WASIX Commentary (Q3 2023)
October 2023
OVERVIEW
At the close of each quarter we pan out in order to better see the forest (economy) vs. the trees (portfolio companies). The goal of this task is to ensure that the fund is well-positioned for the current environment, with a secondary objective of fleshing out a well-articulated view to communicate to our investors. Without fail, the exercise leads us down a path into global economics. And although we meander with high hopes of finding a clear path this time around, without fail, we exit the forest with some great historical quotes and resignation to hope for the best, yet plan for the worst.
The third quarter was defined by the relentless climb of the 10-year yield, ending near 4.6%, the highest level since 2007. Both the level and magnitude of the increase are notable and unkind to international small-cap investing, but what’s more important is the resulting shift in market expectations from peak rates and inflation, to the “higher for longer” mindset. The factors driving the 10-year yield higher are complex – higher oil prices, a stronger labor market in the face of consistent rate hikes, and a more regulatory-heavy political environment. This leads to a stronger dollar, and re-directs global investment towards the U.S. and away from international markets. Negative cross-currents galore. The macro remains challenging, and it seems like the bottom is yet to be reached.
We don’t believe that we have much to add to these discussion points beyond what’s already being reported. This conclusion was supported by a recent Bloomberg quote from Epictetus: “First learn the meaning of what you say, and then speak.” All of the aforementioned financial realities are facts. Collectively they are symptoms of a debt cycle. We are well into a developed market (DM) debt cycle. There are plenty of history books that can enlighten us as to what has happened in past debt cycles. Spoiler alert: it’s not pretty. It begins with printing money, peaks with printing more money, and ends with enormous wealth gaps and frustration (to put it lightly) from the masses. As we sit within a present-day cycle, the challenge is more about knowing where we’re at in the cycle and having patience as we look for a viable exit, than worrying about the ultimate outcome. We’ll humor readers with a reminder of the definition of cycle: a series of events that are regularly repeated in the same order. What’s most relevant for investors today is simply accepting that we are indeed in a cycle, and there is a pattern to it.
The trouble with accepting this anticipated pattern is that, at best, we can tell everyone else is accepting it as well. This dynamic makes for confusion around risk, since corporates to consumers have been trained to lean on government support as soon as any real pain registers. For example, over the last few days alone we have seen a market that rejoices in both economic weakness and economic strength. To us this is worrisome behavior as it telegraphs that any outcome is a win.
As an advisor that prides itself in discovering and aggregating portfolios that offer some of the smallest market-cap companies available to investors, this makes for an extremely tough market. Behind the scenes of generally solid global index returns, we have seen wildly different performance between small caps from region to region. It’s very clear that the rate path is dictating investor appetite in developed markets, whether that makes sense or not. It is certainly frustrating from our perspective to endure environments where fundamentals don’t matter. The silver lining is that many high-quality companies are on sale right now.
In contrast to DMs, emerging markets (EM) have performed very well through the year. In our recent shareholder letters we noted the superior balance sheet positioning and better ability to endure inflation that most EMs exhibit. This has been rewarded in 2023. But it is impossible to assume that the economies of the world operate autonomously. They don’t.
How are we reacting to this environment? With (or without) the current backdrop, every investment we make is hinged on determining whether or not the business in question is a “real growth” business of quality with competitive advantage. The environment that we are in today makes this question more relevant than ever, given that the free-flowing money of the past decade has effectively been shut off – for now. We have always maintained the same strategy and objective, and plan to continue through all the cycles that come and go.
PERFORMANCE
The chart below displays our track record over short- and long-term periods:
| Periods ended 9/30/2023 | WASIX | MSCI ACWI
Small Cap Index |
|---|---|---|
| Quarter | -5.70% | -3.41% | Year to Date | -1.70% | 4.34% | 3 Years Annualized | 3.81% | 6.81% | 5 Years Annualized | 1.52% | 3.53% | 10 Years Annualized | 4.45% | 6.16% |
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.
The fund underperformed the benchmark by 2.3% in the third quarter, with DMs dragging and EMs adding. The fund produced a +1.8% total return with our 40% exposure to EM, while losing nearly 10% in our DM exposures. Glancing down the geographic and sector constituents of the global benchmark, there was not a single DM that closed the quarter positive, and only two sectors, (energy and financials), that escaped the quarter without losses.
Germany and Japan take the title as performance killers of the fund. The combined 20% exposure detracted 3% from performance. Both countries have deep markets with an abundance of innovative and compelling quality small-cap stocks. While the year’s results in these regions have been lackluster, we have continued to deploy capital to assets towards companies that appear extremely mispriced given the long-term growth characteristics.
In Germany we added Hypoport (HYQ GR) and Patrizia (PAT GR), which are both high-quality platform businesses catering to industries experiencing cyclical dislocations. We found the valuations compelling, but the market continued to punish those stocks this quarter, sending them down 26% and 33% respectively. Our other German holdings were also impacted by the sharp decline in the overall German small-cap market, which dropped nearly 9% this quarter, retracting all positive performance for the year. Overall, we think the volatility we’re seeing in German small caps is reflective of the continuing difficult near-term economic outlook in Germany. We are investing for the long term and are unperturbed by the near-term fluctuations, as we consider these companies to be resilient long-term investments.
