WASIX Commentary (Q2 2024)
July 2024
OVERVIEW
Fund performance for Q2 was solid, returning 5.70% versus the benchmark’s -1.43%. We recognize, however, that global small-cap performance has largely been overshadowed by outsized returns from a handful of US large caps. Because this phenomenon is relevant to our expectations for the fund, we feel it is worth a brief discussion.
The second quarter of 2024 was characterized by a strong US economy, as indicated by 49 consecutive months of expansion and robust employment data. More importantly, inflation continued to be moderate, giving the market hope that the Fed would soon cut interest rates. Against this backdrop, US stock markets delivered a strong return, with both the S&P 500 and the Russell 3000 reaching all-time highs. However, most of the returns were concentrated in large-cap names, with the Russell Top 50 returning 8.5%, while the smaller-cap Russell 2000 ended in the red with a -2.6% return, indicating continued capital flow from small-cap assets into large-cap assets. Another trend is that the “Magnificent Seven” have increased weight in the S&P 500 and are driving outsized returns. This high concentration of weight and return in a handful of names makes investing in US stocks a concentrated momentum bet, posing risks for large-cap investors. While the Magnificent Seven are innovative and phenomenal businesses, their aggregate valuation is about 45x P/E. In our opinion, it will be challenging for the Magnificent Seven to achieve the type of growth that justifies this high valuation, potentially putting pressure on these companies' stock prices and the S&P 500's performance. On the other hand, as large-cap asset valuations have marched higher, global small-cap asset valuations have become more attractive. Excluding the Magnificent Seven, in aggregate, the other 493 companies of the S&P 500 grew earnings by 6.1% annually and expanded their P/E multiple by 3.9% annually over the last decade. In contrast, the MSCI Global Small Cap Index grew earnings by 8.5% annually over the last decade, with its P/E multiple contracting by 1.8% annually over the same period. This means that small-cap names have been growing earnings faster than most large-cap names, but their valuations have become cheaper. As small-cap investors, we love this setup because it allows us to buy faster-growing companies at a lower price. We strongly believe that over the long term, earnings growth drives stock performance. While it is impossible to predict when capital flows will reverse from large-cap assets to small-cap assets, the data suggests that the groundwork is laid for the cycle to turn. We believe now is the perfect time for investors to allocate more capital to small-cap assets, as the change in capital flow could be swift and dramatic.
Performance of the fund was also influenced by election results in India. Aside from the US, India is our largest weight, performing very well in Q2, with a return of 19.6%. The notable event in India was that Narendra Modi, the incumbent Prime Minister, won his third term, but failed to secure a parliamentary majority. Since taking office in 2014, Modi has promoted a score of economic reforms, driving strong economic growth, and advancing India from the 11th largest economy globally in 2014, to the 5th in 2024. The Indian stock market expected Modi to win a majority, so the market reacted negatively immediately after the election, but quickly regained all the losses plus an additional 5.5% gain by the quarter-end.
The chart below displays our track record over short- and long-term periods:
| Periods ended 6/30/2024 | WASIX | MSCI ACWI
Small Cap Index |
|---|---|---|
| Quarter | 5.70% | -1.43% | Year to Date | 0.18% | 2.29% | 1 Years | 4.17% | 10.64% | 3 Years Annualized | -6.20% | -0.75% | 5 Years Annualized | 3.97% | 7.31% | 10 Years Annualized | 3.64% | 6.23% |
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, 2025. This agreement is in effect through January 31, 2025, may only be terminated before then by the Board of Trustees, and is reevaluated on an annual basis.
