WASIX Commentary (Q3 2024)
October 2024
OVERVIEW
The third quarter produced a strong equity performance around the globe with the fund returning 8.15%. The Fed not only delivered the long-awaited first rate cut of this cycle, but also cut to a greater degree than markets expected. The Eurozone, a significant portion of the fund’s universe, has been leading the interest rate-cutting trend, delivering its first cut in June followed by another cut in September. The markets cheered, with a strong move up after largely going sideways for the first half of the year. Interestingly, small caps outperformed the S&P in Q3. Is this the start of a catch-up trade? Perhaps. Yet, international small caps remain a heavily out-of-favor asset class, with many companies sporting a massive valuation disconnect versus their US peers.
Another influential theme was the impact of the Chinese market. After a capitulation-level sell-off in Chinese stocks, the Chinese government finally announced a sizable stimulus, and the heavily oversold Chinese market rallied hard. China was one of the best performing markets in the quarter, returning 18.5% – a reflection of the stimulus-triggered excitement. Although it comprises a de-minimis portion of the benchmark (2.6%), when China makes big moves, they tend to reverberate globally. WASIX does not have any exposure in China, as it is a market where our process has not worked well; we thrive on companies with earnings visibility, and in China we have not been able to find such visibility despite years of trying. Nevertheless, the global impact of the Chinese stimulus is quite positive. Having another region of the world shifting from a restrictive to a more accommodative stance is a tailwind to global demand. Whether that lasts, we shall see.
The aforementioned highlights are acutely relevant to us, given that lower interest rates and stimulus particularly help small and international stocks. We do not hang our hope on the direction of interest rates, nor do we pontificate on where they may go, but we do anticipate broader equity allocation in response to the changes. We are bottom-up investors focused on company fundamentals, and the fundamentals of the companies in our portfolio look solid as these companies continue to grow and take market share regardless of the economic or interest rate environment.
DETAILS FROM THE QUARTER
The inline quarterly results were captured the “hard way.” Our stock selection was superb, as we beat the benchmark soundly in our top five geographic exposures: India, USA, Germany, Japan, and the UK. Even so, our allocation weighting wasn’t aligned with the best performing geographies. In the US, for example, our positions returned 17%, versus 9% for the bench, but our underweight cost us -2.7% as a result of having too little exposure in this upward-moving and largest component of the index.
Korea was the biggest offender to performance, detracting -1.6% from our total quarterly return. The country made up 6% of our portfolio, and in aggregate declined 18% last quarter, with every position in the red versus the overall index decline of 3%. Any underperformance is frustrating, but the absence of a shift in fundamentals triggering the declines of our positions is particularly head-scratching. A close look at FNS Tech (083500 KS), our largest Korean position and detractor in Q3, may help demonstrate why we continue to have confidence in Korea despite the Q3 results. FNS declined 31% this past quarter following a quarter that showed 29% sales growth and 50% backlog growth. An oversimplification of FNS’s business is that they sell semiconductor-related equipment and parts. The equipment side of the business is cyclical, while the parts side is recurring and growing. CMP pads, used to polish and flatten silicon wafers, are the part we are most focused on. Currently Samsung spends 400B KRW annually on CMP pads, with Dupont delivering 80% of their supply. FNS is the number two supplier, with 5% share – starting from zero in 2020. However, Samsung is now actively transitioning away from their dependence upon Dupont, and has selected FNS to produce CMP pads for their high-bandwidth memory (HBM) polishing. HBM is required for AI and supercomputing semiconductors, and requires double the CMP pads as traditional memory. We anticipate exponential growth in the recurring CMP division which carries operating margins north of 20%. Additionally, they are in the midst of an upcycle in the equipment division that generally lasts three years. The stock is trading 6x 2024 earnings and <5x 2025 anticipated earnings. FNS is a small company with no sellside coverage currently. We view the decline this past period as illogical, and therefore a perfect opportunity to add to weight into what we view as an extremely mispriced asset.
Similar to our geographic divergence from the bench, 50% of our portfolio was in industrials and technology, which were two of the bottom three sector performers. Our 34% weight in technology returned 7%, versus the benchmark return of 1%. Our 16% allocation to industrials returned 18%, versus 8% for the benchmark. While the allocation was a headwind, the upshot is that we materially outperformed the benchmark in both sectors.
Our top contributor was Climb Global Solutions (CLMB US) which marched 59% higher and contributed 1.35% to the fund’s quarterly performance. CLMB acts as a distributor for emerging software companies. When young and novel software companies are ready to hit the market, they’re typically too small to support a direct sales channel. This is where Climb steps in to vet the tech, determine if it’s sellable, and become distributor of those they classify as the latest and greatest software – albeit still emerging. When we first purchased the stock it was trading at an attractive 15x P/E, despite growing earnings at a 21% CAGR for the five years prior. What we liked just as much as the valuation and track record, is that they had zero debt and were sitting on a war chest of nearly $50mm in cash, which they intended to use for acquisitions. Since our purchase, the company has deployed cash into highly accretive acquisitions – such as paying ~5x EBITDA for their last acquisition, which should add an incremental 20% earnings growth in 2025. The stock has moved sharply higher but we still see value creation ahead as they put to work their remaining $25mm in cash and an untapped $50mm credit facility.
The chart below displays our track record over short- and long-term periods:
| Periods ended 9/30/2024 | WASIX | MSCI ACWI
Small Cap Index |
|---|---|---|
| Quarter | 8.14% | 8.80% | 1 Years | 19.45% | 24.62% | 3 Years Annualized | -4.13% | 2.60% | 5 Years Annualized | 5.63% | 9.40% | 10 Years Annualized | 4.49% | 7.81% |
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.
OUTLOOK
Tucked into our earlier remarks was the subtle comment about small caps outperforming the S&P. While one quarter does not a trend make, the superior performance from small caps over the last period has been the exception versus the rule. Over the past five, ten, and fifteen years, large-cap stock returns have reigned supreme by a wide margin. A closer look shows that a significant portion of the long-term large cap outperformance occurred over the interest rate upcycle that began in early 2022. Ebbs and flows between asset classes are normal and, more often than not, market behavior can be attributed to a catalyst. The small cap performance over the past three months can clearly be attributed to the rate cut that arrived last month. It is also an unsurprising outcome. As small cap specialists, this both frustrates and excites us. Our frustration stems from the fact that our fundamentally sound and undervalued positions are simply seen as pawns of the Fed’s action on interest rates. Our excitement stems from the acceptance that capital allocators seem to buy into that perspective and are now leaning into small caps. Our core belief is that good companies that grow earnings will eventually be noticed. At the same time, we acknowledge that a supporting catalyst is often required for allocators to diverge from the trend dujour. We remain confident in the quality and growth of our portfolio and optimistic that winds are shifting towards our backs. We thank you for your trust and support.
DEFINITIONS
CAGR – compound annual growth rate is the mean annual growth rate of an investment over a period longer than one year
The Strategic Global Fund invests globally in high quality small-mid cap growth businesses that demonstrate sustainable, long term earnings growth.
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