Seven Canyons World Innovators Quarterly Commentary
Global equity markets in the first quarter of 2019 posted something akin to a photographic negative of the final quarter of 2018. In a welcome reversal, one could almost keep the numbers and simply change all minus signs to plus signs. Our benchmark, the MSCI All Country World IMI, a broad index with over 8,000 constituents from countries all over the world, increased 12.29% during the quarter. Indeed, stocks were up everywhere. The Seven Canyons World Innovators Fund increased 11.30%.
During an upswing like the first part of this year, market volatility suddenly seems acceptable. But frankly, it’s worth paying attention to sharp moves up or down. Recall that bigger swings started happening at the beginning of 2018 after two unusually placid years. In January 2018 the benchmark shot up 6.60% only to give it all back, falling 8.42%, by mid-February. Our benchmark seemed to settle down during the middle part of the year, though the internals of that average were anything but smooth. Most emerging market equity indices were down double-digits, and some, like Argentina and Turkey, were down much more. At the same time, the NASDAQ went up by double-digits and was hitting all-time highs. Then came the most recent two quarters: down double-digits in December, up double-digits in March. This persistent volatility suggests a change in current market conditions rather than a one off.
At Seven Canyons, we want to understand why things have changed, and then figure out how to apply the tools we have to outperform in these new conditions. We think elevated global debt levels set the stage, and the catalyst that broke the calm markets was the shift from a decade of ever-easing financial conditions to a slight-tightening. Higher interest rates and tougher lending standards impact the economy by forcing people and companies who’ve taken on too much debt to buy less. And then there’s the impact of the less tangible sentiment shift, which is perhaps the more important factor for asset prices and stock markets. We believe we’re experiencing both a moderate economic slowdown, and a sentiment shift to greater risk aversion.
At SCA our business is confined to investing in stocks, specifically our strategy to win in the long run is to find, buy, and grow with the best small cap companies in the world. If you know our history, then you know SCA team member Sam Stewart built the largest, most successful mutual fund company in Utah with this strategy, so it’s in our DNA. However, this strategy does confine us. When market sentiment tilts in the direction of risk aversion, unlike a multi-asset strategy, we cannot shift from stocks, to corporate bonds, to treasuries for safe harbor. But we do have other tools at our disposal. Some common sense things we do include screening for companies with low or no debt and strong cash flows, and including in our portfolio businesses that sell “staples” — products that individuals and companies need to survive.
But we can and do take it a step further in the World Innovators Fund. In much the same way that a bond fund manager might shorten duration risk in volatile times, we can shorten the Fund’s quality duration. Now we invented that term, so don’t be alarmed if it sounds unfamiliar – here’s the explanation. One of the key metrics we use to find investments that will deliver superior long run returns is sustainable market share gains through the economic cycle. We think of market share gains as quantifiable evidence that our companies are selling disruptively better products; customers are voting with their feet, which gives us conviction we’ve picked the right investments. That said, the spectrum of sustainable market share gainers we investigate is broad, it includes methodical growth companies chipping away at the competition, and faster market share land grabbers.
Let me share two examples of “quality duration” using companies in our portfolio. High single-digit sales compounder Avon Rubber (AVON LN), a methodical growth company that makes gas masks for police, fire, and military use, and disruptive 40% sales grower Roku Inc. (ROKU) both clear the market share hurdle, and we think they are both high quality businesses. Avon has extremely dependable customers (i.e. the US DoD), its products are mission critical, it has a rock solid balance sheet, enough internally generated cash flow to fund its growth and pay a dividend, and returns on assets (ROA) consistently in the mid-teens. Avon fits the classic definition of a quality company with financial metrics that fit the title. Roku is an exciting company with disruptive products that its customers love. Management is investing heavily to become the defacto advertising platform for companies that want to connect with cord cutters; a massive long term opportunity. The business has a net cash balance sheet, and generates just about enough cash flow to cover its growth investments. We can see that the business is scaling well and we have a line of sight on high and rising ROA. However, Roku is losing money. It does not fit the classic definition of a quality company today, though we think it will in a few years. When markets get choppy, investors get short sighted and prefer quality now to future quality. That’s what we mean by quality duration. Admittedly this evidence is anecdotal, but while Roku’s shares have significantly beat the market since its September 2017 IPO, as 2018 progressed and volatility set in, Avon started to outperform. Over the last six months, Avon shares advanced 14%, our benchmark was up 6%, and Roku managed a 5% gain, only after a heroic 110% bounce in 1Q:19 to make up for a 58% fall in the late 2018 panic. At SCA we believe that over-performing in volatile and down markets is the secret to exceptional long-run returns. As such, we spent the last quarter shortening our quality duration: we bought more shares of Avon Rubber and, for now, took profits in Roku.
