Apis Global Discovery Fund commentary for the second quarter ended June 30, 2024.
Dear Partners,
The Apis Global Discovery Fund was up 1.7% net in Q2 2024 and is up 7.6% YTD. Over the same periods, the MSCI ACWI SMID-Cap benchmark index was down 2.1% and up 2.8%, respectively.
Performance Overview (Gross Returns)
The second quarter remained positive despite the overall downturn in small-cap markets. Geographically, strong stock selection in Asia drove performance, with North America also outperforming, while the European contribution aligned more closely with soft market indices. The Industrials and Materials sectors delivered outstanding performance, while Technology and Consumer declined in line with broader markets. Names previously highlighted in the electrification theme were among the biggest long contributors. HD Hyundai Electric again led the group, adding 2.2%, while another Korean company, Cheryong Electric, added 1.9%. Among other top performers were DPC Dash (Hong Kong) and E-ink (Taiwan), which are highlighted below. Despite overall success in Materials, Victoria Gold was a notable detractor from our performance, reducing it by about 80 bps. Victoria – a mature, producing mine in Canada on 3x earnings – experienced a landslide that severely damaged its mine and impacted the stock. These outcomes, unfortunately, come with the territory and reinforce why we keep mining positions small.
Portfolio Outlook And Positioning
Goldman Sachs recently published a report, “Small but Mighty? The Landscape and Opportunity Set for SMID-Cap Hedge Fund Strategies” (we are pleased to include the full report for our partners and prospective investors). We appreciated it not so much because of the data cited to support small- vs. large-cap investing but also because it provides a list of more subjective reasons that small-cap investing works and, more importantly for us, why it’s fun.
To paraphrase some of the more interesting takeaways:
- There are many more stock-picking opportunities – 1000s of names vs. an index of 500 stocks where nearly 40% of the S&P’s market capitalization is comprised of 10 stocks. In the Russell 2000, the top 10 stocks are 3% of the index. A good fundamental story in small-caps can work despite index direction.
- Inefficiencies – the average S&P 500 stock has 18 analysts covering it, while a Russell 2000 company averages 5 analysts and 13% of the index components have no coverage at all.
- Within hedge funds it’s a less competitive space. Only 3% of equity long/short funds focus on SMID-cap, while only 1% of all hedge fund strategies focus on this market segment. In long-only funds, less than 5% of funds are dedicated to small-cap.
- Lower liquidity can have advantages – small stocks are less attractive to systematic managers or multi-managers and are less subject to price dislocations from their herding tendencies.
- The business models of small companies are generally less complex and easier to analyze. Investors can have closer relationships with top managers who often have large stakes in their companies. Investors have opportunities to get involved in improving the company’s story.
- Lower liquidity provides volatility that managers with long-term time horizons can utilize to provide attractive entry points.
- Small companies also offer a superior shorting opportunity set for hedge funds. Characteristics such as profitability (one-third of the Russell 2000 is unprofitable), leverage, and weak management provide fertile ground for finding shorts
For allocators, the report supports that small-cap managers (like Apis!) can generate meaningful alpha and should provide exposures that won’t overlap with existing strategies. Large-cap managers tend to overlap, making it harder to outperform small-cap managers who can build more differentiated portfolios.
As to the all-important “why now?”, Goldman provides evidence that valuation differences do regress and we are currently at extremes. Profitable Russell 2000 companies trade for 15x with 35% consensus growth, while the S&P currently trades for 23x while offering 14% growth. Lastly, the role of interest rates is highlighted as small companies generally have more debt and exposure to variable interest rate financing. A rate cut could be the catalyst for small-caps, as it was during the 2001-2007 period.
Clearly, the large- versus small-cap discussion continues to rage as “indexes” like the S&P 500 (up 15.3% YTD) outperform; however, the average stock in the S&P is up 4.1%, the Dow is up 3.8%, the Russell 2000 is up 1.0%, and the MSCI ACWI SMID Cap benchmark is up 2.8%. While the Goldman report noted the breadth of the SMID-cap universe, many interesting charts illustrate the extremes, with one eye-catching example below (courtesy of Canaccord Genuity). This indicates that today’s “Nifty 10” stocks now represent a larger share of the S&P 500 index than the “Nifty 50” stocks did in their era.
