WASIX Commentary (Q1 2024)
April 2024
OVERVIEW
As global small-cap investors, our mandate is to own the highest quality and most undervalued small-cap assets worldwide. Each year we screen thousands of companies and speak with hundreds across the globe, and through this process we continue to find superior opportunities outside of the US. We are confident that our portfolio can deliver higher and more consistent earnings and return on asset (ROA) growth at more reasonable valuations than the benchmark as a whole. As a result, we have underweighted the US for the last three years and believe that we have crafted a much higher quality portfolio compared to the benchmark as a result. Our portfolio’s captured earnings grew by over 20% annually over the one-year and three-year periods, while the benchmark’s earnings grew by only 2% and 10% during the same periods. Yet performance was -5% for the first quarter and -4% for the prior year, driven by an underweight in the US. We are investing in higher growth companies at valuations similar to the overall benchmark. However, despite superior growth and valuation metrics, our portfolio underperformed the benchmark over the past three years. We firmly believe that earnings will ultimately drive stock prices in the long term. Although stock returns may diverge from earnings-growth trends in the short term, we are confident they will realign over time. Based on our experience, we anticipate that the current gap between our portfolio return and its underlying fundamental strength will eventually narrow.
To further demonstrate why we believe non-US companies offer more attractive investment opportunities compared to US companies, let’s take a look at the following two examples.
The first example is FlatexDegiro (FTK GR), a dominant online-brokerage player in continental Europe with a $1.2B market cap. Online brokerage is a very attractive business when you are the leader – the majority of operating costs are fixed, and scale leads to low unit costs, creating more scale and resulting in market dominance over time. As of today, FTK has 2.7M customers and is the largest digital player in continental Europe, offering immense opportunity. While Covid provided a tailwind for most online brokerage businesses, FTK continues to gain market share post-Covid while unprofitable competitors have scaled back. This speaks to the quality of the business. FlatexDegiro has been growing earnings by over 30% over the last five years and is trading at 10x trailing earnings. Its US equivalent, Charles Schwab (SCHW US), grew earnings by only 5% annually in the last five years and is trading at 25x trailing earnings. Furthermore, due to the much lower online brokerage penetration in Europe compared to the US, we expect FlatexDegiro to grow earnings at 35% annually for the next three years, while the market only expects Charles Schwab to grow earnings by 20% annually for the same period.
Another example from the lower end of our market-cap spectrum is Winfarm (ALWF FP). Winfarm is the leading online agricultural distributor in France and aims to consolidate the highly fragmented EU agricultural supplier market. With its online presence, the company offers about 90,000 SKUs and professional support to farmers who have traditionally been served by local co-ops that offer only limited selection of supplies and resources. Farmers are attracted to Winfarm for its extensive selection, competitive pricing, and doorstep delivery. Over the past three years, the company has invested $1M per year in R&D, and last year it spent an additional $2M on an enterprise resource planning system to provide the robustness needed for the company to scale across all EU countries. All these past investments have been expensed as operating costs. With the investment cycle now completed, the company sits on a revenue base that is approximately 40% higher than three years ago. We expect their EBITDA margins to normalize to their historical range of 6-7% over the coming year. To us it seems clear that their EBITDA should triple in FY24, and grow by another 60% in FY25. Tractor Supply (TSCO US), a similar business model in the US, is a company trading at 13x FY25 EBITDA. While it is too early to frame Winfarm as the next Tractor Supply, it’s easy to see the valuation mismatch when Winfarm is growing faster and trading on 3x FY25 EBITDA.
The chart below displays our track record over short- and long-term periods:
| Periods ended 3/31/2024 | WASIX | MSCI ACWI
Small Cap Index |
|---|---|---|
| Quarter | -5.22% | 11.98% | Year to Date | -5.22% | 11.98% | 3 Years Annualized | -3.13% | 1.58% | 5 Years Annualized | 3.40% | 7.98% | 10 Years Annualized | 3.69% | 6.75% |
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.
DETAILS FROM THE QUARTER
The primary driver for our fund's underperformance for Q1 was our overweight position in India and underweight position in the US. While this allocation contributed positively to our performance last year, it has posed a challenge for us since Q4 2023. Within the Global Small Cap Index benchmark, the US market outperformed the Indian market by 5.1%. We already discussed our belief that better growth/valuation opportunities lie outside the US, and thus remain underweight the US market. India is a region where we continue to find many attractive opportunities, and we continue to be overweight in India as a result.