DETAILS FOR THE QUARTER
Many of the stocks in the Fund went on even wilder rides than the benchmark during the March quarter. Fortunately most of them were going up, but often only to make up for lost ground in December. The Fund’s largest contributor to performance was New York Times (NYT), which benefited from the market rebound, and then excelled after reporting new digital subscriptions well ahead of expectations. The stock was up 50.34% and was one of our top 10 holdings. Other strong contributions came from ROKU, Gamma Communications (GAMA LN), eGain (EGAN), and Japan Animal Referral Medical Center (6039 JP).
It seems noteworthy that, unlike the last quarter of 2018, it was mostly companies from developed markets (DM) that made our top 10 contributions list this quarter. We think this says more about the sharp sell off in DM in the December quarter than it does about emerging market (EM) assets. After the sharp rebound in DM stocks, we believe the more attractive valuations remain in EM countries. During the quarter we added several new companies to the Fund, including Mavi Giyim Sanayi (MAVI TI), Grupo Herdez (HERDEZ* MM), Becle SAB de CV (CUERVO* MM), and Medikaloka Hermina (HEAL IJ). Our current EM allocation makes up about 14% of the portfolio, up from 10% at the end of December, and 2% at the beginning of 2018. Since moving the Fund to our new home at SCA, we have swung from being under to overweight EM versus the benchmark. So far so good. Our EM stocks were up 13.8% during the quarter, and for the second quarter running we beat both the overall benchmark and the EM portion of the benchmark, by 1% and 4% respectively. The change of direction with emerging markets is in part a reaction to great businesses being sold at very attractive prices after the 2018 EM fire sale, but equal credit goes to our better resources here at SCA. We have a small tight-knit team that has been ferociously vetting old and new ideas, and Spencer Stewart’s extensive experience investing in small-cap emerging market companies helped us get up the curve fast. We can’t count on such positive contributions from our EM investments every quarter, but we are confident that we are buying great business at historically great prices — a strategy that reliably pays off in the long run.
Goals Soccer Centres (GOAL LN) was an exception to the otherwise solid performance during the quarter. Bad accounting was brought to light by their new management team, and the stock dropped 66%. We are cheered by the fact that current results are strong. The accounting issues were quickly uncovered and addressed by the new management, and we believe they will be fully resolved, but we are monitoring the investment closely.
We had a proud moment at our fledgling firm this quarter when we were informed that the Seven Canyons World Innovators Fund won the Lipper Award for best 10-year performance in its category for the second year in a row. We are especially pleased that we are winning long duration awards, and see it as a validation that our bottom-up stock picking process favoring small-cap, quality growth companies, is effective. And while volatile markets may continue, we think SCA has structural advantages that will help us deliver above-average returns. Our research team is small but experienced, and our boutique investment strategy, with just a couple of core Funds and low asset levels, allows us to be exceptionally nimble.
We thank you for your decision to invest with us in this exciting new venture.
The World Innovators Fund seeks to provide long-term capital growth by investing primarily in domestic and foreign growth companies that we believe are innovators in their respective sectors or industries.
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.
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.
For a list of top ten holdings and performance charts, please click here.
MSCI All Country World Investable Markets Index is a market capitalization weighted index designed to provide a broad measure of equity-market performance throughout the world
Nasdaq is an American stock exchange. It is the second-largest stock exchange in the world by market capitalization, behind only the New York Stock Exchange located in the same city.
Return on assets (ROA) measures a company’s profitability by showing how many dollars of earnings a company derives from each dollar of assets it controls.
The Refinitiv Lipper Award for Best Fund Over 10 years Global Small-/Mid-Cap Funds is based on a review of 17 funds in this class based on risk-adjusted performance for the ten-year period ending November 30, 2018. Award for U.S. Region Only.
The Refinitiv Lipper Fund Awards are based on Overall/Small fund family groups and will need to have at least three distinct portfolios in one of the asset classes — equity, bond or mixed asset. The lowest average decile rank of the three years’ Consistent Return measure of the eligible funds per asset class and group will determine the asset class Group Award winner over the three-year period. The Lipper Leader for Consistent Return rating, which is a risk-adjusted performance measure, is calculated over 36, 60 and 120 months. The fund with the highest Lipper Leader for Consistent Return (Effective Return) value in each eligible classification wins the Lipper Fund Award. The Lipper Fund Awards, granted annually, highlight funds and fund companies that have excelled in delivering consistently strong risk-adjusted performance relative to their peers. Additional information is available at LipperFundAwards.com.
Group Methodology: For the 2019 Refinitiv Lipper Fund Awards (based on three-year period ending November 30, 2018), a small fund family is defined as having assets of $76.8 billion or less.