WASIX Commentary (Q4 2022)
January 2023
OVERVIEW
After a chaotic and painful year for global equities, the fourth-quarter performance was a welcome reprieve. The fund returned 14.85%, outperforming the MSCI Global Small Cap (M1WDSC) benchmark by 4.4%. This represents a decided directional change away from macro-fear-driven trading, towards fundamental-driven investing. We believe that the strong performance of the fund reflects both the change in market focus and first semblance of normalization.
The chart below displays our track record over short- and long-term periods
| Periods ended 12/31/22 | WASIX | MSCI ACWI Index | Bloomberg Barclays US Aggregate Bond Index | MSCI World Small Cap Index |
|---|---|---|---|---|
| Quarter | 14.85% | 9.76% | 1.87% | 10.45% | Year | -26.52% | -18.36% | -13.01% | -18.67% | 3 Years | 1.01% | 4.00% | -2.71% | 3.18% | 5 Years | 3.27% | 5.23% | 0.02% | 3.23% | 10 Years | 6.82% | 7.98% | 1.06% | 7.69% |
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 1.76% and 1.56% for the Investor Class Shares and the Institutional Class Shares respectively until at least January 31, 2023. 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.
At a time when so much has changed, it is natural to ask how normalization can be found. To answer, we turn to three basic market truths: the first truth is that large unknowns create fear; the second, that the market ultimately will reflect the underlying economy; and the third, that the market is forward looking.
Let's take a look at how the fear of the unknown relates to normalization. We are in the midst of a debt cycle, and are slogging through the unwinding of the easy-money economic strategy pursued by large central banks. For a generation this strategy boosted perceived wealth to unimaginable heights for those who borrowed money at very low interest rates. With the course now reversing and the cost of money now a multiple of where it was for most of the 21st century, much of this perceived wealth may evaporate. The silver lining, and what paves the way to normalization, is that we know that high interest rates are a tool for managing easy-money induced inflation. The negative impact of high rates doesn’t matter, what matters is that the question of where rates are going is no longer unknown. Temporary as rate stabilization may be, this leveling-off has allowed investors to set fear aside and again begin to value stocks with more certainty. We believe that resolution of the near-term rate unknown comforted and propelled markets over the last quarter.
The second truth states that the stock market will ultimately reflect the economy. As bottom-up fundamental investors, we consider this to be a foundational truth. As we see it, the rate shifts that have occurred are now being digested by the economy. While the market awaits concrete evidence of the extent of the outcomes, we know that an enduring change in the cost of capital will have significant effects on the economy. We focus our energy on the effects, while the markets do not. Currently, though the economy is directionally deteriorating, most businesses and jobs remain intact. This permits investors to downplay the second truth, making normalization a possibility.
Rising markets despite wavering economic data turns us toward the last truth: that markets are forward looking. While this truth is incredibly powerful and always present, it resides wholly in the “inexact market psychology” realm. This tenet shifts between pessimism and optimism, but for most of recorded market history, optimism has ruled. This is the truth that is driving the market today, and there is indeed room for optimism. Stocks are cheaper (for now), the second largest economy in the world (China) is reopening, and many asset prices (homes and used cars) have fallen. All three are tangible changes that generate hope. But there is one more intangible positive which we consider most significant: we believe that the “Fed Put” remains intact – that rate increases will reverse if signs of real economic trouble arise. The top Bloomberg headline this morning proclaimed “Fed’s Disdain for the Dot Plot is Making Markets Doubt its Message.” Investors apparently assume that the Central Bank actually will flinch if the economy begins to suffer. We can’t argue with this belief because we can’t imagine that anyone is truly motivated or ready to accept the pain required to unwind the current debt cycle. Following the Global Financial Crisis, “kicking the can down the road” has been the most apt descriptor of Central Bank policy decisions. We are now living through a moment where the proverbial can (i.e. economic contraction) cannot be kicked further because inflation, one of the consequences of the debt-cycle strategy, has appeared. We believe that rising rates will be offered as a Band-Aid to inflation, and once inflation is out of sight, the strategy of kicking the can will resume until it cannot be kicked further and we are back combatting the same problem. Though long-term sustainability of the debt cycle is anything but normal, it is a cycle with patterns that we have grown to expect, hence the current market rally as it looks forward with the expectation of Fed intervention. The anticipated involvement of the Central Bank feels like normalization.
What does this all mean? We think that growth will slow and economies will suffer from the higher rates. We also think the suffering will be visible in short order, which means that central banks will likely react sooner vs later, rotating back towards cutting rates again. This scenario playing out in developed market economies will be great for foreign currency, small caps, stock valuations, and international and emerging markets. In fact, as we enter 2023, we consider international and emerging markets to be well positioned. China is open, and we expect to see a consumption surge driven by a return to “business as usual” and anxious-to-spend consumers emerging from lockdowns. The US dollar has weakened substantially over the past three months, and as a result the weight of debt service has lightened for foreign borrowers. India, Brazil, Indonesia, and Mexico have positive real interest rates and therefore have weathered inflation more successfully than DM countries. Additionally, their real rates offer them more flexibility to stimulate domestically should an economic slowdown ensue.