Reflections On 20 Years Of Apis Capital
After 20 years, why Apis? Why now?
We are proud to announce that we celebrated our 20th anniversary during the second quarter (April 2024). Throughout the years, prospective partners have frequently asked us, “why Apis?” Behind the question is a very understandable desire to know why someone should choose to invest with Apis over the variety of other investment options in the marketplace. We think about this question a lot, not only from the perspective of our existing LPs and future partners, but also for our own wealth which is all invested in the firm.
In answering this question, it’s important to note that we’re not a startup; we’re seasoned veterans and, at this point in our journey, we have the luxury of starting with the numbers. From our launch in April 2004 through June 2024, our Flagship Fund has outperformed the MSCI All Country World Index (ACWI) by nearly 3.0% annually, net of fees. Our Deep Value Fund, launched in November 2005 and focusing on micro-cap companies has outperformed by nearly 6.0% annually. Our Global Discovery long-only Fund, which selects long positions from both our Flagship and Deep Value long/short strategies, was launched in January 2020 and has outperformed the MSCI All Country World SMID index by nearly 9.0% annually as well. We are tremendously proud of this track record, as only around 1 in 10 investment managers outperforms over an extended period of time.1 Not only have we outperformed, but we have done so with similar or less volatility. The question we ask ourselves is, “what would prevent us from repeating this performance in the future?” We have already demonstrated significant net-of-fee outperformance. But we are also well aware of all the funds that have seen their returns fade over time. Looking back over our history, there is a laundry list of formerly successful firms that could not sustain their outperformance. As we think about our own sustainability, it makes sense to look at the major causes of what can go wrong and consider how these might apply to Apis.
Let’s start with one of the biggest issues we see firms run into – people problems. Headlines are filled with big personality conflicts across all sorts of funds; size doesn’t seem to matter, as even the most gargantuan firms can fall apart when personalities clash. But when a partnership works, it is wonderfully synergistic, with strengths and weaknesses complementing each other. We’ve navigated a lot at Apis over the years, including the ups and downs of asset flows, team building, and predictable turnover. Doing this through good and bad markets is what battle-tests a partnership, a strategy, and a firm’s culture. Fortunately, like Warren Buffett and Charlie Munger or Howard Marks and Bruce Karsh, we’ve made this “work marriage” last through thick and thin. It is, without a doubt, one of the most important keys to generating continued strong outperformance. We see no reason we can’t continue to be a successful partnership.
A second major reason we see firms suffer a decline in performance is competition. Markets are incredibly efficient and the barriers to exploiting any inefficiency are nearly non-existent. The current rage of market-neutral, low-net, super-levered pod-style investing is a case in point, illustrating how quickly people and money flood into a strategy when outperformance is to be had. If you had told us 20 years ago that we would be able to generate this much outperformance in global small and mid-cap long / short strategies, we would have expected at least a few comparable firms to enter the space. We have yet to see anything substantive and it seems that we face little-to-no real competition in this strategy. How is this possible? We suspect the reason is that this investment strategy doesn’t scale, as it is limited by the market capitalizations of our stocks. It’s a strategy that rewards long experience and, quite frankly, is a pain-in-the-$## to execute. Basically, the juice isn’t worth the squeeze when it’s so much easier to just join one of the hot strategies. At this point, we doubt we will ever see much institutional competition for our specific strategy. This is a major reason why stocks in this area of the market continue to be mispriced and continue to deliver outperformance for Apis and its partners.