DETAILS FROM THE QUARTER
In Q2 WASIX outperformed the benchmark by 7.13%. We continued to overweight India and underweight the US. Within the Global Small Cap Index, the Indian market outperformed the US market by 2%, benefiting our allocation. In fact, the fund outperformed the benchmark in all three of our biggest geographic weights. While it is encouraging to see that our process generated alpha, it is not surprising. Our portfolio’s characteristics were superior to the benchmark’s, including a five-year average ROA and revenue growth double that of the benchmark, and five-year average earnings growth triple that of the benchmark. The secret to our portfolio’s superior characteristics is that our fund is a true small cap, with an average market cap of about $600MM compared to the benchmark’s $4.3B, allowing us to invest in undiscovered names with faster growth rates at cheaper valuations. The downside to this strategy is that smaller-cap companies are less likely to be profitable and more likely to need to borrow money to fund their operations, and are thus much more sensitive to increases in interest rates than larger companies. This correlation with interest rates explains our fund’s underperformance over the past 15 years. For nine of those years, during periods when interest rates were low (2009-2016 and 2019-2021), our fund outperformed the benchmark. But during the six years when the Fed hiked interest rates aggressively (2016-2019 and 2021 to the present), the fund underperformed. As inflation continues to moderate, we expect the Fed to cut interest rates, and smaller-cap companies will outperform again. The market seems to agree with this view, as the Russell 2000 outperformed the Russell 1000 by 6.8% following positive June inflation data, stoking hope of an imminent rate cut.
Looking at individual stocks, the top contributor for Q2 was Droneshield (DRO AU). We added this name to our portfolio in Q1, and the stock price has tripled since we bought it. Droneshield makes anti-drone guns that are portable and use electronic signals to take down drones. The war in Ukraine demonstrates how drones have changed the landscape of battle – delivering payloads with pinpoint accuracy at a fraction of the cost and risk of traditional weapon platforms. This change in battlefields has also raised demand for an effective way to counter the drone threat. Droneshield disclosed multiple contracts with the US government and NATO over the last six months. The CEO believes they can triple their revenue this year and again next year. The business has a 70% gross profit margin with great operational leverage. We believe their earnings will grow at double the rate of revenue growth. When we bought the stock, it was trading at around 15x P/E. Given the stock’s significant re-rate over a short period of time, we decided to take some money off the table, reducing our weight from 2.5% to 1%.
Another top contributor, that we have highlighted before, was FlatexDegiro (FTK GR), a European online-brokerage with a $1.2B market cap. FlatexDegiro has been growing earnings by over 30% over the last five years and is trading at 17x trailing earnings. In Q2, positive developments included a drastic reduction in marketing costs, accelerated growth in new customers, and, on the back of higher interest income and improved monetization of trading activities, accelerated revenue growth. These led to significant earnings growth and an upgrade from management for this year’s earnings expectations. Furthermore, with cash in its coffers, the company recently announced a dividend and stock buyback, leading to a long-awaited return of capital to investors. We continue to like this name and maintain it as our top weight in the portfolio.
The biggest detractor in the portfolio in Q2 was Kinx (093320 KS). Kinx is an independent data center in Korea. As data shifts from on-premise servers to the cloud, data centers benefit from rapid volume growth. However, Kinx ran out of capacity in their data center in 2021 and had to use higher-cost, margin-dilutive third-party data centers to accommodate the growth. Concurrently, they began construction of a new data center that will increase their owned capacity more than fourfold. The data center will be finished later this year, but the business’ margin is deteriorating due to additional operational expenses associated with the new center. The market is taking a short-sighted approach, punishing the stock due to the presently deteriorating margin. We still like the company due to its defensive nature, and think that the current weakness in stock price is an opportunity to add in the near future.
We continue to find attractive new investments globally. One of the new additions to our portfolio this quarter is Kitwave (KITW LN). Kitwave supplies goods to independent convenience stores and restaurants in the UK. Kitwave has been around for more than 30 years and has proven to be a strong operator. The independent supplier market is very fragmented, with many local players. Kitwave is one of the largest nationwide suppliers, giving them enormous scale advantages to consolidate this space. Their performance track record has been phenomenal: doubling revenue, increasing earnings sixfold, and growing ROA 50% over the last five years despite being greatly impacted by COVID-19. In our call with the company, the management clearly articulated their acquisition strategy through internally generated cash and expected synergies with these acquisitions. The stock is trading at 13x trailing twelve-month P/E with an expectation of 15-20% annual earnings growth.
