Extended Small Cap – Q1 2023 Commentary

With seeming parallels to last year’s first quarter, the opening stanza of 2023 again heavily featured macro-driven forces resulting in a fairly volatile market, punctuated by reversals in sentiment outweighing company fundamentals.  There was even a ‘surprise’ market shock partway through the quarter – the deposit pressure-led bank ‘crisis’ that hit in early March – which was this year’s invasion of Ukraine, upending the markets briefly and leading to further concerns about the direction of policy and the economy.  We observed exiting 2022 that the effects of the Fed’s steep tightening program on both the economy and the market will take time to be fully realized; we’d argue that the pressures on the banks are a direct example of those effects, with others likely to follow.  We also believe that time will likewise be required to fully divulge the opportunities that these effects will create.  We’d assert that the shape of economic slowing, impacts to employment and the effects of higher costs of capital are all key questions to consider for investments over 2023 and further ahead.

Factors at Work in Q123

The first quarter of 2023 seemed to mostly echo the second half of 2022’s push and pull between risk-on and risk-off positioning in the market.  In our view, this volatility was mostly driven by the debate over a potentially persistent higher inflationary environment, the direction of Fed policy and the influence of those factors upon the real economy, particularly employment, earnings pressures, and the slowing of economic growth.  The market continued to see outsized impacts from sentiment changes, as indicated by significant multiple compression on hard-landing fears and expansion on hopes that maybe the Fed will pivot away from a hawkish stance.  We believe the market continues to be susceptible to exaggerated positioning and sentiment inflections in an environment with relatively low trading volumes, hesitation from fundamental investors, and macro-driven marginal flows.  We’d anticipate at least some level of these dynamics to remain until we get a little more clarity around the Fed’s policy plans and the direction of employment data that will give a better indication about the nature of the economic path.

The first calendar quarter was marked by a rally over its first half, followed by a sharp retreat on the back of bank pressures and the resultant market sentiment change during March.  We’d maintain that the root underlying driver of this seesaw action over the last few quarters appears to be a market alternately concerned about the Fed’s aggressive tightening stance and its commitment to fighting inflation (which risks pulling the U.S. into a potentially sharp recession), to one seeing relief as positioning or momentum highlights a path towards relaxing that stance.  While we believe that there are indications of inflation having peaked, it remains elevated and is our view that the Fed is likely to follow through on its present course and hold short-term rates steady for some time.  We expect lagged effects to continue pricing into earnings, economic forecasts, or market valuations.

While dominated by these macro effects, we still observed some signs of individual stock performance, particularly during earnings season.  As the market digests the Q1 results and updated 2023 forecasts in April and May, we expect more divergence to appear, but until the market is a little more settled around the forward trajectory of Fed policy, we likewise expect to see choppy trading and potentially countervailing forces between company-specific performance and overall market sentiment and momentum.  We would anticipate company-specific signals to improve as the market further evaluates the impacts of economic slowing and the potential for a new cycle.

For the first quarter of 2023, the Russell 2000® Value Index (R2V) finished down by -0.66%.  Extended Small Cap returned -0.58% (gross of fees) and -0.75% (net of fees) for the quarter, bracketing the index, ahead of the R2V by 0.08% (gross of fees) and behind by -0.09% (net of fees).  Relative performance was again solid through earnings season, with weakness during the quarter seen primarily as macro forces came to the fore, with some sharp impacts on the specific days with the most bank stock pressures.  Attribution across sectors in Q123 was relatively balanced, as the portfolio saw positive contributions from Information Technology, Industrials, and Materials, with negative contributions from Energy, Consumer Discretionary and Communications Services.  Selection was the larger component of overall attribution, although we did observe meaningful allocation effects in areas including Financials, Consumer Discretionary, and Information Technology. Additional performance information is included in the table below.

Data as of 3/31/2023

Outlook

With the momentum of the market seemingly focused solely on expectations around Fed policy, the fading of inflation, and concerns over slowing economic growth, we still think that the evaluation of stock-specific forecasts could have a bit of a secondary role over the next quarter or two.  As we enter earnings season, we’ll watch for signs of better discrimination around potentially greater revisions to 2023 forecasts, and we’ll look for the resilience of profitability and any company-specific capacity for growth; as the economic cycle progresses, we believe the market and individual stocks will start showing better response to underlying fundamentals.  Like we observed last quarter, that may require a market assessment that the forward economic path towards a recovery is more visible, but as prospects for 2023 are discounted, it could begin to take shape.

We don’t think that the Fed is quite finished with its work fighting inflation and largely expect an elevated rate environment for more than a couple of quarters.  Likewise, we believe that there will be significant and lagging impacts from the rapid tightening of financial conditions; this manifested in Q1 in regional banks and we expect effects to show up in other areas.  The longer the Fed maintains what is seen as a restrictive policy, the stronger the impulse will be to curb hiring and the greater the chances for recession.  From a real economy perspective, this likely pops up in employment figures, higher funding costs, and less capital available to the economy.  We think impacts might be felt outside public equities, including places that saw significant inflows during the pandemic like cryptocurrency or venture capital.  As the landscape develops, we anticipate many investment opportunities to present themselves in companies with strong or improving business models and compelling valuations that the market can recognize and reward.

As we can see in our usual free cash flow chart below, as Treasury yields have increased they have meaningfully closed the gap, but on a relative basis there remains support for equities.  We’d again note the continued wide gap between small and large caps which we think is a key support for a sanguine small cap view exiting this economic turbulence.  As a result, while we remain mindful of the effects of macro positioning, we expect company-specific opportunities to be available.  We see the potential for leadership changes, based on the new range of rates, debt costs, and a focus that may shift more towards efficiency and returns.  We therefore continue to seek opportunities within small cap and value stocks, our optimism based on three things:  low relative valuations against longer term business potential (even under potentially stressed scenarios), what looks to us like a broad set of investment ideas starting to open up, and the underlying conditions of recovery within the economy ahead.  We remain focused on how these factors play out over the year.

We continue to wish you, your families and stakeholders good health and safety.  We deeply appreciate your interest and support.

Sincerely,

Portfolio Manager

Assistant Portfolio Managers

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 contained herein. 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 Extended Small Cap Composite invests in companies with a low relative P/E and price/book valuation. Such companies generally exhibit relatively lower analyst coverage and institutional ownership than other comparable companies in the Russell 2000® Value 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.

GICS was developed by and is the exclusive property and a service mark of Morgan Stanley Capital International, Inc. (”MSCI”) and Standard & Poor’s, a division of The McGraw-Hill Companies, Inc. (”S&P”) and is licensed for the use by KCM. Neither MSCI, S&P, nor any other party involved in making or compiling the GICS or any GICS classifications makes any express or implied warranties or representations with respect to such standard or classification (or the results thereof),and all such parties hereby expressly disclaim all warranties of originality, accuracy, completeness, merchantability, and fitness for a particular purpose with respect to any of such standard or classification. Without limiting any of the foregoing, in no event shall MSCI, S&P, any of their affiliates or any third party involved in making or compiling the GICS or any GICS classifications have any liability for any direct, indirect, special, punitive, consequential or any other damages (including lost profits) even if notified of the possibility of such damages.

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 and 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. 

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 Kennedy Capital Management, Inc.  Russell Investment Group is not responsible for the formatting or configuration of this material or for any inaccuracy in Kennedy Capital Management’s presentation thereof.   

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® Value Index 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.