Another big consideration we think about when assessing the sustainability of our returns is factor exposure. Many firms just get lucky; they launch a strategy at the right time and deliver 5 or 10 years of fantastic performance only to see it fade away. Value in the early 2000s was amazing. Early in our existence, it was all about Industrials and China and this shifted to Healthcare in the mid-2010s and then mega-cap U.S. Technology companies. The bottom-line is that we’ve navigated all of this through the financial crisis, European solvency crisis, COVID-19 global pandemic, and various other mini-crises. We’ve generated outperformance through all of these eras in up and down markets. We would have concerns about the future if our outperformance had all come from some particular time period, geography, sector, or some other factor, but that hasn’t been the case. We think whatever the factor is in the future, our focus on cash flow and valuation will never go out of style and should continue to reward us with outperformance.
Lastly, sometimes the opportunity set changes. Everyone in this industry has heard the saying “size kills.” The temptation to grow fee-generating assets often overwhelms good judgement and, while firms insist that returns won’t suffer with asset growth, they inevitably do. Growth in assets can quickly limit the opportunity set. Anyone who has followed this industry knows many firms that have fallen victim to this. It’s not just that size limits your investment universe, but it also seems to correlate with distraction – whether it’s politics or sports team investments. We have been consistent in communicating our size limitations and even temporarily soft-closed our hedged funds many years ago to manage our growth. At just over half a billion dollars of total assets, our opportunity set is as broad today as it was on the day we launched. We see no reason why our size should limit our investment opportunities or our ability to outperform.
All of this is to say, if the question is “why Apis?”, then our answer is that we see no reason why we can’t do at least as well over the next 20 years as we have over the last two decades. Moreover, our “pond” of small and medium-sized stocks has been out of favor for over half of our firm’s existence, struggling in the shadows of the mega-cap stocks. We’re very happy with how well we’ve done over this timeframe, but we think we’re due for this headwind to shift to a tailwind; one that would help bolster an already strong record of outperformance.
Investment Highlights
DPC Dash (Hong Kong – $1.1billion market cap)
We’ve long been in awe of Domino’s Pizza’s incredible success in the United States. Since 2010, Domino’s U.S. shares have outperformed Microsoft, Netflix, Apple, Facebook, and nearly every major U.S. stock with an astounding +5,300% return. It accomplished this by focusing on impressively reliable and fast delivery, small stores (and small capital investment), improving food quality, embracing technology, and dominating its markets. It stole massive share from Pizza Hut’s dine-incentric model, and Domino’s has become THE case study of how to turn around a restaurant franchise successfully.
Enter DPC Dash Ltd (HKG:1405) – Domino’s master franchise holder in mainland China – and a name we are very excited about. Recently, DPC Dash became public in 2023, and it has long suffered from changing ownership and ineffective management unwilling to invest in growth. Location count didn’t even break 100 as recently as 2017 despite being in the market since 1997 (compared to competitor Pizza Hut’s approximately 3,200 China locations). Everything changed in 2017 when new CEO Aileen Wang joined from McDonald’s and began aggressively opening stores and replicating Domino’s well-worn U.S. playbook. She also began localizing menus to regional tastes. DPC Dash is now up to 761 stores, but it’s still a small fraction of the nearly 6,500 locations in the U.S. Management plans to achieve 2,000 locations by 2027, however, which is an eyepopping 27% store CAGR.
Such aggressive growth might normally be a risk, but the brand recognition and pent-up demand for Domino’s in China is truly unfathomable. Consider this: Domino’s has over 20,000 locations worldwide, but the top 20 grossing locations in their first month are now all DPC Dash-owned locations. New stores have lines around the block, and DPC Dash doesn’t even advertise! China is effectively a pizza desert – there are only 12 pizza restaurants per 1 million people in China compared to 232 per 1 million in the U.S., and the overall pizza category is growing at an impressive 16% annual rate.
At only 11.5x 2025 EBITDA growing more than 30% with expanding margins, DPC Dash shares are incredibly cheap and we think it’s set up to be a long term compounder much like its U.S. counterpart. More simply taking a step back, we are shocked that the entire Domino’s Chinese franchise can be had for just $1 billion. The stock is still very much under the radar since its IPO, but we think it’s only a matter of time before shares get discovered and re-rated.
