that, while headlines can influence a day, the market ultimately moves at a much slower pace. The art of our business is seeing the forest through the trees. We see challenging times ahead with broad economic growth difficult to come by. Nevertheless, there are plenty of companies that will still show solid growth through the current environment, so attention to valuation will prevent blindly overpaying for growth. Through the first quarter, we began to see cracks in the expensive growth stocks that drove much of the market rebound over the past six months. Despite their high quality, valuations are beginning to be challenged as the pace of future growth comes into question. As always, we seek-out undiscovered GARPy companies with earnings as-close-to-certain as possible, and valuations that make sense relative to the type of business and company prospects. Fortunately we hold and continue to find many companies that fit into this bucket. With the belief that earnings drive stock prices, we expect that our style of investing will be rewarded.
DETAILS FROM THE QUARTER
As mentioned in the intro, we had a couple positions that offered outsized contributions. Emro (058970 KS) added 2% to our return following a 251% move YTD. Emro is a software company focused on the supply chain that started making waves in Korea following supply and inventory mismatches brought upon by COVID. Back in 2020 when the world temporarily froze, companies quickly realized the importance of their supply chain, an operational aspect of their business that had long been taken for granted. The lack of attention has driven internal underinvestment by most companies around the globe. In tandem with that complacence, there has been a shortage of R&D investment into this historically unexciting software niche… with one exception: Emro. For years, Emro has been developing an AI-driven solution that can service most major industries. With the newfound focus on steadying the supply chain, Emro has been eating up market share within Korea. In March Samsung SDS (018260 KS) announced that it is purchasing a 33% stake in Emro, and we see this new relationship as a platform for launching Emro products globally. While our excitement for the company remains, the parabolic move higher made the current valuation too rich to continue holding the position. We hope to reenter once the buzz dies down.
The second largest contributor was GKS Software (GKS GR). The stock contributed 1.3% to performance after returning 41% YTD. It is with some frustration that we acknowledge this “win.” GKS was purchased by private equity for what we view as a very nominal and shortsighted premium. GKS was a true hidden-gem company that provided software as a service (SaaS) point of sale solutions to some of the world's largest grocers – which, shockingly, remain in the first innings of advanced software adoption. With the stock trading below 20x PE, strong free cash flow, and accelerating SaaS revenues, we had been confidently accumulating shares. GKS fit the bill of GARPy growth perfectly, and we were sad to see it eliminated from the portfolio.
Despite some victories, the quarter was not without headwinds. Our largest position, IEnergizer (IBPO LN), declined 17% and detracted 1.3% from performance. Over the past six months we’ve been trimming our India exposure, including IBPO. Yet with an outsized decline in IBPO through the first few months of the year, we’ve begun adding to the position again. We’ve beat the IBPO drum for years, so will stick to a surface overview today. IBPO has a 10-year track record of returning 15% earnings growth per annum. The five-year track record sits at 32% annualized EPS growth. The stock trades at 9x trailing earnings, and currently carries an 8% dividend yield. The company holds a net cash balance sheet and generates an 11% free cash flow yield. Our trim was hinged on reducing a geographic exposure, but strong fundamentals and an attractive valuation always take precedence.
Polypeptide (PPGN SW) is a meaningful new addition to the fund and at the moment is somewhere between a fallen angel and a superdog. Our early entry hurt us in the first quarter with the stock declining ~25%. PPGN is the second largest polypeptide manufacturer in the world, just behind Bachem (BANB SW) which carries slightly over 30% market share (vs ~25% share for PPGN). Given that pharmaceutical ingredients and production are strictly regulated, the business has very high barriers to entry, and is also very sticky. Additionally, their clients want multiple sources to reduce supply chain risk. Keeping that in mind, this new IPO has executed poorly since coming to market 18 months ago. After missing margin estimates repeatedly, the stock has fallen 86% from its December 2021 peak. The margin misses stem from inflationary pressures that weren’t addressed quickly enough, and operational issues requiring costly consultants. In spite of the problems, the company continues to deliver orders on time and win new business. We understand that the company is almost finished with their restructuring, and believe that we should see margin expansion along with accelerated earnings growth in the near future. With the stock trading at 1/10 the market cap of Bachem, we find it grossly undervalued. As shareholders, we have to stomach the earnings burden, but trust that our patience will be richly rewarded.
From a sector positioning perspective, we ended the quarter in a significantly different position than we began. Tech remains our largest exposure at 23% of the fund, but ended the quarter 10% lower than it began. Selective trims of higher-valuation companies, and the outright sales of GKS and Emro led to this pronounced exposure reduction. Most of the tech trimming was allocated to industrials and healthcare. Industrials moved up nearly 10% as we added to our positions in MYEG MK, IBPO LN, and VLRS US. Healthcare weight inched up as we re-added Riverstone (RSTON SP), a niche rubber glove manufacture, and Dentium (145720 KS), a dominant player in the dental implant sector that’s seeing significant demand from an underpenetrated China.
From a geographic view, we remain overweight emerging markets (EM) vs developed markets (DM). We continued trimming India, but most of the trimming was reallocated towards other EMs. Taken together, Mexico and South Korea grew about 8 points, for a combined weight of ~13%. Mexico continues to exhibit strong fundamentals, as policy remains sound and companies benefit from nearshoring to the US. The added Korea weight stems from the addition of Dentium, and putting more wood behind the Ray (228670 KS) arrow. Like Dentium, Ray is in the dental space and benefits from the same Chinese trends as Dentium. The stock has been a long-term holding that is starting to perk up with new distribution wins.
OUTLOOK
The rationale behind our overly US-centric market overview of late is driven by our homelands’ impact on the global investment cycle. Currently all developed economies have extremely tight monetary conditions relative to the same period last year. And while we have become accustomed to dividing the investment world into developed and emerging markets – with technical definitions used by index providers to classify a country as “developed” or “emerging” – the reality is that the lines between developed and emerging markets are getting more and more blurred every year. Seeing images of protestors in France burning down buildings, or the indictment of a former US president, makes one wonder if the US and France are really more developed than Taiwan or Korea, where political transitions are peaceful and over half of the world’s semiconductors are produced. We think the current developed vs emerging dichotomy is heavily outdated and is less relevant. In addition, if we look at balance sheets it becomes very apparent that the emerging world looks more developed than the overleveraged and anemic economies of the developed world. Inflation in Mexico is now lower than inflation in the US and the UK, and the Mexican peso has been more stable than the euro or the yen. So while we pontificate the direction of US interest rates and economy, the reality is that markets classified as emerging are in reasonably good shape from both a balance sheet and internal demand perspective. Of course there are different economic vectors depending on where you look: China is in its perpetual black box, Mexico is benefitting from a surge in nearshoring manufacturing demand, India is seeing accelerating capital formation, Poland remains Europe’s back office, and Korea is an innovation hub for medical and dental devices. This long-winded view of the world is punctuated by our underweighting of the US and DM’s in general. Yet with the task of managing your money, we must take into account both the long and short term. The best way we’ve found to do this is to acknowledge the macro backdrop and expected capital flows, and then get back to finding businesses that will thrive through the current, and hopefully any, macro environment. There is downward pressure on growth right now, and 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 WASIX Fund Management Team
DEFINITIONS
GARP (Growth at a Reasonable Price) growth-orientated with relatively low price/earnings multiples.
Dividends are not guaranteed and a company’s future abilities to pay dividends may be limited. A company currently paying dividends may cease paying dividends at any time.
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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