Within the Indian market, our portfolio underperformed the benchmark by 17.5% in Q1, despite outperforming the benchmark by 15% in 2023. Many of the top Indian performers from 2023 experienced significant pullbacks in Q1 because of regulatory noise. For example, the stock price of Datamatics increased by 159% last year, but decreased by 26.6% in Q1, while Arman Financial's stock price rose by 69.2% in 2023, but declined 26.3% in the first quarter. As our top Indian names’ valuations started pulling ahead of our growth expectations, we began trimming our weights in order to rightsize positions and reallocate capital. In March we faced pricing pressure as the Indian regulator (SEBI) vocalized concerns over “froth” in the small-cap market and signaled that it will tighten rules around small and micro-cap investing. This regulatory concern disproportionately affected micro caps. Given that our portfolio's average weight is on the lower end of the market-cap spectrum, our Indian holdings were more severely impacted than larger market cap names. Despite these challenges, we remain bullish on our top Indian holdings and believe that their valuations have become even more attractive following the recent pullback. Our average valuation for our Indian holding decreased from 40x trailing P/E to 30x, while maintaining more than 20% earning growth expectation for the next twelve months.
Looking at the individual stocks, the top contributor for Q1 was Fragua (FRAGUAB MM). Fragua is the largest pharmacy chain in Mexico both by sales and by the number of stores. This is within a market that remains 40% controlled by single-location mom and pop outlets. The company has been growing store count at 6% and EBIT per store at a 9% clip, leading to a 16% five-year annualized revenue growth rate, and an even more impressive earnings growth pace of ~20%. When we started purchasing the stock, it was trading below 10x earnings and yielding over 3% – less than half the valuation of comparable companies in other growth markets. The company has consistently delivered on store openings and revenue growth, and has managed to expand margins throughout our holding period. It seems like the stock is finally being recognized by the market and valuation discount is shrinking, although it is difficult to pinpoint why the recognition came this quarter. We still like the fundamental story of the business, and valuation remains reasonable at 12x FY24 price to earning ratio (P/E).
Another top contributor was NextVision (NXSN IN). NextVision is the global market leader in sub 2kg cameras and gimbals used for drones. The company is rapidly gaining share in the extremely fast-growing military drone market as a result of their offering being “lighter, better and cheaper.” When comparing the NextVision products to their closest competitors, their offering stands head and shoulders above on every metric. On top of these attributes, the company has designed their product to be a “plug and play” solution for any drone manufacturer. The performance of the business speaks for itself, with revenues growing north of 80% over the past three years and earnings up five fold. What’s most compelling about the opportunity is that adoption remains in the early innings. Military budgets are just now starting to shift from large and extremely expensive drones to small and cheaper drones. Furthermore, the US currently accounts for roughly 15% of their revenue, yet is where the bulk of global military spend derives. The company is just now gaining a toe-hold in the US and anticipate it to ultimately be their largest market. The stock has performed very well, but still trades at 18x forward earnings with an expectation of 65% earnings growth in ’24.
The biggest detractor for our portfolio in Q1 was Sirca (SIRCA IN). Sirca paints has been a long-term holding of the fund. The company, which manufactures a well-known brand of premium Italian wood coatings, is dominant in Northern India and has been expanding across the rest of the country. It benefits from growing demand for wood paint for housing and furniture manufacturing, and from consumers shifting from low end to premium paint brands. The stock corrected significantly in Q1 for two reasons. First, the company posted decelerating revenue growth and falling margins in Q4 of 2023 due to growing pains such as production delays, market disruptions in Northern India, and difficulties with novice sales teams in the newer regions. As of now, we think these pressures are transient and, per our recent discussion with management, we believe the company will accelerate revenue growth this year. We believe the second reason for the stock decline in Q1 was due to the Indian regulator’s efforts to dissuade the local fund managers from increasing their small-cap exposure, which amplified pressure on Sirca’s stock price. Immediately after quarter end the stock price had a strong recovery, reversing some of the initial sell-off. We have known the business for years and believe management’s reasons and guidance for accelerated growth this year, and thus we have retained our weight in Sirca.