DETAILS FROM THE QUARTER
As stated in the intro, we view the primary tailwind of the quarter is a return to normalization. Through the first three quarters of the year, fear-driven macro trading ruled markets, and consequently our international small-cap growth bias hurt us badly. With the markets now accepting the changes that have occurred, we saw a strong and broad recovery within the fund. More than one third of the stocks in the portfolio returned greater than 25%, seventy-five percent of which are companies we’ve owned for more than a year that operate businesses we view as undervalued relative to their earnings potential.
Five of the top ten performing stocks were 2022 additions to the portfolio. M1 Kliniken (M12 GR) is a leading aesthetics (botox) provider in Europe. Recession fears pushed the stock down 50% in the first half of the year, but with spending remaining resilient, and growth solidly double-digits in their services business, the stock recovered 147% in the fourth quarter. It is a discretionary business, but willingness to pay for beauty has proven extremely resilient over time. Oro Co (3983 JP) returned 50% in the quarter. Oro has two businesses, each which we view as high quality: their cloud ERP software business, which generates 45%+ operating margins, and their IT services business, which held on despite margin pressure resulting from two large clients pulling back spending due to weakness in their own Covid-impacted end markets. We are seeing an acceleration of the software business as the company increases marketing spend, and we’re seeing a recovery of the IT business as their two customers begin to spend again as Covid lockdowns end. We were able to buy this extremely profitable and growing company for 15x earnings. The last company we’ll mention is Victoria Plumbing (VIC LN) which returned 49% for us in the quarter. Victoria is the leading online bathroom and plumbing fixture company in the UK with a 50% share of the online bathroom fixture market as well as a strong private brand that comprises 75% of sales. The company IPO’d in the midst of Covid at a high valuation. With the immediately ensuing weakness in the UK economy, the stock lost 88% of its value over a one-year period. Meanwhile, the company sits on GBP40mm in net cash and continues to show growth and generate strong cash flow. With the cost of capital increasing, we expect to see most of their smaller online competitors fall by the wayside over the coming year. We were able to purchase the stock for 12x earnings.
Our top performing stock was Va-Q-Tec (VQT GR). The stock returned 176% after receiving a takeout bid. There are always mixed emotions when a position is gobbled up. We feel vindicated by the fact that we are able to find small companies that aren’t being valued properly, but at the same time we don’t feel that the premium being paid nearly reflects the true long-term earnings potential of the company. We are beginning to see bids surface around the globe for small-cap companies. We agree that the sell-off in the growth space is creating attractive opportunities, and we would expect M&A in the small-cap space to increase should valuations remain depressed.
We have made no dramatic changes to our sector positioning. We remain overweight tech and consumer discretionary and underweight real estate, utilities, and industrials. This allocation was a headwind for us in the quarter, but in spite of suboptimal positioning, our stock selection was strong. Tech, consumer discretionary, and industrials comprise 60% of the portfolio, and our returns in each of these sectors doubled that of our benchmark.
From a geography view, India and the United States are respectively our most significant over- and underweights. Our exposure to India was a headwind with our positions declining 4% vs the bench decline of 1.7%. India has been a significant outperformer for us over the past few years, and while we continue to find great companies, the broader market has become expensive and we expect a period of digestion. We have been trimming our India exposure selectively over the past few months. Our US exposure has been very light for years. Valuation has been the primary reason for our low exposure, but we still find great opportunities – albeit selectively.
Our top contributing stock for the year and quarter actually happens to be a US company. Richardson Electric (RELL) jumped 42% in the fourth quarter and contributed 2 points to our overall return. Richardson is an electronic components distributor that has crafted their offering towards green energy. The company continues to outperform expectations and sits at a very reasonable 14x trailing earnings ratio.
We close the quarter with confidence in our portfolio and style. With markets recovering from their fear-driven focus on company size, liquidity, and location of securities, towards a focus on fundamentals, we feel great about our strategy. We sit on a portfolio of very high-quality companies that have historically generated returns on equity (ROEs) and assets (ROAs) at levels two to three times that of our comparable benchmark. The same companies have grown earnings at double the pace over the past five years. With our focus on the small and undiscovered businesses, we are able to own this superior set of businesses for a very small valuation premium of 15x forward PE ratio compared to our benchmarks PE ratio of 14x.
OUTLOOK
The markets are emerging from a three-year period that included two black swan events. First, the Pandemic, and second, the war in Ukraine. With the events themselves fading into the rearview, we are left to contend with the more enduring policy responses that each country has taken. And what we see currently is a world where the relative health of the “risky” emerging market economies is better than that of the largest developed market economies. The developing economies have shown more prudence and discipline over the recent years, and as a result, they are in better shape today. But without mincing words, we see tough times ahead for the global economy. And though we have a rosier outlook for emerging economies, we understand that their success remains inextricably linked to the health of the developed markets. Earlier in this letter we laid out a scenario of economic weakness followed by policy easing. Whether or not this comes to pass, we are currently in a market that requires an ability to allocate capital more judiciously. The era of free money and stimulated growth has ended for now, which means quality growth will only be selectively found. The dramatic events are behind us and we are simply back to the basics of analyzing stocks based on their individual prospects, which is a comfortable place for us to be. Thank you for your continued trust.
Sincerely,
The WASIX Fund Management Team
DEFINITIONS
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