AEC Commentary (Q4 2023)
January 2024
PERFORMANCE
The chart below displays our track record over short- and long-term periods, net of fees:
| Periods ended 12/31/2023 | AEC | MSCI Emerging Markets
Small Cap Index |
|---|---|---|
| Quarter | 7.28% | 8.96% | Year to Date | 26.87% | 23.92% | 3 Years Annualized | 9.11% | 6.46% | 5 Years Annualized | 15.84% | 9.92% |
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 full year 2023, the fund returned 26.9% vs 23.9% for our benchmark. In the fourth quarter the fund added 7.3% vs 9.0% from the benchmark. While fourth quarter results lagged, we are very satisfied with our annual performance. In 2023 we not only took our greatest single slump since inception with the privatization of IEnergizer (IBPO LN), but also faced headwinds from both sector and geographic allocations. Looking at the gross results for the year, our geographic allocation was a -5.6% headwind, with stock selection adding back 11.3% to performance. When looking at sector allocation, we faced a small -1.83% headwind, but selection carried outperformance up 7.5%. The fourth quarter paralleled annual results with a -1.76% hit from geographic allocation modified by a contribution of 1.13% from selection, and a sector allocation loss of 1.17% and a .54% gain from selection. Since inception of the fund, sector outperformance has been dramatic, being driven by +111 percentage points from stock selection and -21 percentage points from allocation. The divergence here suggests a) that the fund has essentially been “misallocated” vs the best performing sectors and b) that our founding belief in the inefficiencies of the emerging market small cap space absolutely holds true for the diligent fundamental manager.
Since inception, geographic outperformance has followed a similar pattern, with 98% attributable to stock selection. This year though the trend didn’t diverge, it stands out because of the scale of the geographic headwinds, which were driven primarily by our exposure to Taiwan. Taiwan was the second largest benchmark weight and returned a whopping 44% last year. We only carried a 2.3% weight in Taiwan, vs a 21.3% weight for the bench. Our small exposure in Taiwan performed very well, returning 87% in aggregate, but we did not have the confidence in our positions to carry a more significant weighting in the fund. Despite the exceptional performance, it was a tough year for our Taiwan positions fundamentally, with earnings declines related to excess inventory in the semiconductor channel leading to declining sales and profits. Out of curiosity we pulled the Taiwan Stock Exchange (TWSE) data, and it shows the same. The TWSE closed out ‘22 with a price to earnings (PE) ratio of 10.4x and ended 2023 with a PE ratio of 21x, meaning that with the 31% return for the index there was a ~35% decline in earnings through ‘23. What this says to us, is that the performance in Taiwan hinges on a cyclical gambit that will require a strong earnings recovery through ‘24. Earnings indeed are beginning to recover, but we do not anticipate the majority of companies to achieve earnings anywhere near the levels seen through Covid for a number of years. We feel no shame that we were not on par with the benchmark’s 2023 contribution for Taiwan because we were able to find equally strong returns elsewhere.
What we missed in Taiwan, we gained in other markets. India has long been our largest exposure, and our 33% weight returned 51% last year vs 43% for the bench. South Korea was our number two exposure, at 11%, but was our largest contributor to performance. Emro (058970 KS) was our largest Korean position, and the stock returned 251% early on in the year. On the whole, our return in Korea was 101% vs the benchmark at 26%. We underperformed in Brazil, Malaysia, and China, but with the three markets collectively making up ~10% of our exposure, the hits were small.
Our top three detractors for the year were IEnergizer (IBPO LN), Shanghai Yongguan Adhesives (603681 CH), and Essex Bio (1061 HK). When looking at our losers, the only common theme appears to be China, which produced five of our top 10 biggest detractors for the year. Frustratingly, we lost money in every chinese company we held a position in and collectively the exposure pulled 3.4% from performance. As challenging as this was the losses from our China exposure were marginal compared to the 890 basis points we lost from IEnergizer (IBPO LN). They express a message that we cannot ignore: China does not seem to work well for our style of investing. For now it has led us to throw in the towel on our exposure. We currently have no Chinese investments in the portfolio. For a team that focuses entirely on the bottom-up merits of the individual businesses, unpredictability and communication difficulties are once again pushing us away from China.
As for our biggest winners, it turns out that our fourth quarter and annual top contributors are the usual suspects that we have written about in prior letters. Fourth quarter 2023 top contributors were Kinx (093320 KS), Ifirma (IFI PW), and Caplin Point (CLPL IN). Top contributors for 2023 as a whole were: Emro (058970 KS), Ifima (IFI PW), and Datamatics (DATA IN). Having walked through all the positions in the past, we’ll instead focus on a couple of new positions to the portfolio.
