WASIX Commentary (Q4 2023)
January 2024
OVERVIEW
We ended 2023 with a fourth quarter market rally that drove performance of the fund solidly into positive territory. The rally is understandable given the decelerating inflation and strong jobs data coming out of the US, which seem to indicate that the Fed’s strategy is working. In Q4 the market sentiment shifted strongly towards the soft landing narrative. We think that it is still early to call the winner of the tug of war between rising vs. falling expectations of inflation and interest rates. As we write this, December inflation data came in higher than expected, showing that the Fed doesn’t yet have inflation completely under control. The lack of clarity on what the “new normal” looks like has long had a negative impact on small-cap assets, especially in international markets. Small-cap companies are more sensitive to interest rates, dollar strength, and overall economic growth, and the prevailing uncertainty has deterred investors from returning to our asset class until the dust completely settles.
While the overarching macroeconomic environment is still volatile, we are bottom-up investors, spending our time searching for businesses with sustainable competitive advantages that allow them to chart their own destiny and outpace the market even in difficult times. Talking to hundreds of companies each year leaves us excited about our portfolio and confident that we will be able to find companies primed for real growth in the coming years.
Our fund returned 8.39% for the year compared to 16.84% from our benchmark. Our underperformance was largely driven by iEnergizer (IBPO LN), which we discussed in a previous commentary. Tellingly, if we exclude iEnergizer, our fund would have outperformed the benchmark for the year. During Q4 the fund returned 10.26% compared to our benchmark’s 11.98% return.
DETAILS FROM THE QUARTER
The chart below displays our track record over short- and long-term periods:
| Periods ended 12/31/2023 | WASIX | MSCI ACWI
Small Cap Index |
|---|---|---|
| Quarter | 10.26% | 11.98% | Year to Date | 8.39% | 16.84% | 3 Years Annualized | 2.28% | 3.33% | 5 Years Annualized | 6.44% | 9.85% | 10 Years Annualized | 4.64% | 6.66% |
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 US and India continue to be our biggest underweight and overweight respectively. This allocation worked well and was a positive contributor to our performance for the year. Our Global Small Cap Index benchmark had an 18% return for the US market in 2023, and a 43% return for India. Our portfolio’s India return was 67%, beating the benchmark’s return for India by nearly 25%. While it was pleasant to see that our allocation and selection outperformed for the year, this strategy was actually a headwind in Q4. With favorable inflation and jobs data in November, the US Fed’s tone became more dovish. This means that earlier and faster interest rate cuts were being priced in, and we saw a stock rally in the US, leading the US to outperform India by 2% in Q4. While the difference in the US v. India performance was small, our 40% US underweight amplified the gap in performance.
While we continue to look for portfolio candidates in the US, domestic stock valuations appear expensive relative to the opportunities we are seeing in the rest of the world. In the US market, there seems to be a big mismatch between valuations and fundamentals, especially when we consider that valuations are back to pre-Covid levels, while access to capital is tighter and growth is harder to come by. We are no longer living in a “free money” era, yet stocks are trading as though we are. While we do not know if the zero interest rate will come back, we believe that today the US economy is arguably worse than pre-Covid. On the other hand, India’s fundamentals still look very solid: inflation is under control, the credit cycle remains strong, there is low external deficit, and domestic demand is vigorous. We don’t allocate capital based on top-down decisions dictated by macro indicators. However, having talked to a large set of companies in both countries, the differences in macro fundamentals between the US and India were evident even on a company level. Most of the Indian companies were upbeat about business and expect accelerated growth in 2024. We didn’t get the same upbeat tone from the US companies. Because of our bottom-up process, we continue feeling comfortable with our India overweight.
Looking at the individual stocks in the portfolio, the top contributor for Q4 was Semler Scientific (SMLR US). Semler is a SaaS player in the healthcare space. They sell testing equipment for Peripheral Arterial Disease (PAD) and charge a monthly subscription fee to use their software. Their product is 100% non-invasive and is much cheaper than the traditional testing method. As the only company offering a non-invasive PAD test, the growth headroom is massive – currently only 10% of PAD patients are tested because of the invasive nature and cost of the traditional tests. Insurance companies have strong incentives to use Semler’s test because the early treatment cost for PAD is only a fraction of late-stage treatment or cardiac surgery. We believed that Semler could triple their market share in the near term, making it a great target for acquisition. In retrospect, we first bought the stock too early, right after demand got pulled forward from Covid in the spring of 2022. Noise around Medicaid’s reimbursement policy for PAD tests put pressure on the stock, taking it from $80 to $20 within a year. After reviewing the business in Q3, we believed that, despite weaker fundamentals, the company was still a phenomenal business. The stock was clearly oversold, trading at 13x current PE for a 15-20% growth SaaS business. We doubled down and bought more. The market realized the disconnect between fundamentals and valuation of the business, and our analysis paid off as the stock surged 75% in Q4.