We continue to find attractive new investments globally. One of the new additions to our portfolio this quarter is Segyung Hitech (148150 KS). Segyung Hitech (148150 KS) is a specialty optical film manufacturer. The growth engine supporting their business is the adoption of foldable phones and organic light-emitting diodes (OLED) displays – more efficient light sources than electronic. Samsung (005930 KS) is the largest foldable phone manufacturer in the world, and Segyung has a three-year exclusive agreement with them ahead of a concerted push to accelerate their foldable phone roll-out. While only a projection, on a base of 15M units sold in ‘23, the outlook for foldable phone volumes is strong, going from 23M units in ‘24 to 73M units by ‘27. On the OLED side, Apple (AAPL) is in the early innings of shifting to OLED for their tablets and PCs and, given Apple’s larger screen sizes, Segyung stands to benefit via increased volume requirements. The key to any manufacturing business is maintaining high utilization. We are seeing the benefits of utilization increases, with margins starting to climb exponentially year over year. With company-wide utilization at 49% in ‘23, and a strong pipeline in ‘24, we expect another year of exponential earnings growth as utilization moves higher and revenue increase goes straight to the bottom line. What makes the stock so attractive is that when we purchased the shares they were trading at 2.2x EV/EBITDA. We expect the market to take note this year as fixed cost utilization drives earnings higher. We never bake-in valuation expansion as part of a thesis, but do believe there is ample room for a rerating on top of strong earnings growth.
As we add better ideas to our portfolio, we continue to rotate out of holdings with either a broken thesis or an unattractive risk/return balance. One of the significant positions we exited this quarter was Linical (2183 JP). Linical is a well-run contract research organization that scaled up its business significantly just before Covid reduced demand for their services. This left them with an elevated cost base and limited access to the human-patient population required to conduct their studies. Fortunately, their US exposure, added right before the Covid lockdowns, is now thriving. Unfortunately, their core Japanese business has yet to return to normal. The company reduced labor costs and our expectation was that as the world further normalized demand would increase and the company would experience significant margin expansion by the end of the year. However the anticipated margin expansion did not materialize, and business pressures in Europe and Japan have not eased, raising concerns about management's credibility. We decided to exit this position as our expectations for the company were not met.
Another notable position we exited was Riverstone (RSTON SP). Riverstone manufactures high-end cleanroom gloves used in semiconductor manufacturing. Before Covid, the business was growing earning 15% annually while maintaining a ROA of 20%. The business is highly cash generative, offering a 2.5% dividend yield pre-Covid. They greatly benefited from Covid due to the global demand for healthcare gloves exceeding supply. However, their earnings and revenue dropped significantly in FY22 as demand for healthcare gloves decreased. The industry is experiencing several years of excess capacity due to overproduction during the pandemic. Our original thesis was that there were no issues with their cleanroom business, which made up over 90% of their profits. However the valuation dropped significantly as the market did not differentiate between healthcare glove manufacturers and cleanroom glove manufacturers, valuing Riverstone the same as commoditized healthcare glove manufacturers. The stock was trading at a P/E ratio of 9.5x, while the cleanroom glove business was expected to continue growing at 10-15% annually. Additionally, the business had accumulated significant cash during Covid. Riverstone recently reported FY23 results which came in below our expectations. While the cleanroom business improved, it fell short of our projections, signaling increasing competition. Additionally, we had anticipated an increase in dividend yield to 20%, but management decided to only offer 11% dividend yield without convincing arguments on why they want to maintain a big cash balance. The change in the competitive landscape, and the misallocation of capital reduced our confidence in the business, prompting our exit during Q1.
OUTLOOK
While we certainly keep an awareness of what is occurring from a macro perspective, that is not our focus. We focus on our bottom-up investment process: finding businesses that are growing sustainably, have strong balance sheets, good management teams, and are reasonably valued. Looking forward, we expect our portfolio earnings to grow by 30% in the next 12 months compared to the benchmark’s expected earnings growth of 14%. Despite expected earning growth that is twice the benchmark, our portfolio’s valuation is in line with the overall market. We like those metrics. As we look forward to a successful and prosperous 2024, we remain grateful for your trust, and we welcome any questions you may have.
DEFINITIONS
EBITDA (Earnings before interest, tax, depreciation, and amortization) is a measure of a company's operating performance.
MSCI ACWI Small Cap Index is an index representing small cap companies in 23 developed market countries and 24 emerging market countries, covering roughly 14% of the free float-adjusted market capitalization in each country.
The Strategic Global Fund invests globally in high quality small-mid cap growth businesses that demonstrate sustainable, long term earnings growth.
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.
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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