Extended Small Cap – Q1 2022 Commentary

The transition from Q421 to Q122 carried with it some elements of déjà vu from last year’s turn of the year.  After strong returns to close out 2021, the first quarter of 2022 saw a return to macro-driven forces and a volatile market, much like the start of 2021.  Likewise, we witnessed a return of positioning, de-risking and other nonfundamental drivers determining stock movements, especially outside of earnings season.  While the invasion of Ukraine at the end of February also impacted the market, we believe the primary underlying driver was a market contending with inflation expectations, the positioning of the Fed and its monetary policy, and much handwringing over an economic cycle seemingly moving at an accelerating pace.

Factors at Work in Q122

In our view, the second half of 2021 offered significant benefit for micro-driven and company-specific results.  As we turned the year, the market’s focus shifted considerably from evaluating the shape of the economic recovery towards concerns about a pro-inflationary cycle taking hold and whether the Fed was either prepared or positioned to address inflation in a way not required of it for multiple decades.  We continue to believe that inflation in many bottlenecked areas is more likely to prove transitory, although perhaps more sustainable in areas like labor costs.  Some areas of energy and agricultural products were also impacted by the conflict in Eastern Europe.  We are, however, starting to see indications of labor force participation picking up which may help to buffer the rate of increases in labor costs, and intuitively it would seem that there would be some natural slowing in the rate of other areas such as housing costs, so we believe that there are likely several corrective factors to slow inflation over the course of the year.

During the quarter, while we still observed some signs of better individual stock performance through earnings season, overall results across all areas of the market were dominated by multiple compression, which drove the negative market returns.  This was partly a function of the steep rise in rate expectations as the Fed signaled the beginning of a rate hiking regime.  Notably, we also saw some unusual effects including the decoupling of bank performance from expectations around the Treasury yield curve and a return of significant forced de-risking both at the macro and single-stock level which led to exaggerated stock movements in an otherwise relatively lower market volume environment.  We think the movement of the Treasury yield curve and the potential for inversions of short (2-year) and long (10-year) rates, often widely watched to signal the potential for upcoming recessions, perhaps don’t account for where much of the actual economy transacts (much more in the 3-month to 5-year range) nor the difference between nominal and real rates.  In addition, lower rates in the future imply much lower inflation expectations, potentially generating some signal noise.

While first quarters often offer rallies in small cap stocks, returns were quite volatile over Q122 and finished somewhat negative, with the Russell 2000® Value Index (R2V) down approximately -2.40%.  Extended Small Cap returned -5.08% (gross of fees) and -5.23% (net of fees) for the quarter, behind the R2V by -2.68% (gross of fees) and -2.83% (net of fees).  Relative performance was strongest in January and February through earnings season, with the weakness during the quarter concentrated in March as macro forces took over.  Attribution across sectors in Q122 was somewhat bifurcated, as the portfolio saw positive contributions from Health Care, Financials, and Materials, with negative contributions from Consumer Discretionary, Energy and Information Technology.  While selection remained the larger component of overall attribution, allocation effects were also significant during the quarter as Energy’s outsized absolute return and our somewhat underweight position, along with weakness in homebuilding, contributed to attribution effects.

Outlook

With the market now seemingly obsessing over the pace and duration of economic growth, that evaluation is dominated by forecasts for policy actions much more so than the pace of estimate revisions and potential for upside to stock-specific forecasts.  After a quarter of volatile macro-driven movement, as those economic paths become a little clearer, we believe the market and individual stocks will show better response to the underlying fundamentals.  We anticipate this environment picking up over 2022 as quarterly comparisons off the pandemic bottom pass and more sustainable patterns begin to emerge.

We continue to expect factors at work in 2022 to likely include components of company-specific levels of revenue and earnings growth, as well as policy changes and how those might influence long run economic expectations (growth and inflation, both here and abroad), geopolitical tensions, and the upcoming midterm elections.  It does feel a little like the market believes the economic cycle is running at a very rapid pace, so we’re watchful for cycle impacts.  As shown in our usual chart below, we still think on a cash flow basis that rates offer support for equities, and we’d again note the continued wide gap between small and large caps.

We are perhaps a little more mindful of macro rotations but continue to expect company-specific opportunities to be available.  We remain relatively optimistic about finding opportunities within small cap and value stocks, based on three things:  low relative valuations against anticipated business forecasts in many areas, even under potentially stressed scenarios, the still broad set of opportunities that we are finding in terms of investment ideas, and the underlying conditions of expanding economic growth and low absolute rates, all of which are broadly favorable to small cap valuations.  We remain vigilant to see how these factors play out over the year.

We continue to wish you, your families and stakeholders good health and safety.  While the pandemic seems to be receding for now, we continue to hope for a steady improvement in the months ahead.  We deeply appreciate your interest and support.

Sincerely,

Michael Bertz, Ph.D., P.E., CFA®

Portfolio Manager

Sean McMahon & Robert Van Bergen, CFA®

Assistant Portfolio Managers

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