Extended Small Cap – Q2 2023 Commentary

Much like the prior March quarter, the second quarter of 2023 was largely dominated by big-picture concerns around inflation, the path of Fed policy, and the potential for economic slowing.  While many individual market days and weeks were a little volatile, due to the backdrop of entering the period after a weak March (primarily on the back of regional bank concerns), small caps overall saw the second quarter mostly as one of modest recovery.  We saw signs of that recovery within financials, though not evenly, as we also saw an ‘echo’ of the March shock in regional banks on resurfaced concerns around deposit pressures and potentially distressed banks, disrupting the group.  We’ve maintained for a while that the effects of the Fed’s steep tightening program on both the economy and the market will take time to be fully realized; even with a ‘pause’ in Fed actions in June, these effects are still working their way through the economy.  We still believe that time will be needed to uncover the opportunities that these delayed effects will likely create.  As we begin the second half of the year, we’d assert that the pace (and location) of economic slowing, impacts to employment, and the effects of higher costs of capital are all key investment questions to consider looking ahead.

Factors at Work in Q223

The second quarter of 2023 appeared to continue the unrelenting push and pull between risk-on and risk-off positioning in the market.  In our view, volatility was mostly driven by some waning of concerns about a persistently higher inflationary environment (perhaps influenced by expectations around the direction of Fed policy), balanced against some economic data points suggesting slowing of economic growth.  We still saw meaningful impacts from sentiment on market valuations, particularly as a wave of excitement about the potential for artificial intelligence (AI) on business models swept certain areas of the market.  We believe that the multiple expansion exhibited by the rush to find AI-focused ideas exemplifies the impact sentiment is currently having.  We expect the market to remain susceptible to exaggerated positioning and sentiment inflections, especially into a summer quarter which usually features lower trading volumes.  As we haven’t yet gotten more clarity around the Fed’s policy plans and there is still much debate over the direction of employment data, we’d continue to anticipate these dynamics to remain in place.

As we’ve noted, the second quarter was one of modest recovery, in particular rallying some over the month of June.  We still think that some market participants harbor concerns about the Fed’s tightening stance and whether that will push the U.S. into a recession, but the market overall seems to be getting more comfortable (dare we say complacent?) with the notion that strong employment data in particular could signal an elusive “soft-landing.”  Recent inflation indications continue to suggest that inflation has peaked, but it remains elevated above the Fed’s target and it is still 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 working their way into earnings, economic forecasts, and market valuations.

Although the quarter was dominated by these macro effects, we observed some increasing signs of individual stock differentiation, particularly during earnings season.  We look forward to the Q2 results during July and August as important signposts of how well the market has calibrated expectations around pricing or cost pressures for companies, and especially how company-specific outlooks for the balance of the year will be revised.  We would anticipate choppy trading to be present as the market sorts between single stock performance and overall sentiment and momentum, with the company-specific signals getting stronger as the market more fully digests any impacts of economic slowing and the potential for a new cycle.

For the second quarter of 2023, the Russell 2000® Value Index (R2V) finished up 3.18%.  Extended Small Cap returned +4.65% (gross of fees) and +4.48% (net of fees) for the quarter, ahead of the R2V by 1.47% (gross of fees) and by 1.30% (net of fees).  Relative performance was again solid through earnings season, with pockets of weakness during the quarter seen primarily as macro forces came to the fore.  Attribution across sectors in Q223 was relatively balanced, as the portfolio saw positive contributions from Financials, Industrials, and Communications Services, with negative contributions from Information Technology, Real Estate and Materials.  Selection was the larger component of overall attribution, although we did observe meaningful allocation effects in areas including Financials, Industrials, and Information Technology.

Data as of 6/30/2023     

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 as we head into the fall.  As with last quarter, entering earnings season we’ll watch for signs of better discrimination around revisions to 2023 forecasts and we’ll look for the resilience of profitability and any company-specific capacity for growth.  We believe as the economic cycle progresses that the market and individual stocks will start showing better response to underlying fundamentals.

It does not appear that the Fed is quite finished with its work fighting inflation and we 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.  We have already seen effects appear in regional banks and anticipate that small businesses will likely feel some impact as well; since they have been the biggest source of job growth, their response will be important.  The longer that 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.  We continue to think that impacts may be felt outside public equities.  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.

Source:  FactSet Research Systems Inc.

FCF Yield for each of the R1000 and R2000 indices represents the total free cash flow (FCF) of the components of the index divided by the total market capitalization of those components.  It is a measure of the cash flow provided by the businesses represented in each index and is presented for comparison to the cash flow (yield) provided by current 10-year U.S. Treasury bills.

Sincerely,

Portfolio Manager

Assistant Portfolio Managers

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