Spyrosoft (SPR PW) is a new addition that we added in the fourth quarter and have rapidly scaled to a sizable 1.75% weight. The company is small and undiscovered, but sits alongside a number of darlings in the emerging market (EM) investment world including Globant (GLOB US, $9.6B mkt cap), EPAM Systems (EPAM US, $17.3B mkt cap), and Endava (DAVA US, $4.3B market cap), which are all peers and all are very large companies that have grown organically as well as through aggressive mergers and acquisitions (M&A). Though the large peers are listed in the US, their businesses are hinged on employing the highest quality software engineers in EM countries and leveraging the wage differential. It’s worth noting that these companies stand a notch above the typical IT services companies in their superior quality, capability, and customization of work. For years it has been tough for us to determine the nuances between their business strategies, beyond their individual end-market expertise and quality of customer set. This is where we find Spyrosoft extremely compelling – the business is the same, but the strategy is clearly unique. Spyrosoft is essentially the back office, support, and majority owner for many entrepreneurial engineers that wish to be rewarded for their own efforts. Many of the engineers at Spyrosoft have defected from premium software companies around the world. The CEO shared a simple example about two engineers that came to them after years at Salesforce (CRM US). Spyrosoft wanted their expertise, so they set up a company, linked up the back office and support, and let the engineers get to work as a new offering under the Spyrosoft umbrella. Per the CEO: “the business is now flying.” This organic strategy appears shockingly effective as they allow the engineers to directly push their business and share in the returns. The company launched in 2017 and generated $2.5M USD in revenue, and at the close of ‘22 they generated $83M USD in revenue. Over the same period the company has grown to 1200 engineers. Endava (the smallest of the peer set) at 11K engineers is 10 times bigger from a headcount perspective, yet 30 times larger from a market cap perspective. Additionally, the impressive growth DAVA has produced is majority driven by M&A, while Spyrosft has grown at an exponential rate with the support of only one acquisition over their history. The position is already paying off with a 48% return in Q4, but we think this is just the beginning. Ultimately, we think the Spyrosoft model is superior and will allow the company to grow to rival the size of the industry peers we mentioned.
It’s almost with frustration that we continue to find exciting ideas in India. Our weight there is nearly maxed out, so we are in a position of having to assess the relative attractiveness and return profiles of our existing portfolio versus new ideas. In Q4 we trimmed Arman Financial (ARLF IN). The position has been a top five contributor for both of the past two years, with the stock returning 65% in 2022 and 69% in 2023. We still own a significant position, but with the 190% return over the past two years, a rerating in the valuation, and an upcoming shift in strategy, we have been searching for another less-appreciated high-quality lender. We believe that we may have come across this with CSL Finance (CSLF IN). CSL specializes in small and medium enterprise (SME) loans and has a founder that has been very careful in his approach to accelerating the book. Our team met with the company in late ‘22 and returned with an exceptional review of management, but passed on purchasing due to what we perceived as an overly conservative strategy of maintaining the size of their loan book instead of growing while they invested in technology. Fast forward 15 months, and the company has found comfort in their platform and is now growing their book at a 40% clip. On paper, CSL’s focus on SMEs doesn’t sound as attractive as Arman’s focus on microlending for obvious reasons: fewer lending opportunities, lower rates, more competition, and so on and so forth. But of that list, only one of the reasons is accurate – lending opportunities are fewer in the SME space. The shocking reality within India is that uncollateralized microloans generally have lower interest rates than small-ticket collateralized SME loans. The reason for this is that the microloan space has been the focus of large, organized, and competitive players. In the surprisingly less competitive small-ticket SME space, CSL is becoming a sizable contender. The environment is primed for CSL to gain share over the long term as they scale and continue to reduce funding costs, resulting in even more competitive pricing and higher returns compared to smaller players. CSL Finance’s credit rating was upgraded to BBB+ this year, and management has guided that they anticipate another upgrade to A- within six months. When this happens, funding costs will again drop for them. We see a lot of resemblances between CSL Finance and Arman: owned and operated by founders; strong and consistent ROA profile; conservative provision policy with strong asset quality; and a similar growth profile. However, CSL Finance’s leverage ratio is only 2x compared to Arman’s 5.2x, which is the limit for lenders in India. We love this because it means CSL Finance can grow their book 2.5x without a need to raise capital. This also suggests that CSL can continue to improve their return on equity (ROE), while Arman’s ROE is probably near peak levels and will decrease when they raise new capital for growth. Although we are still peeling the onion on CSL, we are extremely excited about the upside given the stock trades at a 50% discount to Arman.
OUTLOOK
Long-time readers know that our general outlook has not been nearly as rosy as our returns over the past year. As we look at markets today, a lot of good news already appears baked into markets around the globe. Even with the widely anticipated interest rate cuts – a possible tailwind for both small caps and emerging markets – we are not comfortable or happy with the current state of the global macro. But not being happy doesn’t mean that the market won’t march higher, nor does it mean that there aren’t hundreds, if not thousands, of small companies that will find an ability to differentiate and grow through any environment. We will continue to stick to our knitting of finding these undiscovered and mispriced businesses. Thank you for your continued trust.
DEFINITIONS
PE (price to earnings ) multiple compares a company’s price, or market value, with its earnings.
The MSCI Emerging Markets Small Cap Index includes small cap representation across 27 emerging markets countries. With 1,693 constituents, the index covers approximately 14% of the free float-adjusted market capitalization in each country. The small-cap segment tends to capture more local economic and sector characteristics relative to larger emerging markets capitalization segments. An index does not charge management fees or brokerage expenses, and no such fees or expenses were deducted from the performance shown.
This report was prepared by Seven Canyons Advisors, a federally registered investment adviser under the Investment Advisers Act of 1940. Registration as an investment adviser does not imply a certain level of skill or training. The oral and written communications of an adviser provide you with information about which you determine to hire or retain an adviser. Neither the information nor any opinion expressed it so be construed as solicitation to buy or sell a security of personalized investment, tax, or legal advice.
The mention of specific securities and sectors illustrates the application of our investment approach only and is not to be considered a recommendation. The specific securities identified and described herein do not represent all of the securities purchased or sold for the portfolio, and it should not be assumed that investment in these securities were or will be profitable. There is no assurance that the securities purchased remain in the portfolio or that securities sold have not been repurchased. For a complete list of holdings please contact your portfolio adviser.
The information herein was obtained from various sources. Seven Canyons does not guarantee the accuracy or completeness of information provided by third parties. The information in this report is given as of the date indicated and believed to be reliable. Seven Canyons assumes no obligation to update this information, or to advise on further developments relating to it.
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.