Extended Small Cap – Q3 2023 Commentary

At the risk of sounding like a broken record, we saw many of the same themes from the first half of the year continue to exert their influence during the third quarter of 2023.  These included overall market concerns about inflation, the path of Fed policy remaining “higher for longer” and the ongoing debate between hopes for soft landing or fears of a real economic slowdown, indicated both by economic data and significant switches in market positioning.  Summer quarters often feature market participants having less conviction as they look for economic or policy direction, which can become exacerbated due to investors being on vacation and volumes being lighter overall.  In 2023, these impacts seemed magnified, and we think led to a market much less willing to discount company-specific future improvements, instead more focused on short term sentiment swings.  These can be particularly challenging conditions for small cap stocks, which often trail their larger peers over the summer.  We continue to believe that the effects of the Fed’s steep tightening program are yet to be fully realized, as they are still working their way through the economy.  We likewise expect time is still needed to uncover and take advantage of the opportunities these delayed effects likely create.  As we work through concerns about the pace of economic slowing, the eventual impacts to employment, and the lagged effects of higher costs of capital, we do believe that the conditions are forming for a sustainable market cycle to take hold, offering strong potential for single stock differentiation to come to the forefront.

Factors at Work in Q323

The third quarter of 2023 appeared to be meaningfully driven by sentiment, as hopes or expectations for a plateau in Fed policy ran alongside economic data that sometimes suggested otherwise.  The continued rise in long-term rates, while re-steepening the yield curve somewhat, indicated higher rates were likely for a longer window of time impacting rate sensitive areas of the market (both in equities and bonds).  Much like the AI effects of the prior quarter, these broad and sometimes monotonic factors imply a sentiment driven regime.  Until there is a little more rate policy clarity from the Fed, we expect the market to remain susceptible to outsized positioning and sentiment inflections.

The market modestly faded overall during the third quarter; after a rally in the month of July, stocks largely declined over the remainder of the quarter.  We believe that many participants remain worried about the Fed’s tightening stance and whether that will push the U.S. into a recession, but the market continues to often be playing along with the notion that strong employment data in particular could signal an elusive “soft-landing.”  It remains 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 tightening effects to continue working their way into earnings, economic forecasts, and market valuations.  In the real economy, we can see indications of rising stresses – increasing consumer costs (fuel prices), mortgage rates at fifteen year highs, consumer savings down, and credit card delinquency rates rising.

In a quarter dominated by these macro effects, we observed less value given to individual stock differentiation, even during earnings season (although we did see a substantial amount of downside asymmetry in post-result stock reactions).  As we approach the reporting season for Q3 results, we are anticipating finding opportunities where fundamental results are better than the stocks would suggest following Q3 drawdowns.  We’re watching for milestones indicating how well the market has calibrated expectations around business volumes, pricing or cost pressures, and especially how company-specific outlooks for the rest of 2023 and into next year will be revised.  Choppy trading is likely to be present as the market sorts between single stock performance and overall sentiment and momentum, and we look for company-specific signals to get stronger as the market more fully digests any impacts of economic slowing and the potential for a new cycle.

For the third quarter of 2023, the Russell 2000® Value Index (R2V) finished at -2.96%.  Extended Small Cap returned -4.19% (gross of fees) and -4.34% (net of fees) for the quarter, trailing the R2V by -1.23% (gross of fees) and by -1.38% (net of fees).  Relative performance was solid through earnings season and August, with pockets of weakness during the quarter seen primarily as macro forces came to the fore.  Attribution across sectors in Q323 was relatively balanced, as the portfolio saw positive contributions from Financials, Utilities, and Health Care, with negative contributions from Communication Services, Energy, and Information Technology.  Selection was the larger component of overall attribution, although we did observe meaningful allocation effects in areas including Energy and Health Care. Additional performance information is included in the table below.

Data as of 9/30/2023

Outlook

We wrote last quarter that the momentum of the market seemed focused primarily on Fed policy, fading inflation, and slowing economic growth, meaning that the evaluation of stock-specific forecasts could take a secondary role into the fall.  That was largely the case, but as we enter earnings season, we’ll again watch for signs of greater confidence around 2023 revisions and especially any forecasts into 2024.  We think that resiliency of profitability and any company-specific capacity for growth will be rewarded and believe as the economic cycle progresses that the market and individual stocks will start showing better response to underlying fundamentals.

We still expect an elevated rate environment for more than a couple of quarters.  Likewise, we believe that there are significant and lagging impacts forthcoming from the rapid tightening of financial conditions.  Effects began to appear in regional banks earlier in the year and we anticipate other businesses will feel some impact as well.  The longer we have a restrictive policy, the more likely that hiring slows, and the greater the chances for recession.  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, Treasury yields have continued to climb and have closed the gap to large caps.  We’d again note the wide spread between small and large caps, which we think supports a bullish small cap view exiting this economic turbulence.  While we remain mindful of the effects of macro positioning, we expect company-specific opportunities to be more plentiful in the quarters ahead, with the potential for leadership changes based on a new range of rates, debt costs, and a focus that may shift more towards efficiency and returns.  Our process and experience tell us that attractive investment opportunities arrive during periods of uncertainty and volatile or bearish sentiment.  We thus continue to seek them out within small cap and value stocks, our optimism based on three things:  the availability of low relative valuations against longer term business potential (even under potentially stressed scenarios), what looks like a broadening set of investment ideas starting to open up, and the underlying conditions of recovery within the economy ahead.  We are increasingly focused on how these factors likely play out over the next 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,

Michael Bertz, Ph.D., P.E., CFA®

Portfolio Manager

Sean McMahon & Robert Van Bergen, CFA®

Assistant Portfolio Managers

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