Small Cap Growth – Q3 2025 Commentary

Small-capitalization stock performance was robust in the third quarter, both absolutely and relatively, with the Russell 2000® Index +12.39% and the Russell Microcap® Index +17.03% vs. the Russell 1000® +7.99%. However, it was a very difficult period for active managers to keep up and deeper analysis highlights the primary reasons why: the outperformance delta between individual stocks was larger than average and led by a historically narrow group of stocks with typical “low quality” factors. Excluding biotechnology names, only 30% of R2 index stocks outperformed (third lowest in any quarter since 1986)¹. And applying our own factor analysis to the Russell 2000® index showed that not only were these top performers typically unprofitable (low EBITDA/EV), with a high valuation (price to sales), high volatility (beta), high momentum, and high short interest, but they were in the highest quintile on every one of these metrics (i.e. the most extreme).

Source:  Factset Resource Inc.

While reflecting on this environment, it is worth noting that our portfolio was performing relatively well thru the typical earnings reporting season (i.e. end of August), which provides some comfort that, in aggregate, our companies continue to execute similarly in, an albeit, choppy environment. It was really only in the month of September when this previously described performance gap occurred. Announcements from several major artificial intelligence (AI) firms regarding their investment plans & new technology endorsements led to outsized returns in specific companies and/or industry areas with exposure to those multi-year potential opportunity. In contrast, for the majority of companies dependent on generating revenues in today’s economy, macro concerns continued to build in the face of monthly data indicating a stagnant consumer and cautious enterprise spending. This created meaningful bifurcation in monthly price performance and the narrowness of the market. While it is normal for low quality factors to outperform in the beginning of an interest rate cycle, this does not appear to be a typical “early cyclical” rotation. This is different. While we have been bullish on the outlook for AI and industrial onshoring investment spend, we have been surprised by how much value the market has been willing to ascribe to certain more nascent solutions where the future market size and market shares are far from certain. While recognizing that artificial intelligence, and its power demands, will provide for a number of multi-year growth opportunities, we will continue to take a balanced approach to investing that includes evaluating the status of proven unit economics, execution time frames, and valuations.

Performance:

The KCM Small Cap Growth (SCG) composite increased +5.64% (gross of fees) and +5.44% (net of fees) for the third quarter of 2025, underperforming the Russell 2000® Growth (R2G) Index, which increased by +12.19%, by -655 bps (gross of fees) and -675 bps (net of fees). Year-to-date the KCM SCG composite increased +5.83% (gross of fees) and +5.27% (net of fees), underperforming the R2G Index, which increased +11.65%, by -582 bps (gross of fees) and -639 bps (net of fees).

Additional performance information included in the table below.

Data as of 9/30/2025

On a relative basis Health Care and Real Estate were the best-performing sectors versus the benchmark in the quarter. Health Care was led by strong gains in a biotechnology company following very positive results in two pivotal Phase 3 trials for one of their drug, which is expected to launch in 2026. The outperformance from Real Estate was simply the result of not owning any companies in this underperforming sector.

The largest detractors to relative performance for the quarter were Industrials and Consumer Discretionary. At an individual stock level, Industrials was most impacted by our not owning one stock, which increased +254% during the period following the announcement that, a large data center developer, would deploy their fuel cell technology as an onsite power solution. Additionally, underperformance in the sector from owned names was led by an operator of a digital marketplace for used wholesale vehicles, which declined following a weak Q2 and reduced earnings outlook. This was primarily due to macro headwinds continuing to impact their end market more than anticipated, with weak auto market volumes and lower conversion rates constraining the revenue potential at the same time they are continuing to invest in a new commercial platform. The sizeable stock price reaction seems to reflect greater concerns around their ability to continue gaining market share, however, there has been a lot of quarterly volatility in these metrics and the recent tariff “noise” has likely impacted dealer behavior. We will be watching market share gains closely in the coming quarter to confirm that our long-term thesis remains intact. Consumer Discretionary underperformance was led by a decline in a franchisor and operator of restaurants. While still growing units rapidly, The company has experienced slightly weaker same store sales growth this year (along with the entire restaurant industry) as consumer budgets appear to be facing constraints. While this is a drag on near term earnings, we do not expect it to have a significant impact on the longer-term potential as the company increases its global footprint and benefits from several specific initiatives that should increase unit throughput over the next couple of years (i.e. smart kitchen and loyalty program).

