October 2020 IssueLong scroll reading

Seven Canyons World Innovators Fund (WAGTX)

By David Snowball

Objective and strategy

The fund invests primarily in non-US growth companies that they believe are innovators in their sectors or industries. Nominally the managers can invest in “domestic and foreign … companies of any size.” As a practical matter, they invest in international small-cap companies. That’s reflected in the first four words atop their homepage:

While retaining the flexibility of investing in the US, as well as non-US, small caps, the team’s understanding of the opportunity set has convinced them that they can add more value by focusing on the non-US slice of their universe. As of August 2020, three-quarters of the fund’s portfolio was invested in small-cap growth stocks, an area to which they are far more committed than their Morningstar peers. By Morningstar’s calculation, they have 16-times the exposure to microcap stocks as their peers and their average market cap is one-sixth of their peers. Virtually all of that is non-US: Morningstar reports 91% non-US equity, 2.5% US equity, and the remainder in cash reserves.

The managers use a combination of quantitative screens and fundamental research.

Adviser

Seven Canyons Advisors, LLC. Seven Canyons (SCA), headquartered in Salt Lake City, Utah, was founded in 2017 by Sam Stewart and his sons, Josh and Spencer. The elder Mr. Stewart founded Wasatch Advisors, which is primarily a global small-cap investor, in 1975, and helped it grow to about $17 billion in assets. When he and son Josh left Wasatch, they took responsibility for two the Wasatch funds that they’d overseen: World Innovators and Strategic Income. SCA advises the two Seven Canyons funds and Ark Global Emerging Companies, L.P. As of August 31, 2020, the firm had $207 million in assets under management (per Morningstar).

Manager

Sam Stewart, Josh Stewart, and Spencer Stewart.

Sam was the founder of Wasatch Advisors and long-time manager of both World Innovators (since 2008) and Strategic Income (since inception, 2006). Prior to that, he was a university professor.

Josh Stewart worked at Wasatch Advisors for 12 years and was Lead Portfolio Manager of the Wasatch World Innovators Fund. In 2019 the fund received the 10-year Lipper Award for best Global Small/Mid-Cap Fund.

Spencer Stewart was a Portfolio Manager at Grandeur Peak Funds. He managed Grandeur Peak Emerging Markets Opportunities Fund (GPEIX), the top fund in its category during his three-year tenure, and co-managed Grandeur Peak International Opportunities (GPIOX) and their flagship Grandeur Peak Global Reach (GPROX) funds.

The Stewarts are supported by Andrey Kutuzov, a former Wasatch manager, and Justin Bodily, a former Goldman Sachs Analyst.

Strategy capacity and closure

SCA plans to close the fund when it reaches $500 million in assets. Seven Canyons is founded upon the conviction that the key to success in small-cap investing is having a small and elite team managing limited AUM. We believe there is a tipping point where growth in team and AUM size becomes an impediment to successful investing in true small and micro-cap stocks.

Management’s stake in the fund

Samuel Stewart has invested over $1 million in the fund (per the 2020 SAI, he owns 25% of the fund’s shares), Josh Stewart has invested between $100,000 – 500,000, and Spencer Stewart, added to the team a year ago, began investing in the fund in January 2020. No member of the Board of Trustees has invested in the fund.

Opening date

December 19, 2000.

Minimum investment

$2,000

Expense ratio

1.79% on assets of $201 million (as of 10/20/2020).

Comments

Understanding Seven Canyons World Innovators requires understanding a bit about the global small-cap universe in which they invest, the importance of innovation as an investment characteristic, and the record of the Seven Canyons team. We’ll take those in order.

Seven Canyons invests in non-US small caps. It is a remarkable and underutilized asset class. There are a huge number of international small-cap stocks; depending on the exact cutoff for “small-cap,” there are about twice as many non-US small caps as US ones. ISC tend to outperform their large-cap brethren on both an absolute-returns and risk-adjusted basis. For many measurement periods this century (for example, 2000-17), they also outperformed the S&P 500 on both absolute and risk-adjusted returns. They tend to have high diversification value (based on factors such as dispersion of returns and inter-stock correlations) because their performance is more often driven by country-specific or market-specific factors than by greater international tides. Because of their sheer numbers and cutbacks in the investment industry, international small-cap stocks have little analyst coverage: the average international small-cap firm is covered by five analysts and the average microcap firm, by one. Collectively, that makes this one of the strongest bastions of active management.

The Seven Canyons team targets, in particular, highly innovative companies. Their argument is that, in the long-term, earnings growth drives stock prices, and innovation drives earnings growth. The managers use quantitative screens to reduce the universe to a manageable core, then undertakes rigorous fundamental analysis (in a time of pandemic, that translates to lots of time on Zoom) to select their portfolio. Their ideal company controls innovative technologies or products, is financially solid, gaining market share, and run by an experienced team.

The team is particularly cognizant of the world’s new economic reality: enormous public and corporate debt, which can only be serviced if interest rates remain at or near zero for a long while. It’s an ugly reality but not, they posit, a new one:

The foundational characteristic of most economies today (that locks them in a vicious cycle) is record levels of indebtedness. This forces central banks to keep interest rates low so that borrowers can repay debts and make lenders whole. An economy focused on loan repayment leads to underinvestment in innovation and productive assets, and slower GDP growth. Prior to 2020, the global economy was already on this slippery slope of indebtedness, and COVID-19 just gave it a shove in the back, accelerating the slide. 

