Micro Cap Opportunities – Q2 2024 Commentary

Market Review

The Russell Microcap® Index decreased -5.27% in the second quarter of 2024, as investors adjusted to the reality that inflation is likely to remain elevated, and fewer, if any, interest rate cuts may occur this year. Consumer Staples led the way in the Russell Microcap® index during the quarter, returning 6.24%. Specifically, within Consumer Staples, the Packaged Foods & Meats and Tobacco industries generated the bulk of the performance with no noteworthy theme. Offsetting this performance, Health Care and Information Technology were the two weakest groups. Within Health Care, Biotechnology was particularly weak, down 11.6%, which we believe is due primarily to investors’ view around the timing of interest rate cuts. Lastly, at the end of every June, the Russell Microcap® Index rebalances their holdings. Most of the changes were relatively mild; however, two of the top five increasing industries were from Health Care – Pharmaceuticals increased 67 bps, and Health Care – Services 35 bps. 

Performance Recap

The KCM Microcap Opportunity Composite decreased 91 bps (gross of fees) and 105 bps (net of fees) in Q224, outperforming the Russell Microcap® Index by 436 basis points (gross of fees) and 422 basis points (net of fees). Both stock selection (+422 bps) and sector allocation (+8 bps) contributed to relative outperformance. Health Care was the best relative performer, adding 266 bps to performance. Financials was our largest laggard (-53 bps detraction), which was tied to stock selection in banks.  Additional performance information is included in the table below.

Data as of 06/30/2024

The largest individual detractor from portfolio performance in the quarter was a provider of rental equipment to construction firms. While the Company beat Q1 expectations, they discussed a slowing demand outlook. Fortunately, management discussed April utilization increased from Q1 average levels. While I remain excited about the potential for large infrastructure demand from the Infrastructure Bill, I believe it will take time for these projects to get funded and started. I believe shares remain attractive at current levels and continue to hold shares in the business.

The strongest performing stock in the quarter was a provider of advertising cloud technologies used to help marketers accelerate brand growth. The KCM Microcap Opportunities strategy has been a holder of this business since 2021. The market cap has moved from approximately 1 billion dollars when purchased in the fund to nearly 4 billion dollars today. The Company had a great Q1 2024 result, which included a record number added of Super Scaled customers, clients that spend > 1 million dollars. Additionally, they have begun to launch their AI product suite, which could help accelerate client spending even further. Bottom line, while the Company is “hitting on all strides,” I have begun to trim the position and redeploy into new ideas as shares have moved out of my ideal market cap range.

 Outlook

Looking back at my Q1 letter, it feels like the market is in the same place – 1.) the timing of potential interest rate cuts and 2.) what will be the outcome of the presidential elections. While the market is pricing in fewer interest rate cuts compared to the beginning of the year, I don’t believe this scenario will have a significant impact on our ability to find compelling ideas or for companies to deploy capital in transactions.

I think it’s important to highlight two other notable outperformers in Q2 2024 – two medical device manufacturers. Both companies announced an agreement to be acquired at significant premiums. One announced a deal with a larger-cap peer and the other announced a transaction with private equity. Bottom line – I continue to expect/anticipate a robust M&A environment even in the current interest rate environment and believe many of our companies cannot only help boost revenue growth for larger peers but can offer an ability to generate significant cost savings for companies that already have an existing overhead infrastructure. 

Additionally, given the pullback in biotechnology, I’m continuing to increase exposure and believe this area will be a focus that can potentially generate returns for investors regardless of interest rates or the outcome of elections.

As always, we thank you for your support, and please don’t hesitate to reach out with any questions or concerns.   

Sincerely,

Sean McMahon

Portfolio Manager

Important Disclosures

Kennedy Capital Management LLC (“KCM”) is a Delaware limited liability company headquartered in Missouri.  KCM is registered as an investment adviser with the Securities and Exchange Commission under the Investment Advisers Act of 1940. Registration with the SEC does not imply any level of skill or training. Clients of the Firm include U.S. corporations, pension and profit sharing funds, colleges and universities, trusts, not-for-profit organizations, foundations, and individuals. KCM claims compliance with the Global Investment Performance Standards (GIPS®). GIPS® is a registered trademark of CFA Institute. CFA Institute does not endorse or promote this organization, nor does it warrant the accuracy or quality of the content. GIPS® are a set of standardized, industry-wide ethical principles that provide investment firms with guidance on calculating and reporting their investment results to prospective clients to ensure fair representation and full disclosure of an investment firm’s performance history.

 Although the statements of fact and data in this report have been obtained from, and are based upon, sources that the Firm believes to be reliable, we do not guarantee their accuracy, and any such information may be incomplete or condensed. All opinions included in this report constitute the Firm’s judgment as of the date of this report and are subject to change without notice. This report is for informational purposes only and is not intended as an offer or solicitation with respect to the purchase or sale of any security. A complete list of all securities recommended by KCM in the preceding year, a full compliant GIPS Composite Report, and the list of composite descriptions are available upon request from KCM at 10829 Olive Blvd., Suite 100. St. Louis, MO, 63141.