For the year-to-date period, relative performance was strongest in the top outperforming sectors of Communications Services and Consumer Discretionary. Unfortunately, the largest detractors to performance, Industrials and Information Technology, were more significant and more than offset.

Outlook:

We anticipate a mixed Q3 earnings reporting season as overall activity has remained relatively steady, but there is clear bifurcation between the areas that are benefitting from increased capital investment (AI, onshoring) vs. those that are not. And while we expect that the Federal Reserve will continue to reduce the Fed Funds Rate, it is not clear to what degree this will impact the longer end of the curve and act as an economic stimulant. These items may continue to result in market volatility and could impact our expectation for overall economic growth and/or a certain sector’s ability to fully participate. However, outside of these factors there are a couple of large transformational multi-year growth opportunities that we expect will persist, such as Artificial Intelligence, onshoring of production, and increasing power generation needs, which are driving significant domestic investment and business activity. Several sectors are also benefitting from shifting government spending policies and/or an expectation of lower government regulations. And even though there are macro pressures in certain sectors of the economy, there are individual companies that can offset this by gaining meaningful market share. The core of our strategy remains focused on identifying companies that can benefit from these types of durable trends, or simply their own unique product opportunities, to gain market share and/or expand their end markets meaningfully with good economic returns. Rather than trying to predict specific short term macro-outcomes, we use scenario analysis and continually adjust the portfolio to lean into the best risk/reward opportunities that the market provides.

Thank you for your continued confidence in the Kennedy Capital team. Should you have any additional questions, please do not hesitate to contact us.

Sincerely,

Portfolio Manager

Assistant Portfolio Managers

Important Disclosures

¹Karande , A. (2025). 3Q25 Quarter-End Letter [Review of 3Q25 Quarter-End Letter]. Furey Research Partners.

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Investing in the stock market involves gains and losses and may not be suitable for all investors. Investing in equity securities is speculative and involves substantial risk.  Small cap securities may involve more risk than larger-cap securities. Investments concentrated in sector or specific industry may involve greater risk and volatility than more diversified investments.  

The Small Cap Growth Composite invests in growth securities of predominately small companies that generally have a market capitalization that is reflective of the Russell 2000® Growth Index. The Manager seeks companies with durable business models able to deploy assets into growing sets of opportunities providing superior rates of return. For comparison purposes the composite is measured against the Russell 2000® Growth Index. The U.S. Dollar is the currency used to express performance.

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The Russell 1000® Index measures the performance of the large-cap segment of the US equity universe. It is a subset of the Russell 3000® Index and includes approximately 1,000 of the largest securities based on a combination of their market cap and current index membership. The Russell 1000 represents approximately 93% of the US market. The Russell 1000® Index is constructed to provide a comprehensive and unbiased barometer for the large-cap segment and is completely reconstituted annually to ensure new and growing equities are included.

The Russell 2000® Index measures the performance of the small-cap segment of the U.S. equity universe. The Russell 2000®  Index is a subset of the Russell 3000® Index representing approximately 7% of the total market capitalization of that index, as of the most recent reconstitution. It includes approximately 2000 of the smallest securities based on a combination of their market cap and current index membership. The Russell 2000® is constructed to provide a comprehensive and unbiased small-cap barometer and is completely reconstituted annually to ensure larger stocks do not distort the performance and characteristics of the true small-cap opportunity set.

The Russell 2000® Value Index measures the performance of small-cap value segment of the U.S. equity universe. It includes those Russell 2000® companies with relatively lower price-to-book ratios, lower I/B/E/S  forecast  medium term (2 year) growth and lower sales per share historical growth (5 year) . The Russell 2000® Value Index is constructed to provide a comprehensive and unbiased barometer for the small-cap value segment. The Index is completely reconstituted annually to ensure new and growing equites are included and that the represented companies continue to reflect value characteristics.

The Russell 2000® Growth Index measures the performance of the small-cap growth segment of the U.S. equity universe. It includes those Russell 2000® companies with relatively higher price-to-book ratios, higher I/B/E/S forecast medium term (2 year) growth and higher sales per share historical growth (5 year). The Russell 2000® Growth Index is constructed to provide comprehensive and unbiased barometer for the small-cap growth segment. The Index is completely reconstituted annually to ensure new and growing equities are included and that the represented companies continue to reflect growth characteristics.

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