Japan started down this path of extreme indebtedness … over three decades ago and remains on that path today–which means we’ve seen this movie before and we can learn from it. From an investment standpoint, we have been doing bottom-up stock picking in the country for nearly two decades and the recipe for success is clear–find, buy and hold high-quality growth companies. [In Japan] a small cohort of well managed, progressive companies exist that consistently grow 10%, 20%, or even 30% a year. Japanese growth companies cannot rely on a booming economy to lift outcomes, they must innovate and offer customers dramatically better solutions to convince them to change old habits. In other words, they take market share, lots of it, in order to grow sales double-digits. Investors in Japanese growth companies have been handsomely rewarded with stock prices lifted by compounding sales and earnings growth with an added benefit: because growth companies are scarce, market participants tend to crowd into them, leading to valuation multiple expansion that endures over time. 

They believe that their portfolio is positioned to weather, and quite likely thrive in, the globalization of the Japan malaise.

The Seven Canyons team has had sustained, phenomenal success in building winning portfolios. A series of highlights:

  • The fund is the top-performing international or global small-cap fund over the past 10- and 15-year periods, based on both total returns and risk-adjusted returns. It is one of the top five (of 99) funds, based on those same metrics, over the shorter three- and five-year windows.
  • WAGTX has outperformed the S&P 500 over the past 10 years (through 9/30/2020).
  • It has earned a Great Owl designation from MFO, which is awarded only to funds that place in the top 20% of their peer groups for risk-adjusted returns for the past 3, 5, 10, and 20 year periods, as applicable.
  • It earned a five-star rating from Morningstar and a Silver analyst rating.
  • The fund has pretty much stuffed its Lipper global small-cap peer by every measure.

Comparison of Lifetime Performance (Since 200101)

  APR MAXDD
%
Recvry
mo
STDEV
%/yr
DSDEV
%/yr
Ulcer
Index
Sharpe
Ratio
Sortino
Ratio
Martin
Ratio
Seven Canyons World Innovators 9.6 -59.2 42 23.6 15.6 17.5 0.35 0.53 0.47
Global Small-Mid Cap 6.9 -60.7 62 20.0 14.3 19.0 0.28 0.39 0.30

Here’s how to read that. Seven Canyons has returned 9.6% annualized since inception; its peer group has returned under 7%. The price of substantially higher returns has been modestly higher volatility. That combination leaves the fund with substantially higher risk-return metrics than its peers; indeed, for the past 10 and 15 years, higher than any of its peers.

That success is not terribly surprising. Mr. Stewart, the senior, has a remarkable record as both an individual manager and as a teacher of managers. He helped build a remarkably successful record at Wasatch, whose managers then went on to found two other remarkable, global small-cap firms: Grandeur Peak and Seven Canyons. Rondure Global, with an emphasis on slightly larger firms, is led by another manager who trained under Mr. Stewart.

What about the passive / ETF option?

In general, passive funds efficiently harvest the gains in a steadily rising market. Few analysts believe that the next five years will see such gains, which might give any investor in a passive vehicle cause to double-check their understanding of their investments. Beyond that, the challenge to passive funds is substantially greater in some markets than folk wisdom suggests.

Small-cap growth – domestic, international, and global – is not a place to count on passive funds. If we screen the Lipper Global database for the 25 investment vehicles with the highest total returns in the combined international and global small-cap growth category over the past 10 years (through 8/2020), no ETF landing in the top 25. None made the top 25 based on the Sharpe ratio, the most common measure of risk-adjusted returns. The same thing is true over the past three and five years: one in the top 25 for total returns, one in the top 25 for risk-adjusted returns.

Bottom Line

It’s hard getting it right. It’s incredibly hard getting it right over and over again. The team at Seven Canyons has. World Innovators is not a mild-mannered fund, but it’s a highly successful one with a clear, repeatable discipline that has served its investors well for a long time. Investors looking to the next market (to the markets beyond the late 2020 manic-depressive one) really ought to put Seven Canyons on their due-diligence list.

Fund website

Seven Canyons World Innovators.

For those interesting in learning more about the dynamics of the international small-cap market, we would commend white papers by Artisan Partners (“The Case for International Small Caps,” 2020) and AMG (“The Case for International Small Cap,” June 2019) to you. Both offer a lot of the detail that substantiates the observations we made above in the section on Seven Canyons’ investment universe. While many other comparable white papers are available, you’ll quickly discover that all of them offer slightly different takes on the same four or five themes.

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About David Snowball

David Snowball, PhD (Massachusetts). Cofounder, lead writer. David is a Professor of Communication Studies at Augustana College, Rock Island, Illinois, a nationally-recognized college of the liberal arts and sciences, founded in 1860. For a quarter century, David competed in academic debate and coached college debate teams to over 1500 individual victories and 50 tournament championships. When he retired from that research-intensive endeavor, his interest turned to researching fund investing and fund communication strategies. He served as the closing moderator of Brill’s Mutual Funds Interactive (a Forbes “Best of the Web” site), was the Senior Fund Analyst at FundAlarm and author of over 120 fund profiles. David lives in Davenport, Iowa, and spends an amazing amount of time ferrying his son, Will, to baseball tryouts, baseball lessons, baseball practices, baseball games … and social gatherings with young ladies who seem unnervingly interested in him.