Small Cap Growth – Q2 2023 Commentary
U.S. equity markets shook off the brief “banking crisis” and a lackluster earnings reporting period to continue their march toward recovery, ending the half closing in on early 2022 highs with growth stocks outperforming in both large and small caps. This positive development unfolded as each subsequent month’s macro-economic data reports showed the rate of inflation subsiding (largely as expected, but good news nonetheless) while employment levels and total consumer spending remain strong (better than expected). In addition, Nvidia sparked excitement within the technology sector with early proof of strong investments in artificial intelligence (AI) capabilities. With long- term rates moving sideways since their peak last October and improved equity valuations, the market now appears to be forecasting that a “goldilocks” scenario is indeed possible this time; in other words, inflation can be tamed without breaking the economy. If that is the case, we can expect the Fed Funds rate to peak soon while avoiding a full-blown recession. As with everything, time will tell if this is correct, but it certainly is possible given all the unusual comparisons due to COVID, government stimulus, and extremely low interest rates. Employment levels remain the key macro datapoint that we are tracking to evaluate this outcome.
While there were positive returns across all market caps and styles in U.S. equity markets in Q2, the areas of outperformance were actually quite narrow. In large caps, as represented by the S&P 500® (SPX), the newly monikered “magnificent 7” (i.e. Apple, Microsoft, Alphabet, Amazon, Nvidia, Tesla, and Meta Holdings) drove more than half of the gains and all the outperformance of that index vs. the rest of the market (Q2 gains for SPX +8.7% vs. SPX excluding the “magnificent 7” at +4.1% and the Russell 2000® +5.2%). Likewise, in small caps the Russell 2000® Growth Index’s return of +7.1% outperformed the Russell 2000® Index (+5.2%) & the Russell 2000® Value Index (+3.2%) due to just three industry sub-groups (Biotechnology, Technology Hardware & Equipment, and Transports) representing a mere 15% of the index that were all up a very strong 18.7% combined. Excluding these three groups, the remaining 85% of the Russell 2000® Growth Index was up +4.3%. Factor analysis on the Russell 2000® Growth Index also showed that several low-quality factors outperformed meaningfully, including companies that are unprofitable and/or highly shorted. Typically, these types of narrow markets are difficult environments for active managers to outperform and that proved to be the case in Q2. And unfortunately, we did not fare any better. Our quality bias (higher ROIC) and structural underweight of biotechnology were headwinds. In addition, we did not anticipate the excitement around potential AI investment spending and thus did not benefit from that thematic stock trend.
The KCM Small Cap Growth (SCG) composite increased +4.92% (gross of fees) and +4.76% (net of fees) for the 2nd quarter of 2023, underperforming the Russell 2000® Growth (R2G) Index, which increased +7.05%, by -213 bps (gross of fees) and -229 bps (net of fees). Year-to-date, the KCM SCG composite increased +12.43% (gross of fees) and +12.03% (net of fees), underperforming the Russell 2000® Growth (R2G) Index, which increased +13.55%, by -112 bps (gross of fees) and -152 bps (net of fees). Additional performance information is included in the table below.
Data as of 6/30/2023
On a relative basis, Communication Services and Consumer Staples were the best-performing sectors versus the benchmark. The strength in Communication Services was led by a provider of technology solutions that automates the purchase and sale of digital advertising inventory with a leading position in connected TV. The company has been impacted by the cyclical decline in advertising spending over the past year, but continued to execute on their platform integration and rollout of new products and is gaining share. The Consumer Staples result was again led by a provider of branded, affordable cosmetic and skin-care products that has continued to demonstrate strong sales momentum primarily due to the launch of new products and brands. The company has also been successful in increasing prices, which is benefiting margins as supply chain cost pressures ease.
Our largest detractors to relative performance for the quarter were Information Technology and Health Care. The poor performance in Information Technology was primarily due to the Technology Hardware & Equipment subsector and a combination of both what we didn’t own performing strongly (i.e., several AI investment beneficiaries) and absolute weakness in our owned names. In particular a provider of optical networking solutions, saw its stock decline on a weaker Q2 outlook due to order timing and generally softer customer spending, despite reiterating their expectations for a stronger H2 rebound and their multi-year targets. Skepticism remains over whether they are really gaining market share with their 800 MHz product rollout or if last year’s gains were simply short-term due to a competitor’s supply constraints. The next couple of quarters will provide critical evidence for that thesis. Within Health Care, Biotechnology was the worst-performing industry. The Biotechnology industry in the R2G increased +18.5% in the quarter and was one of the best-performing segments of the index. Since we are structurally underweight Biotechnology, the strong index performance was a headwind during the period. In addition, a contract manufacturer for clinical and commercial biologics underperformed due to a bookings slowdown in early-stage clinical trial work. We believe these headwinds are short-term and continue to hold the position.
We continue to be incrementally constructive on equity markets and expect that the positive performance will broaden out as/if the macro-economic backdrop stabilizes. That said, we are mindful that overall markets have come a long way back already and near-term valuations are no longer particularly cheap. That puts more of the risk on earnings execution. We believe that our strategy of investing in companies with higher CFROIs (cash flow return on investment) and higher asset growth (i.e., re-investment opportunities) will mean that they are better positioned to deliver on earnings growth expectations over the next year or two. In the short-term relative performance is much harder to predict, but assuming our companies can execute against their growth opportunities, we believe this should be a recipe for longer-term outperformance.
Thank you for your continued confidence in the Kennedy Capital team. Should you have any additional questions, please do not hesitate to contact us.
|Jean Barnard, CFA®
|Ryan Dunnegan, CPA
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The Small Cap Growth Composite invests in growth securities of predominately small companies that generally have a market capitalization that is reflective of the Russell 2000® Growth Index. The Manager seeks companies with durable business models able to deploy assets into growing sets of opportunities providing superior rates of return. For comparison purposes the composite is measured against the Russell 2000® Growth Index. The U.S. Dollar is the currency used to express performance.
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The Russell 2000® Growth Index measures the performance of the small-cap growth segment of the U.S. equity universe. It includes those Russell 2000® companies with relatively higher price-to-book ratios, higher I/B/E/S forecast medium term (2 year) growth and higher sales per share historical growth (5 year). The Russell 2000® Growth Index is constructed to provide comprehensive and unbiased barometer for the small-cap growth segment. The Index is completely reconstituted annually to ensure new and growing equities are included and that the represented companies continue to reflect growth characteristics.
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