E-Ink (Taiwan – $9.5 billion market cap)
E-Ink (TPE:8069) holds a monopoly position in electrophoretic display (EPD) technology, commonly known as e-paper. This unique technology consumes energy only when changing images on the screen, offering significant advantages over traditional displays. Unlike LCD or OLED screens, which require constant power to maintain an image, e-paper does not emit light from the panel. This makes it lightweight, power-efficient, and easily readable under direct sunlight. The technology is protected by patents acquired through past acquisitions and in-house R&D. E-Ink is the only manufacturer of the e-paper material and sits atop the supply chain network, collaborating with over 60 upstream and downstream partners globally.
Today, e-paper is primarily used in e-readers like Amazon Kindle (40% of E-Ink's 2024 revenues) and Electronic Shelf Labels (ESL, which represents 60% of 2024 revenues), which are digital price tags used by retailers. The e-reader market is returning to growth after a period of stagnation, driven by new product launches as the technology transitions from black and-white to color. The anticipated launch of Amazon's color Kindle by 2025 is expected to trigger a significant replacement cycle, further boosting market growth. The ESL market has seen remarkable growth over the last few years, catalyzed by labor shortages during the COVID-19 pandemic. Retailers have been adopting ESL to lower headcount and improve operational efficiency by centralizing pricing for both online and physical stores. Growth in the ESL business is accelerating again with recent adoption by Walmart, a key catalyst for the U.S. market where penetration remains close to zero. The potential scale of the Walmart rollout alone is as large as the global installed base, and many other retailers in the U.S. are expected to follow suit. Publicly traded distributors in Korea, France, and Sweden have all confirmed these substantial opportunities.
In the medium term, new markets in outdoor signage, in-store advertising, and fashion retail are likely to further increase the overall total addressable market and growth for the company. At 25x 2025 earnings, the company trades at a substantial discount to its peer, Universal Display. We believe the market is underestimating the growth runway for E-ink. Our model suggests a 20% earnings CAGR over the next decade based on the existing business, which supports at least another 50% upside from today's price. There are ample untapped opportunities for e-paper, and we view this stock as a quality compounder for years to come.
Short: Sumitomo Pharma (Japan – $1 billion market cap)
Sumitomo Pharma (TYO:4506) is a Japanese pharmaceutical company historically focused on neurological and psychiatric drugs. Patent cliffs are always important for any pharmaceutical company, and Sumitomo knew that they were going to lose exclusivity for Latuda, a drug that was contributing 40% of sales, in 2023. To compensate, they first bought Urovant in 2022 (at $515mm valuation) for their core asset Gemtesa, a drug for overactive bladder. They followed that up by acquiring Myovant (at a valuation of $2.5bn) in 2023 for two drugs: Orgovyx for prostate cancer and Myfembree for uterine fibroids and endometriosis. We had been familiar with Myovant’s pipeline and early commercial struggles through previous work, which made the acquisition stick out to us as a poor fit in a neuropsychiatric company. Commercializing drugs for oncology and women’s health was unlikely to be the growth engine Sumitomo hoped it would be. Not surprisingly, all three drugs have been off to disappointing starts, with the next shoe to drop being a generic version of another well-known drug for overactive bladder, Myrbetriq, which is due to come off patent this year. This will surely intensify competition for Gemtesa.
Although estimates have come down, we still see expectations for these three key products about 20% too high. Bottom-line expectations for losses remain optimistic by 50%, with projections for profitability in 2025 unlikely. With little help in the pipeline near term, we think the potential for 40% downside remains.
Firm Update
As referenced earlier, our firm celebrated its 20th anniversary in Q2 2024. We are deeply grateful for the unwavering support and trust of our investors, which have been the cornerstone of our success. Over the past two decades, we have sought to consistently deliver exceptional value and performance, and we look forward to welcoming new partners to our strategy. We anticipate many more fruitful years ahead, driving success and achieving new heights together.
Thank you for being a part of our journey thus far.
