Small Cap Core – Q3 2018 Commentary
The strong performance of the Russell 2000® Index in the first half of 2018 continued into the third quarter, with the index returning 3.58%. Many of the underlying characteristics that were present through the first half of 2018 sustained into Q3: benefits from lower corporate tax rates on earnings and cash flow, solid consumer confidence, and a healthy industrial economy all combined to drive equity appreciation. These tailwinds have overcome the ongoing uncertainty in US trade policy and the gradual increase in interest rates.
Growth stocks continue to lead vs. Value, with the Russell 2000® Growth Index up 5.52% in the quarter and 15.76% year-to-date vs. 1.60% in the quarter and 7.14% year-to-date for the Russell 2000® Value Index. We believe this performance differential is a reflection of the long duration of low interest rates, negative sentiment on certain cyclical sub-sectors, and momentum-driven traders that have been conditioned to expect equity appreciation with limited regard to valuation.
Health Care and Information Technology continued to lead the market. Over 1/3 of the appreciation of the Russell 2000® index was driven by the Software & Services and Health Care Equipment & Supplies sub-sectors. These two groups represent just 10.6% of the index overall, highlighting the “narrowness” of the performance of small cap equities in the current environment.
For the third quarter of 2018, the KCM Small Cap Core Composite increased 4.88% (gross of fees) and 4.66% (net of fees) as compared to the Russell 2000® Index, which increased 3.58%. We outperformed in July and August, but underperformed in September. During the third quarter, the average actively managed Small Cap Core Fund increased 3.0%, according to research published in the Jefferies Strategy Note dated 09/30/18.
Within the Small Cap Core Composite, the Industrial sector was significantly overweight vs. the benchmark, and the Communications Services sector was significantly underweight the benchmark at September 30, 2018. Notably, we were underweight the Software & Services and Healthcare Equipment & Supplies sub-sectors that were key drivers of the benchmark performance this quarter. This underweight position is a reflection of the valuation discipline in our portfolio construction process.
Stock selection was a positive contributor to portfolio performance overall in the quarter. This performance was led by the Health Care and Industrials sectors, partially offset by unfavorable selections in Financials and Consumer Staples.
As we enter the fourth quarter, key watch items for the equity markets include the midterm elections in the U.S., the ongoing trade war with China, the strengthening of the U.S. Dollar, and the tightening monetary policy of the Federal Reserve. As part of our research process and informed by our conversations with company management teams, we consider a variety of economic scenarios as well as specific sensitivities to tariffs, interest rates, and currency movements. We don’t make significant macro “bets”, but instead focus on constructing a portfolio of attractively-priced companies that have specific opportunities to improve their returns on invested capital and to reinvest in their businesses.
While we have been challenged to find compelling investment ideas in certain sub-sectors of our investible universe (e.g., portions of the Health Care and Information Technology sectors), we are still able to identify a compelling portfolio of stocks that fit our criteria. The market has experienced an uptick in volatility to start the fourth quarter, and, in the past, this has enabled our team to discover new, high conviction investment ideas. We believe increased volatility may also lead to a break in the momentum trade that has yielded unappealing valuations in the aforementioned sub-sectors. We look forward to the opportunities this may create.
Thank you for the opportunity you have afforded us to manage your account. Please don’t hesitate to reach out to us with any questions about our process or about Kennedy Capital Management.
Donald Cobin, CFA®
Chris McDonald, CFA®