Small Cap Value – Q2 2022 Commentary

US equity markets sold off sharply during the second quarter of 2022, with all major US equity indices declining double digits.  The Russell 2000 Value (R2V) Index fell 15.28%, outperforming the Russell 2000® Growth and S&P 500® indices, which declined 19.25% and 16.10%, respectively.  The Kennedy Capital Small Cap Value (SCV) composite declined 13.51% (Gross) and declined 13.70% (Net) during the quarter, outperforming the R2V.  For the rolling 12-month period, the SCV composite declined 10.57% (Gross) and declined 11.36% (Net), compared to the R2V’s decline of 16.28%.

Within the R2V, Communication Services and Consumer Discretionary were the two worst-performing sectors, down 30%, and 21%, respectively.  Consumer Staples and Utilities, which tend to be more defensive during market downturns, were the top performing sectors in the index, down 3.6% and 3.9%, respectively.  On a relative basis (vs the R2V), the best performing sectors in the SCV composite were Health Care and Consumer Discretionary.  On the downside, Financials (particularly regional banks) and Information Technology were the two worst-performing sectors on a relative basis.

Inflation remains the dominant theme driving markets this year.  The Consumer Price Index (CPI), a closely followed barometer of inflation, rose +8.6% year-over-year in May, the largest increase since 1981.  The Federal Reserve responded by raising short-term rates from 0.50% to 1.75% during the quarter and has signaled a more aggressive stance on future rate increases in order to quell inflationary pressures.  Longer term interest rate measures, such as the 10-year US treasury yield and the 30-year US fixed mortgage rate, have also moved meaningfully higher this year in response to rising inflation expectations and the impact from the Federal Reserve’s transition away from quantitative easing.  The combination of tightening financial conditions and the hit to consumer spending power from inflation has fueled concerns that the US economy is heading towards a recession.

We are not macroeconomic forecasters, but we do closely monitor how changes in the economic environment are impacting the fundamentals of the companies in our portfolio and the broader market.  In our view, inflation has two major impacts that require consideration:

1) Rising cost pressures, which negatively impacts the returns a company can generate.

2) Higher discount rates, which puts downward pressure on company valuations.

We believe our investment process gives us a leg up in this uncertain economic environment.  We focus on companies with competitive advantages that can maintain and/or improve their returns profile by leveraging pricing power.  Our disciplined approach to valuation helps us avoid overpaying for businesses and identify opportunities where market expectations are disconnected from underlying company fundamentals.

Much like we did during the early stages of the pandemic, we will continue to focus on the long-term, value-creating capacity of businesses as we look for investment opportunities. Often, times of increased uncertainty yield profitable investment opportunities.

We welcome the opportunity to discuss any questions or concerns you may have, and we thank you for the opportunity you have given us to manage your account.

Sincerely,

Frank Latuda, Jr., CFA®

Chief Investment Officer & Portfolio Manager

McAfee Burke, CFA®

Portfolio Manager

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