Japan was another area of weakness for the portfolio. While the Japan market performed in a fairly resilient fashion for the quarter, our Japan portfolio declined by 12%. We showed significant underperformance in our healthcare segment with Linical (2183 JP) as the main detractor. The stock declined 20% this quarter and is a top five weight in the fund. Linical is a well run Contract Research Organization that scaled up its business significantly right before COVID impaired demand and access to patients for their research studies. The timing of expansion saddled them with an elevated cost base and no access to the human patient population required to run their studies. Encouragingly, the US exposure, added right before COVID lockdowns, has returned and is going strong, whereas their core Japanese business is lagging due to patient-access COVID restrictions that only ended this May. The company has not been sitting still over the past three years, and has thinned their operations significantly. As Japan fully opens, we expect the company to demonstrate significant margin expansion. The company is highly cash generative and, as a result, has carried an average EV/EBITDA multiple of >13x over the past 15 years. Today the stock trades <6x EV/EBITDA, while margins are at half of what we expect them to soon be.
A highlight of the fund’s performance has been India. This country has the two ingredients that drive long-term returns: a deep market, and structurally sound economic growth. As the developed world remains stuck at the tail end of a long-term debt cycle, suffering from stagnant, debt-driven economic growth, and as China decouples from the global supply chain, India stands to benefit. With the world short on economic growth, India’s deep and under-penetrated market, and the shift of export-oriented industries from China, are turbo-charging its economy. The fund is carrying a 17% weight in Indian stocks, making it the largest country exposure.
Despite the tough macro, mergers and acquisitions (M&A) are a continuing bright spot in our universe, implying that valuations are compelling enough for long-term-oriented investors to make big bets on companies. This quarter Ergomed (ERGO LN) was taken over by a private equity fund specializing in healthcare tech. Ergomed was a 1% average weight during the quarter and returned 31% in the quarter. We think the continuation of the M&A trend is indicative of the fact that valuations of small-cap growth companies are compelling to long-term investors.
During the quarter, we added a few high-quality, long-term compounders at attractive valuations. Two additions stand out: we added Epsilon Net (EPSIL GA), a leading small business accounting software in Greece, with a long-term track record of strong organic growth and a history of accretive acquisitions. Epsilon has 75% market share of small and midsize enterprises’ accounting software within Greece. As digitalization continues, (accelerated by EU development funds), Epsilon Net will layer in additional software solutions such as e-invoicing on top of their existing dominant reach. While Greece is a fairly small market of 10mm people, there is still significant room for increasing software penetration and improving monetization of this software. In H1 2023 the company reported 25% organic revenue growth while doubling its operating profit, with a medium-term objective of doubling revenue by 2025. The company is also demonstrating excellent operating leverage with its EBITDA margin increasing from 22% last year to 29% this year. We are paying 25x this year’s earnings for this combination of strong revenue and profit growth, and at a market cap of $500mm, this company remains largely undiscovered by sell-side analysts.
Kinx (093320 KS) was another sizable addition. Kinx operates a defensive yet fast growing data center business in Korea. A few years ago we had sizable ownership in Kinx, but then exited upon the announcement of a massive capital expenditure (CapEx) investment. The timing of our sale in 2021 was good, and thus far the timing of our return to the company has also been good. Our view on the expansion has changed given the demand the company is seeing for the yet-to-be completed data center. When they announced the CapEx program in 2021, they hoped to achieve full utilization within three to four years of the launch. When we spoke to them this August, they communicated that current demand is 3x the announced capacity, which means they now expect to achieve full utilization within a year of completion. The importance of full utilization lies in their ability to maintain margins post investment. With strong demand lined up, we see earnings doubling within 24 months. The stock currently trades on 16x trailing earnings even after a 30% move over the past three months.
In the third quarter we exited Ergomed due to the aforementioned take-out offer. We also exited what used to be a fairly large holding for the fund, Mitra Adiperkasa (MAPI IJ). It is a leading foreign-brand retail store operator in Indonesia. MAPI’s franchises account for 30-40% of retail space within major malls there, including Zara, Skechers, Converse, and Starbucks. We knew this company to be an excellent operator, and two years ago we noticed that their shares were unduly punished due to the negative impact of lingering COVID lockdowns in Indonesia. As Indonesians returned to mall shopping, the stock more than doubled, propelling Mitra Adiperkasa’s revenues well above pre-COVID levels. However, we think that the challenging inflationary environment will lead to tougher consumer discretionary spending, and the ability of the company to grow long term is challenged by the lack of new mall construction in Indonesia. When the valuation multiple became fully reflective of the current state of the business, we exited this stock to take advantage of better opportunities elsewhere.
OUTLOOK
Every day we receive macro strategy “spam” emails. One of our founders, Sam Stewart, spent an entire lifetime investing in the markets and used to say “reading macro research is like reading the comics. It’s fun, but only entertainment.” We make this reference because of a recent macro headline that labels the current environment as a “game of chicken” with Main and Wall Street teeing off against the Fed. The game of chicken analogy is one used around the office regularly and is also a line suited for this very shareholder letter. It’s a shame that we’re now plagiarizers, but it’s a clear articulation of the environment as we see it. With this immense game of chicken at play, we have little choice but to hone in on the prospects of the individual businesses that comprise our portfolio. With small-cap assets on sale in much of the world, we see no shortage of opportunities. The biggest question is how to balance the portfolio. This can be a tricky spot right now, given the sensitivity to rates we are seeing in our asset class. If the Fed buckles, the knee-jerk reaction will be what we call a “superdog” rally, where the performance of profitless companies, highly leveraged companies, and the smallest companies rockets upward. If Main and Wall Street buckle, we’re in for a digestion-period slog where quality disruptors would be the only play in town. Even with the portfolio positioned in the quality disruptors bucket, either outcome would be welcome given the punishment small companies have seen over the past couple years. Come what may, we are confident in the growth, resilience, and future of the businesses that comprise your portfolio.
DEFINITIONS
EBITDA (Earnings before interest, tax, depreciation, and amortization) is a measure of a company's operating performance.
EV/EBITDA (Enterprise value to earnings before interest, tax, depreciation, and amortization) is a measure of a company’s value, including debt, compared to its earnings.
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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