Another large contributor was FlatexDegiro (FTK GR). This company originated from a merger of two leading online brokers in Europe: Flatex, one of the leaders in Germany, and Degiro, the largest online broker in a number of other European countries. The merger occurred in 2020 and formed a leading digital brokerage in continental Europe, a massive market that resembles the US in the 1990s, before the wave of digital brokers in the US transformed the industry. Online brokerage is a very attractive business when you are the leader – the majority of operating costs are fixed, and scale leads to low unit costs thus begetting more scale and leading to market dominance over time. As of today, FTK has 2.7M customers and is the largest digital player in continental Europe, so opportunity is immense. The stock market rally in the midst of Covid juiced all the metrics of FTK and sent the stock parabolic, with a post-Covid hangover that dragged out into a six-quarter slowdown in new customer acquisition and revenue metrics. However, great companies shine during downturns, and FTK has gradually gained market share in the post-Covid era, while unprofitable competitors have scaled back. This tumult played to the benefit of FTK, which has maintained high profitability, significantly reduced marketing costs, and has continued to grow their client base at a 13% annualized rate. Meanwhile, other key performance indicators of the company have reached a floor and are now pointing up. In Q4 the market recognized the strength of FTK’s business model as well as its strong performance in a difficult environment, and the stock began to rerate from a historically low valuation. Our analysis implies that FTK can become a much larger company with a customer base multiples of what it is today. We appreciate that the company was battle-tested in the 2022/23 downturn and came out ahead.
Kinx (093320 KS) was another large contributor to the fund’s performance. Although it’s a recent addition to the fund, we have closely followed this stock for four years and owned it previously. Kinx is an independent (i.e. not owned by Google or Amazon) data center in Korea. As the world moves more online, and data shifts from on-premise servers to the cloud, data centers benefit from rapid volume growth, so much so that Kinx ran out of capacity in their data center in 2021 and was using higher-cost, margin-dilutive third-party data centers to accommodate the growth. At the same time, they began construction of a new data center that would take nearly three years to build, but would increase their owned capacity over fourfold. We sold the stock a few years ago based on concerns that the massive new data center would hit classic large-project potholes: cost overruns, delays, and extended ramp up. But we continued to follow the stock and recently checked in as they approached the end of the data center buildout. We learned that the project was running on time and on cost, and demand for data center space was so strong that it should take just one year to get to 80% utilization, rather than the original three year estimate. We bought back the stock now that the project execution risks are behind them. We think Kinx is still largely undiscovered by the US institutional investor community, making the stock look very reasonably priced at 12x 2024 PE.
We didn’t have any big detractors in Q4, nor was there a clear theme or common driver among our underperformers. Our worse performing names experienced company-specific issues. The largest detractor was Linical (2183 JP), one of the larger weights in the fund. This company is a leading contract research organization in Japan, administering trials for prospective new drugs. Most of the business is in Japan, but they have been diversifying geographically by building out a global platform. Although this should be a great business, it requires scale. Their US business is scaling well and growing rapidly, but Japan and Europe have not followed the same path. Linical has been struggling in Japan due a longer than expected downturn in funding for new drugs. We believe this is a function of Japanese bureaucracies slowly adjusting to post-Covid realities. The biggest surprise to us is the scale of the slowdown in their European business. While they are making progress on bringing their cost structure in line with new realities, our confidence in the business is shaken, and we are working to understand whether the long-term trajectory that we forecasted has been impaired.
OUTLOOK
Developing economies have shown clear signs of improvement in 2023, and we expect the trend to continue in 2024. This is both a blessing and a curse. It is much easier to find companies with real growth when the economy is doing well. However, we believe that the market is pricing Fed interest cuts prematurely, and too much of the good news is already baked into the pricing. There is still a lot of uncertainty ahead of us, primarily stemming from the fact that half of the world’s population is heading into general elections, including the US, India, Indonesia, and Taiwan. Nonetheless, we will continue to stick to our investment philosophy which is bottom-up approach, finding undiscovered businesses with sustainable competitive advantage that can grow through all economic cycles. Thank you for your continued trust.
DEFINITIONS
PE (price to earnings ratio) is equal to a company’s share price divided by its earnings per share, and is a metric for valuing a company.
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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