WASIX Commentary (Q2 2022)
June 2022
OVERVIEW
The second quarter of 2022 brought further pressure on stocks. Our benchmark declined 17.09% while our fund fell 15.14%. As inflation dominates market psychology, growth stocks have continued to see what we view as mostly indiscriminate, non-fundamentals-driven selling. Despite our own skew towards growth businesses, we were able to outperform the benchmark by 195 basis points due to better stock selection.
The chart below displays our track record over short- and long-term periods
| Periods ended 6/30/22 | WASIX | MSCI ACWI Index | Bloomberg Barclays US Aggregate Bond Index | MSCI World Small Cap Index |
|---|---|---|---|---|
| Quarter | -15.14% | -15.66% | -4.69% | -17.09% | Year | -27.92% | -15.75% | -10.29% | -21.82% | 3 Years | 1.99% | 6.21% | -0.93% | 4.40% | 5 Years | 3.54% | 7.00% | -0.93% | 4.40% | 10 Years | 6.88% | 8.76% | 1.54% | 8.33% |
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 0.95%. This agreement is in effect through January 31, 2023, may only be terminated before then by the Board of Trustees, and is reevaluated on an annual basis.
In our last correspondence we highlighted the low valuation and high visibility of our top five positions. Today, just 90 days later, our top five positions appear even more attractive, with an average forward P/E multiple of 13x and over 15% anticipated earnings growth (chart below).
Data is from the second quarter of 2022. Past Performance is not indicative of future results.
While no two companies on the list share a similar business or theme, all have been exceptionally well-managed long-term compounders. Ienergizer has compounded earnings per share (EPS) at 38% per annum for five years running, Inter Cars 25% over five years, Future Group 95% for three years, GTPL 35% over five years, and for our youngest company, Sirca Paints, we expect earnings to compound at 50% for the coming three years. Although all but one has seen downward stock pressure, we have touched base with each one and expect no surprise impact to our earnings growth targets.
The top positions are the same as Q1, with the exception of FlatexDEGIRO (FTK GR), the leading online brokerage firm in Europe. We continue to like the low penetration and platform nature of their business, but retail trading volumes have fallen dramatically as a result of geopolitical and macro issues in Europe. We keyed into the impacts, but unfortunately others acknowledged the coming changes as well. The stock ended the quarter down 53%. If we include some trimming early in the quarter, the position reduced from >5% to 1%. It’s worth noting that their underlying business has been performing very well, and we expect to increase this position again before long.
Our sector allocations (chart below) did not shift much through the second quarter. We remain significantly overweight technology with a 22% portfolio weighting versus 12% for our benchmark. Tech was the worst performing sector constituent in the second quarter, returning -21%. The -9% return produced by our fund was gratifying, and supports our strategy of finding great undiscovered companies that can potentially perform well through any environment.
One such company is IEnergizer (IBPO LN), our largest tech weighting. It was also the fund’s second-best performing company through the quarter. Two things happened for IBPO in the quarter. Firstly, the company reported very strong half-year results: revenues +30% and EPS +58%. Secondly, there is an undisclosed buyer interested in the company. The founders of IBPO currently own 80% of the stock, which we don’t mind because it ensures that they are aligned with investors. The downside of high inside ownership is that it leaves fewer shares available to trade in the market. The stock has moved 50% higher year to date, yet still trades at 15x trailing twelve month EPS and offers a 4.5% dividend yield as a result of (what we believe to be) a low-liquidity discount. We hope and expect that management will retain majority control of the company and speculate that the interested party is more of a strategic buyer/partner. If our expectation comes to pass, we should see improved liquidity and continued strong execution. ..
Data is from the second quarter of 2022. Past Performance is not indicative of future results.
As far as geographic allocation goes, we remain far underweight the US benchmark, at 7% versus 51%. Over the past few years, we have found more attractive opportunities overseas where valuations have made more sense to us. We are overweight emerging markets, with India making up 28% of the portfolio. At present, and for the first time in a generation, emerging market (EM) inflation is at or below developed market levels, while real rates are much higher. This means EM’s are much further along in their cycle of raising rates to arrest inflation, and are consequently much better positioned to adapt to abrupt changes in the global economy via cutting interest rates if economic support is required domestically. We love investing locally, and anticipate adding weight back to the US once domestic inflation worries settle.
Let’s take a detour to talk about the state of the US economy.
