SMID Cap Growth – Q1 2018 Commentary

“It is always wise to look ahead, but difficult to look further than you can see.”   

-Winston Churchill

Ten years into this economic cycle and Growth investing continues to flourish.  We get asked frequently how long this could last.  We struggle to give an answer with an exact timeline but encourage all our clients to understand what is happening is not an accident.  Growth scarcity has become a common component of this surge in performance.  There are less S&P 500® companies growing more than 15% than any time since 2000.  This growth is led by industries such as Software, Biotech, Industrial Automation, etc.  You don’t see the typical Value index heavy sectors such as Banks, Energy, and cyclical Industrials.  Taking this one step further, the recent Merger & Acquisitions inside Software and Biotech suggest the consolidation is not slowing down.  The valuations we have seen paid for what we call premium growth assets have skyrocketed further.  Meanwhile, the IPO market is heating up again and we see a decent pipeline emerging for the first time in a while.  Again, the next generation of leaders seems to be coming from Software/Information Technology and Biotech. Combining all these factors seems to make a nice neat theme but we struggle to provide a more definite timeline of when this all may change.  We fundamentally believe the Growth portion of the world is where you want to be for as far as we can see but we understand it’s difficult to see any further.

Performance

The KCM SMID Growth composite was up 0.83 (gross of fees) and 0.67% (net of fees) for the 1st quarter of 2018 underperforming the Russell 2500™ Growth Index benchmark, up 2.38%. For the quarter, Energy and Real Estate were our best performing sectors versus the benchmark. Our largest negative contributors were Consumer Discretionary, Industrials and Information Technology. Our largest overweights were Health Care and Consumer Discretionary while Financials and Industrials were our largest relative underweights.

As we look back upon on our last quarterly letter, we discussed the significant decrease in volatility for 2017 and our view that it was unlikely to continue.  Well, in the 1st quarter the VIX index moved from 9 to 39 and finished at 20 and with the daily discussion around Trade Wars and Tariffs we would expect the volatility spread to remain wide for the near term.  We continue to see high-sales growth companies outperforming, which is a theme that has carried over from 2017.  Meanwhile, the market has narrowed even further as only 4 sectors in the benchmark were up to start the year.   Information Technology (strong software participation), Health Care and Financials.  On the other end, the traditionally defensive sectors struggled as Utilities, Real Estate and Energy were the worst performers.  Overall, the Growth / Value spread has continued to widen at the end of 1st quarter with the Russell 2000® Growth at 2.3% versus the Russell 2000® Value at -2.6% (see chart below).  Cornerstone Macro recently suggested this is the longest span of Growth outperformance since the Great Depression.  We suggest this will continue as investors’ appetite for growth continues to increase and rates move higher.

Source:  FactSet Research Systems, Inc.

Market Outlook

This quarter’s Churchill quote reminded us of a letter from years ago based on a similar sentiment then espoused by Donald Rumsfeld regarding the unknown unknowns. Most of the time investors work to understand what they think they know and what they believe are the things they need to understand. A big part of risk involves the many items you don’t know exist but can affect the business. It’s a key reason we strive to build a diversified portfolio of businesses across the growth life cycle and in various sectors and industries. It’s also why we spend time and effort on understanding the macro factors at work as well as the business drivers of our companies. We know there is much to learn and that we will never know it all. Understanding how far you can see and how to view those changes is vital to our investment success. The investment world is not static and a successful investment process must be disciplined but not too rigid. As we look at the remainder of 2018 and beyond we see a continued appetite for growth investing, an active M&A market, a consistent flow of IPOs and an increase in volatility. We will continue to do what we have for over 10 years, search for businesses that can grow their capital, earn a rate of cash flow return and reinvest in the business.

Sincerely,

John Rackers

Portfolio Manager

 

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