Seven Canyons World Innovators Quarterly Commentary
After a rip-roaring start to the year with both the Fund and its benchmark, the MSCI All Country World IMI, reporting positive first quarter returns in the low teens, the final results from the June quarter are in and the end result makes it look like it was a snoozer: the Seven Canyons World Innovators Fund increased 2.91% while its benchmark was up 3.58%. That said, we do not think the staid final score tells the story of what happened during the game last quarter. Rather, markets this spring fit snugly into the return-of-equity-volatility narrative that began to unfold at the beginning of 2018.
For review, during all of 2017 the S&P 500 saw big daily moves (up or down by more than 1% in a day) a grand total of only eight times. In contrast, in 2018 there were 64 days with big moves, 10 of which came in the month of December alone. The first quarter of 2019 had 11 big move days, and in the “snoozer” second quarter there were seven days with big moves, just one shy of the entire year 2017.
We think the tone of the market has decidedly changed, although its general direction can still be described as up and to the right. And we think we know what the root cause of the change is: after seven years of unprecedented quantitative easing (QE), the US Federal Reserve (Fed) started to shrink its balance sheet, albeit slowly, in October 2017. The direct impact of this quantitative tightening (QT) on the real US economy has thus far been muted, though we see pockets of weakness, such as declining prices for luxury properties near the coasts. But we think QT has had a major impact on investor sentiment, changing it from risk-on speculative behavior, to uncertainty and sensitivity to headline news. Meanwhile, overall US gross domestic product (GDP) figures have remained robust and even accelerated in 2018 as a result of Trump’s tax cuts. But last year’s strength has quickly become this year’s “tough comps” — finance industry lingo for periods when growth rates come under pressure due entirely to the successes of prior comparative periods. Under these conditions we expect market volatility to continue and in the short term investors will take cues from the Fed.
At Seven Canyons, our reaction to higher volatility in equity markets is to look for opportunities to buy the best long duration growth companies on “sale”. We have no edge when it comes to predicting whether or not the Fed will stop QT and shift policy back to neutral or QE, but we do know how to find great companies around the globe and we know that the probability of generating solid returns for our shareholders goes up dramatically when we buy at cheap prices. During the recent spate of volatility, the valuation gap between US listed companies and international peers went from wide, to wider, and in many cases to the widest on record. Better valuations have lead our investment team to look overseas, and the World Innovators Fund is currently over-indexed to international companies. We have gone from almost no exposure to emerging markets companies at the beginning of 2018, to 12.78% of the portfolio invested there today; almost 2% more than our benchmark’s emerging market exposure. And with 18.71% of the portfolio in UK stocks, where prices have been weighed down by chronic Brexit fears, we are well above the 5% allocation of the benchmark. We do not think our holdings compromise on quality or future growth potential, rather, these assets are temporarily on sale due to investors getting overly excited about US companies and the USD. We expect our companies to steadily grow sales and compound earnings, the engine for stock price increases, and eventually sentiment will swing in our direction giving our returns a boost.
DETAILS FOR THE QUARTER
Our stock picking during the quarter was good. Emerging market investments were up 4.11% , developed market investments gained 4.04%. Our investments increased in value and beat the benchmark. However, the Fund’s elevated cash balance, which hovered around 20% for most of the period, held the overall return back. Normally we like to hold a little “dry powder” in the form of cash in the Fund; 5% is typically more than enough. However, we’ve found it more difficult to stay fully invested during the latter stages of this protracted bull market. Coming out of the global financial crisis the bull market started off broad and inclusive, but over the last three years the bull market morphed into a very narrow market led by the US technology sector. This helped the World Innovators Fund because some of our largest holdings over the past 10 years are innovative US tech companies, such as Amazon and Roku. These companies have delivered on lofty growth expectations. Meanwhile, growth rates from old economy sectors like banking, industrials, and retail have been disappointing during this economic expansion. Investors have reacted by crowding into the few winners driving valuation multiples to extremes. In the US tech sector analysts no longer value companies on PE or EBITDA multiples, rather, they talk sales multiples of 10x, 20x, and sometimes even higher! We think chasm between winners and losers is exacerbated by the monumental shift in our industry from active to passive investments, mostly in the form of index funds. By definition index funds chase winners and are agnostic to valuations. At the start of 2007, passive funds made up just 20% of the U.S. equity assets under management, today that figure is approaching 50%!
With the benefit of hindsight, we should have added to our favorite tech darlings in order to beat the market. However, we could not and cannot get comfortable with such high valuation multiples. We felt obliged to trim and take profits in our favorite US tech companies and eventually sold most to zero. This has left us with the problem of raising cash faster than we can find companies to reinvest in. That said, we do not expect our cash balance to remain elevated for long. The recent market volatility is creating some very attractive buying opportunities.
This strategy paid off in June when our two biggest holdings, Nintendo and Abcam, made significant positive contributions to the Fund’s returns — 108 basis points and 99 basis points, respectively. We accumulated shares in both companies in 2018 and early 2019 when their stock prices sold off excessively for what we considered unwarranted reasons. In the case of Nintendo, analysts and investors became obsessed with the management’s guidance that they would sell 20 million Switch units during the year. As the quarters rolled in it became clear that selling 20 million units was too much of a stretch. Switch unit sales kept coming in marginally below analyst estimates, and the classic pavlovian response from the investment community took over — the missed forecast triggered hyperactive selling of the stock. Rather than obsessing over quarterly Switch figures, we took the long term view. Even though Switch units ended up at only 18 million for the year, the console is a blockbuster! In fact, sales are tracking ahead of the PlayStation 4 at the same point in its lifecycle, and it is the most popular console ever. Driven by the console, sales at Nintendo have grown fast. By establishing such a large user base, future sales will shift from being console driven to software (games) and services driven. Since the latter have higher margins, earnings growth should accelerate. Now that the Switch guidance miss is (finally!) in the past, we hope that robust earnings growth and reasonable valuation will reclaim the narrative in 2019. So far so good.
Only one of our investments detracted more than 50 basis points from the Fund’s return during the June quarter, Japan Animal Referral Medical Center, which is the largest veterinary hospital company in Japan. Veterinary care is a defensive growth business as pets are treated more and more like members of the family, and people are willing to spend money on good healthcare for their cats and dogs. During the quarter the company announced that it would push back the opening of its fifth hospital by 18 months. On the one hand, this means sales growth will be slower over the next couple of years. On the other hand, it gives the company time to focus on filling capacity at its newest hospital in Tokyo, which should mean decent growth with higher margins and earnings, and more debt repaid. We don’t mind this trade off and see the sell off as a buying opportunity.
We think that buying innovative companies that can gain market share through economic cycles is a good strategy for long term outperformance. Finding the right businesses to buy is half the battle. The other half is paying the right price to get above-average returns. Currently we see opportunity in the great prices offered for small companies outside the US. Volatile equity markets call for increased caution, but the silver lining is that some great assets are being put on sale. Our research team is diligently reviewing the portfolio and our watch lists, and screening and vetting new ideas in order to take advantage of good deals for our shareholders.
Basis Points (bps) are a one hundredth of one percent
Earnings before interest, tax, depreciation and amortization (EBITDA) is a measure of a company’s operating performance
Gross domestic product (GDP) is a monetary measure of the market value of all the final goods and services produced in a period of time, often annually or quarterly.
Price-to-earnings (PE) is the ratio for valuing a company that measures its current share price relative to its per-share earnings.
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.
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