Another new addition to our portfolio is Repositrak (TRAK US). Repositrak provides Software-as-a-Service for food traceability and regulatory compliance. Repositrak started out as a supply chain software business. Their software is connected to about thirty thousand suppliers that sell to big retail chain stores such as Walmart, Costco, and Kroger. In 2022, the US Food and Drug Administration passed a new food traceability requirement, mandating retailers to track all products that use ingredients on the Food Traceability List to allow for faster identification and rapid removal of potentially contaminated food. This new requirement will be fully in effect in January 2026, putting a lot of stress on retailers’ inventory systems. Due to high switching costs, management expects all thirty thousand existing suppliers to use their software by January 2026, and their revenue should increase fivefold. Repositrak currently has about a 10% market share of the suppliers' supply chain software, giving them significant room to gain more market share in the future. What we like most about Repositrak is that it is a very well-run business. Their operating expenses have been flat for the last five years, despite their subscription revenue doubling in the same period. We expect them to maintain the same headcount as they grow – thus, if they can grow revenue fivefold in the next three years, their earnings will increase by about thirteenfold. The business is very cash generative, and management returns all profits to investors through dividends and buybacks. The stock is trading at 60x trailing twelve-month P/E which seems expensive, but as we expect earnings to grow thirteen times over the next three years, this valuation strikes us as cheap.
To make room for better investment ideas in 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 scaled back on this quarter was Epsilon (EPSIL GA). Epsilon is a leading small business accounting software provider in Greece, with a long-term track record of strong organic growth and a history of accretive acquisitions. Epsilon holds a 75% market share of small and midsize enterprise accounting software within Greece. As digitalization continues to accelerate, supported by EU development funds, Epsilon Net plans to add additional software solutions such as e-invoicing to complement their existing dominant market presence. While Greece is a relatively small market with a population of 10 million, there is still significant potential for improved monetization and increased penetration of their software offerings. Epsilon was acquired by private equity in April 2024, but we intend to continue our ownership. Another notable weight reduction was Fragua (FRAGUAB MM). Fragua is the largest pharmacy chain in Mexico both by sales and by the number of stores. We continue to like the business, but Fragua's valuation increased from 10x trailing P/E to 19.5x trailing P/E in the past six months. Additionally, Fragua management does not communicate with investors. Given the rapid stock rerating and lack of management communication, we felt that the potential return on the stock had become less attractive, so we decided to trim our position.
OUTLOOK
“I didn’t get rich by buying stocks at a high price-earnings multiple in the midst of crazy speculative booms, and I’m not going to change.” –Charlie Munger
This quote from Charlie Munger sums up our thoughts on the current investment environment. We believe that the capital flow into large-cap stocks has been overdone. From a capital allocation perspective, while many investors appear to be chasing the future at increasingly hefty valuations, we believe that now is the time for investors to shift capital into small-cap assets, which offer stronger earnings growth at much more reasonable valuations compared to large-cap assets. We strongly believe that our portfolio is positioned to generate alpha, providing investors with an additional layer of return. We expect our portfolio’s earnings to grow by 30% in the next 12 months, compared to the benchmark’s 14%. Importantly, we do not overpay for growth; our portfolio is trading at a 21x trailing 12-month P/E ratio or a 0.7x PEG ratio, while the benchmark is trading at an 18x trailing 12-month P/E ratio or a 1.3x PEG ratio. Considering these metrics, we feel more excited about our portfolio than ever. Yet the fact remains that our fund has underperformed the benchmark over the last 10 years. This begs the question of whether our performance is driven by our stock-picking skill or by the asset class. We believe it is the latter, as our portfolio has consistently shown a better growth rate at a more reasonable valuation than the benchmark. We therefore urge investors to be patient, as now is the worst time to give up and sell out of small-cap assets. We believe that interest rates will come down in the near future and capital will flow back to small-cap assets. As historical trends demonstrate, our true small-cap portfolio should outperform the benchmark in that imminent environment. As always, we remain grateful for your trust and welcome your questions.
DEFINITIONS
Magnificent Seven – Group of high-performing and influential companies in the US stock markets: Alphabet, Amazon, Apple, Meta Platforms, Microsoft, NVIDIA, and Tesla.
P/E – price to current year earnings per share ratio.
MSCI Global Small Cap Index – 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.
PEG Ratio – price-to-earning to expected 12 month forward earning growth.
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.
For a current list of top ten holdings and performance charts, please click here.