The Micro Cap Opportunities Composite contains fully discretionary micro cap accounts that are invested primarily in micro cap companies (market cap generally in line with Russell Microcap® index) that have opportunities to grow within their respective markets. For comparison purposes the composite is measured against the Russell Microcap® Index. The U.S. Dollar is the currency used to express performance.

Composite specific data provided within this presentation has been calculated from accounts that are discretionary as defined in this paragraph. The assets shown are derived only from discretionary accounts. Non-discretionary accounts, as defined by KCM, are accounts that are not included in the composite due to one or any combination of the following criteria: there were significant cash inflows or outflows within the account; the account’s asset level did not meet the minimum requirement to remain in the composite; the account assets are managed by others using our non-discretionary model. The temporary removal of such an account occurs at the beginning of the month and the account re-enters the composite the month after the criteria has been met.

Performance returns are presented gross and net of investment advisory fees and include the reinvestment of all income. Gross of fee returns reflect the deduction of transaction costs and custodian fees but do not reflect the deduction of investment advisory fees. Net of fee performance is calculated using gross returns less the actual applicable annual management fee applied monthly. Past performance is not indicative of future results. A client’s return will be reduced by the advisory fees as described in Form ADV Part 2A and other expenses incurred by the account. For example, an annual advisory fee of 1% compounded quarterly over 10 years will reduce a gross 14.44% annual return to a net 13.32% annual return. Form ADV Part 2A is available upon request.

The performance figures reported herein are unaudited, may be based upon information obtained via electronic data sources (”feeds”) and may be subject to change. Data feeds from many of KCM clients’ selected custodians are obtained through third party sources, and are used to compare custodial data to KCM’s client account records as frequently as daily. Monthly, KCM reviews clients’ account holdings along with cash and share quantities against the custodial statements. In some instances, variances may exist between final audited custodial information and the information KCM obtains via such data feeds. Generally, any such variances are researched and reconciled within thirty days of the period end.

The information provided should not be considered a recommendation to purchase or sell any particular security. There is no assurance that any securities discussed herein will remain in a KCM portfolio at the time you receive this letter or that securities sold have not been repurchased. Allocations among industries, sectors and securities may vary and are subject to change without notice. Any securities discussed do not represent an account’s entire portfolio and, in the aggregate, may represent only a small percentage of an account’s portfolio holdings. It should not be assumed that any of the industry or sector allocation decisions mentioned, or securities transactions or holdings discussed were or will be profitable, or that the investment recommendations or decisions we make in the future will be profitable or will equal the investment performance of the securities discussed herein.

Sector Weightings are subject to change at any time.  Sectors are based on the Global Industry Classification Standard (”GICS”) classification scheme. Both are measured as a percentage of the total composite in terms of asset value as of the date indicated above. Individual client portfolios may be different based on variations in security purchase price and date, and individual client restrictions.

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Allocations to various assets classes change over time and deviate from any stated or targeted percentages of a total portfolio as a result of market conditions and reallocation decisions. Therefore, nothing herein reflects a static portfolio allocation that will remain the same or match stated target allocations of asset classes.

Russell Investment Group is the source and owner of the Russell Index data contained or reflected in this material and all trademarks and copyrights related thereto. The presentation may contain confidential information and unauthorized use, disclosure, copying, dissemination or redistribution is strictly prohibited. This is a presentation of KCM. Russell Investment Group is not responsible for the formatting or configuration of this material or for any inaccuracy in KCM’s presentation thereof.

The Russell Microcap® Index measures the performance of the microcap segment of the U.S. equity universe. Microcap stocks make up less than 2% of the U.S. equity market (by market cap, as of the most recent reconstitution) and consist of the smallest 1,000 securities in the small-cap Russell 2000® Index, plus the next 1,000 smallest eligible securities by market cap. The Russell Microcap® Index is constructed to provide a comprehensive and unbiased barometer for the microcap segment trading on national exchanges, while excluding lesser-regulated OTC bulletin board securities and pink-sheet stocks due to their failure to meet national exchange listing requirements. The Index is completely reconstituted annually to ensure new and growing equities are reflected and companies continue to reflect appropriate capitalization and value characteristics.

The Russell Microcap® is used as the benchmark. The Index is unmanaged and represents total returns including reinvestment of dividends. The benchmark is used for comparative purposes only and generally reflects the comparable risk or investment style of the Firm’s strategy. The investment portfolios underlying the Index are different from the investments in the portfolios managed by the Firm. Certain accounts may also use other benchmarks not listed in the GIPS composite report. The Verification and Performance Examination Report does not cover the benchmark returns included in the GIPS composite report.  Investors cannot invest directly in an Index.