Prior to the Covid two-month recession (shortest in history), the US was enjoying the longest period of growth in over 200 years (10 years 8 months). Interestingly, from 1789 through 1981, the average duration of time between US recessions was fewer than three years. Since 1981, that gap has extended to over eight years. Through this latter period, interest rates have dropped from >15% to near zero, and only recently jumped back up to 1.75%. The immense wealth seen around the world today stems in part from continually-decreasing interest rates which allowed for ever-increasing levels of investment, and ever-expanding levels of cheap debt. As debt levels increased, our ability to smoothly move in and out of recessions decreased.
How did we get here? The term “zombie firm” was used over a decade ago to describe companies that, prior to the quantitative easing (QE) induced by the Global Financial Crisis (GFC), did not generate enough profits to cover debt service. In simpler words QE = cheap money. The survival of these debt-laden firms received an outsized level of press, as QE opponents called out the shortcomings of such aggressive stimulus and resultant (apparent) capital misallocation. A few zombie firms got lucky, but they were the exception at a time when the system was at risk and dramatic central bank intervention was necessary.
What’s unique about the post GFC-US expansion era, is that the crisis-induced QE was never significantly dialed back. Monetary policy created in the midst of a crisis became the primary fuel stoking the flames of our economic engine. As a result, the cheap money that was a one-time savior to a few ailing zombie firms continued flowing freely to all that could access it. The central bank slogan “Lower for Longer” has supported growth over the last decade. When we google “lower for longer interest rates meaning,” the top hit reads: Low interest rates have lengthened this economic cycle and encouraged risky investment behavior. While there is bias in this explanation, we agree with the angle. A more generous take on “lower for longer” is that keeping rates low propels growth in order to stave off recessions and deflation. Whether it be residual trauma from the GFC, or a fixation on unimpeded growth, we believe that the cheap cost of capital during relatively good times has led to poor capital allocation, i.e. risky behavior. Yesteryears’ zombie companies are repackaged as shiny, new, and “darling” companies that share one similar trait: they cannot exist unless money is excessively cheap. We call these companies “fake” growth companies.
At present we do not know the duration of this “transitory” inflationary period. The Fed is aggressively working to cool inflation by stifling demand. Yet cooling off the economy with the use of higher interest rates is the very antithesis of the same economy, built on a foundation of extremely low interest rate money and extremely high debt loads.
We are not pessimists, nor are we blind optimists. We are new to the world of mega-stimulus measures, zero-percent interest rates, and inflation. We don’t prefer economic pain, but we view the avoidance of necessary pain as a mistake that will inevitably come back to bite us. It doesn’t matter if we are simply digesting an overdue recession, or facing the comeuppance of a decade of easy money capped off by the largest and most scattergun stimulus ever used in history. We are facing inflation and, if effective, the playbook will pressure wealth and slow the economy down. If done delicately, we may be able to hold on to some of the immense “perceived” wealth that has accumulated. But without easy money or stimulus, things will feel painful until inflation is under control. We hope that as we emerge at the other end of the current crisis, the entitlement to growth and handouts will have been tempered as much as possible.
OUTLOOK
For long-term investors, down markets can be viewed as opportunities. We think such an opportunity is being presented. We believe that global growth should structurally be lower and capital allocation more thoughtful. As the capital controls weed out the weak, strong companies will get stronger. And as global growth slows, we hope real growth companies are recognized and rewarded for their discipline and superior business models. Our portfolio is built on companies that we believe exhibit real sustainable growth. Looking ahead, we intend to continue moving your capital to where the greatest dislocations appear. Currently the dislocations are plentiful, but through this market-digestion phase we do not feel urgency to redeploy capital dramatically. We feel no urgency because we have high confidence in growth from the companies we own. We don’t know when the market will turn, but we know that the markets do not favor uncertainty. When the inflation surprise fades, we believe investors will get back to the business of investing where it makes the most sense, providing a potential tailwind for our portfolio.
Definitions
Basis points are a one hundredth of one percent.
CTR (Contribution to Return) measures the contribution of certain portfolio constituents to the portfolio's overall return
MSCI ACWI Small Cap Index captures small cap representation across 23 Developed Markets (DM) and 24 Emerging Markets (EM) countries. With 6,402 constituents, the index covers about 14% of the free float-adjusted market capitalization in each country.
P/E (Price-to-earnings) is the ratio for valuing a company that measures its current share price relative to its per-share earnings.
Trailing twelve months EPS (earnings per share) is a company's earnings generated over a prior, rolling twelve month period reported on a per-share basis.
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.
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.
Sincerely,
The WASIX Fund Management Team
For a list of current top ten holding and performance charts, please click here.
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.