WASIX Commentary (Q2 2023)
July 2023
OVERVIEW
The Great Disconnect. We’ve determined this short phrase to be the most apt description of the year, and particularly the second quarter. The markets are jammed with cross-currents: equities vs. bonds, large cap vs. small cap, US vs. China, manufacturing vs. services, and AI vs. non-AI. This jockeying simmers on the surface of the perennial debate about whether US rates have peaked and whether the US will avoid a severe recession following the steep interest rate hikes. Meanwhile the music played on for most markets in Q2 with the S&P returning 8.74%, the MSCI World Index rising 6.99%, the MSCI ACWI Ex-USA grinding higher by 2.63%, and the MSCI Emerging Markets Small Cap delivering 6.50%.
The overall macro environment paints a fairly clear picture with most data around the world directionally softening. Here in the US the manufacturing ISM hit the lowest point since 2009, and across the sea in China, the long-awaited economic recovery following draconian Covid lockdowns appears to be flagging. Even so, market participants are scratching their heads as they parse through the conflicting economic data, the expectation of even higher rates ahead (as communicated by the US Central Bank), and the screaming yield curve that’s telling investors that although rates may be high today, they may soon be much lower. With conditions like these, one would hardly expect some of the strongest equity performance in decades, as we saw in H1.
Common sense would dictate that the double shock from an unprecedentedly rapid increase in US interest rates coupled with poor post-Covid recovery in China would, at a minimum, lead to significant weakening of global demand, or at a maximum, to a severe global recession. While either scenario may yet happen, we are comforted by the fact that the companies we own are structural market share gainers, and economic weakness can serve them well in the long term by washing away weaker competition. As we wait to see the coming economic cards, it is worth mentioning that the market is still in the mode of the past decade, where negative economic news results in a positive market response. On the surface, a positive response is somewhat rational considering that tackling spiraling inflation seems to be requisite for rates to begin their drop. But as we’ve stated in past commentaries, we don’t find the shift as simple as the markets seem to be making it. The past year has shown us that downshifting the economic engine is no simple task. The Fed has essentially pulled the emergency break, yet momentum has propelled us forward for much longer than anyone anticipated. The effort to get things moving again at a safe speed is apt to be equally as challenging.
We are mindful of the macro backdrop, but keep our attention more closely fixed on what our companies are telling us. Thus far, we are still hearing that revenue trends remain robust. While we wait to see how this plays out, we have confidence that none of our companies “let a good crisis go to waste.” Over the past year, nearly every company we own has optimized and rationalized their cost and/or supply structure to some degree, improving the quality of their operations. So while we do not discount the probability of recessionary headwinds across our universe, the general sense from our owned companies is that they are continuing to grow, and are now in a better position from a profitability perspective.
The chart below displays our track record over short- and long-term periods:
| Periods ended 6/30/2023 | WASIX | MSCI ACWI
Small Cap Index |
|---|---|---|
| Quarter | -2.44% | 3.62% | 1 Year | 4.24% | 8.02% | 3 Years | 10.49% | 10.83% | 5 Years | 3.78% | 4.53% | 10 Years | 5.99% | 7.62% |
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.
PERFORMANCE
The below-benchmark results in the second quarter can be attributed to a single security. In April the fund's largest position, iEnergizer (IBPO LN), fell 82% following the announcement of the boards’ determination to delist the shares “in the best interest of shareholders.”
We disagreed with their determination and assumed the founder (who is also CEO, a board member, and owner of 83% of the shares) would simply vote against the proposal in order to stop the delisting process. We’ve met with IBPO on-site in India and interacted with them over a dozen times in the three years we've held the security. Like the founder, we’ve long felt the shares were undervalued, and have written about it in our quarterly letters. When we heard the news, we immediately contacted the founder, hoping to encourage a rational vote and other shareholder-friendly corporate actions to correct the course.
Over numerous calls the CEO lamented his ~$500M equity loss and expressed the same shock and disappointment that we felt. But he went on to mention the possibility of better access to capital as a private company and a reduction of expenses related to the public listing. His logic felt unsound and his lament insincere. Ultimately, he voted in favor of the proposal, and after 12 years of public trading, IBPO has been delisted.
No one on our team, nor our brokers, clients, nor market confidantes have ever seen anything like this. We can only guess why the founder made the decision he did, and though we did our due diligence, the move feels suspect. While some shareholders, including WASIX, were able to keep their stake in the soon-to-be private company, the decision led to forced selling by many others. The -6.26% impact on our performance drove our 537 basis point underperformance vs. our benchmark.
Despite this setback, we are pleased to report that the rest of the portfolio performed very well. Our top ten contributors returned an average of 36% with a weight of approximately 2.5%. At the other end of the spectrum, our biggest detractors (excluding IBPO) dropped 26% with an average weight of less than 1%. We remain optimistic about the future and are confident that we will continue to deliver strong returns for our investors.
Datamatics (DATA IN) and Arman Financial (ARLF IN) were our top two performers and contributors. Datamatics returned 97% with a 2.8% contribution to performance and Arman returned 68% with a contribution of 2.4%.
Datamatics is an Indian IT services and BPO company that is just now concluding a significant phase of research and development (R&D). The investment phase has been going on for years, masking the true profitability of the business with temporary expenses. We purchased the stock just over a year ago knowing R&D would soon wrap up. Although it took some patience, the diminishing spending showed up in the March results and led to an operating margin jump to 18% from 13.5% in the same period last year. We don’t expect the profitability trend to stop here, and even with an >100% move in the stock year to date, the position still trades below a 1 PEG ratio (PE = 19 / Forward Growth = 20%). The performance is now clearly catching the attention of other investors.
Arman is a longtime holding in the fund and continues to be a strong outperformer. Arman is a non-bank financing company that specializes in micro-financing – small loans to rural borrowers without access to the traditional banking system. Their unique strategy hinges on lending to groups of borrowers who co-guarantee the loans. This lending structure diversifies the borrowers’ profile and creates peer pressure on the main borrower to pay back the loan, a recipe that has proven to reduce credit risk. The business model has also proven to be in high demand, with Arman’s AUM growing at a 35% CAGR over the past five years – even with the Covid disruption. Management has navigated a very challenging landscape almost flawlessly, with continually low default rates and a much faster recovery than peers post-Covid. We believe the business still has enough headroom to maintain a high pace of growth for years to come. Even with the stock rising 5x since our first touch back in 2020, their strength in earnings growth has kept the valuation attractive.
Richardson Electronics (RELL US) saw a big drop in Q2 and was the main detractor behind IBPO. The stock fell 25%, pulling 1.07% from performance. The drop was due to a small decline in backlog year-over-year in their higher-margin semiconductor equipment business. The reaction appears overdone to us, given RELL’s solid fundamentals and Q2 27% revenue increase and 110% earnings growth. We expected momentum to slow down, but already the stock's current 8x-trailing-EPS multiple discounts slower-paced earnings growth. Looking ahead, Richardson Electric has potential for double-digit earnings growth thanks to exposure to growing green energy and semiconductor markets. Although the recent stock decline is concerning, the company's fundamentals remain strong, and we are optimistic about its future prospects.
We ended the quarter with the same number of positions as we started, but turned over ~5% of the portfolio in the interim. The biggest cuts, comprising 3% of the portfolio, were to iEnergizer (IBPO LN), CI Medical (3540 JP), and Wirtualna Polska (WPL PW). CI Medical is an online dental equipment distributor that is gaining share from the traditional sales rep channel. Although we like the business and believe in the share gain, their foreign purchasing has put pressure on margins as a result of the weaker yen. Given the company’s dominant position, we questioned the fact that CI Medical did not increase prices to offset this hit. In addition, CI Medical made a large investment into a new distribution center, further depressing margins and causing us to doubt the company's competitive advantage. Wirtualna Polska provides a broad array of internet and ecommerce services in Poland. Thus far the stock has been decent for the fund, but as the company grows larger we anticipate its growth rate to slow, putting the valuation into question.
The most significant additions to the fund were Swedencare (SECARE SS) and LT Foods (LTFO IN).
Swedencare is a pet nutrition manufacturer and distributor that we have owned in the past. The company diverged from their core manufacturing business back in 2019 and set out on an aggressive M&A strategy, hoping to leverage their niche brand and products globally. The move propelled the stock 11x higher, peaking in late 2021. The pace of acquisitions was followed by challenging integration issues through 2022 that drove the stock price back down 85%. After speaking with management in early May, we got the sense that the integration issues are now behind them and from here on out there will be solid revenue growth and margin expansion. At 45x TTM earnings the stock is not cheap per se, but we anticipate 40% annualized earnings growth for the coming four years.
LT Foods is the second largest branded basmati rice company in the world, and the leading branded player in the US and Europe. The company has both a domestic and an export business that each have considerable headroom. Within India only 30% of the rice sold is branded, and as the country develops we see packaged rice continually gaining market share. In the export markets there are more regions to penetrate, and as the company moves towards more rice-based packaged goods and higher-value organic offerings the margins should march higher. LT Foods is a company that has grown sales at a 12% CAGR over the past decade and earnings at a pace of 19% per annum. The headroom remains large enough that we believe the pace of growth will continue for some time. We have high confidence in the business and were able to purchase our shares for under 10x trailing earnings.
OUTLOOK
A few days back we were looking at the inverted yield curve and pondering whether or not its historical recession-predicting capability still applies. The conclusion we came to is that it’s not a metric we are prepared to bet against. After accepting that stance, the next question was: what sort of an impact would a recession and subsequent rate cut have on our portfolio? This is the million dollar question and another cross-current: while earnings may be under pressure, lower rates allow for an increased equity premium. What will happen is yet to be seen, but with cost pressures and a maturing debt cycle in developed markets, we continue to lean towards emerging markets. We can’t help but look back to one of our founding beliefs – the belief that EM small cap is no different than US small cap circa 1995: overlooked, discounted, and filled with a huge amount of companies that have miles of runway ahead. We think that through the next cycle investors may start paying more attention to areas of the world where high-quality growth can still be found in abundance. The case for a significant emerging markets discount is becoming more difficult to articulate. Regardless of how the big picture pans out, we will continue to work tirelessly finding great companies on the cusp of receiving their due credit. We again thank you for your trust.
DEFINITIONS
CAGR (compound annual growth rate) is a measure of average annual growth over a given period.
TTM (trailing twelve months) describes the past 12 consecutive months for a given data point.
PEG ratio (price/earnings to growth ratio) measures the relationship between the price of a stock, the earnings generated per share, and the expected growth for the company.
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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