SMID Cap Growth – Q2 2024 Commentary

Broadly speaking, growing macro-economic concerns led to a further widening of the performance gap between large cap vs. small cap equity markets in the quarter, with the S&P 500® Index +4.3% (+15.3% YTD) vs. the Russell 2000® Index -3.3% (+1.7% YTD). This was largely a response to higher-than-expected monthly inflation data, which drove a back-up in longer-term interest rates, and an increasing number of weaker corporate earnings outlooks in the face of slowing demand for discretionary items and general economic uncertainty. Under the covers, the reality was even more binary, with investors rewarding the earnings growth of just a handful of mega-cap companies that are benefitting from transformative investments in AI infrastructure, and pivoting away from anything smaller, cyclical, and/or loss-making where the near-term earnings have greater risk. To some degree, this makes sense (earnings drive value); however, the delta in valuations is also at historical extremes, so the key question becomes, at what point is this near-term difference fully priced in? And are there more opportunities within the broader market to identify individual companies whose multi-year potential is being ignored today? We think so. And we spend all our time identifying and compiling a diversified portfolio of these companies. But it is also highly likely that the next couple of quarters will continue to be volatile and driven by the “directional sentiment” of monthly inflation data and political election outcomes. Inflation is the most important macro factor right now because it will determine whether the Federal Reserve will be able to reduce rates in the face of deteriorating economic growth. If they cannot, then there is risk of a harder landing than current expectations. If they can, then we have likely seen the low for GDP growth. As a result, we expect that equity markets will remain highly sensitive to these short-term data points.

Performance:

The KCM SMID Cap Growth (SMIDG) composite decreased -3.54% (gross of fees) and -3.71% (net of fees) for the second quarter of 2023, outperforming the Russell 2500™ Growth (R25G) Index, which decreased -4.22% — an outperformance by 68 bps (gross of fees) and 51 bps (net of fees). Year-to-date the KCM SMIDG composite increased 4.90%% (gross of fees) and 4.55% (net of fees), outperforming the R25G Index, which increased 3.93%, by 97 bps (gross of fees) and 62 bps (net of fees).  Additional performance information included in the table below.

Data as of 6/30/2024

On a relative basis Information Technology and Financials were the best-performing sectors versus the benchmark. The strength in Information Technology was led by a manufacturer of security products. The company continued to execute toward structurally higher margins with the most recent quarter showing an acceleration of the recurring revenue growth (led by fire radios) and an improving hardware equipment mix, as the higher-margin locking products benefit from strong demand. We are pleased to see them executing on the potential identified by our original thesis. The outperformance in Financials was led by a provider of payment processing solutions. The company continues to execute positively on their growth strategy, and the stock has recovered since announcing last quarter that they would remain public and not accept any of the potential buyout offers received. We continue to believe the stand-alone potential value creation remains attractive.

Our largest detractors to relative performance for the quarter were Health Care and Consumer Staples. Within Health Care, the inferior performance was led by a provider of clinical research outsourcing services to pharmaceutical and biotechnology companies. Shares underperformed following the report of a weak quarterly book-to-bill ratio. Although this was incrementally disappointing, we believe the shares have overreacted to this short-term situation, and the company has ample opportunity in the next several years to meaningfully improve its market share and margin structure as they execute on a number of strategic initiatives following a spin-off from its former parent. The underperformance within Consumer Staples was due to a distributor of food products. A weak start to the year for overall restaurant traffic was a drag on their most recent quarterly results, and despite rebounding since, concerns remain regarding the health of the consumer. We recognize this risk, but expect the company to see offsetting market share gains from ramping new business wins and consolidating the c-store channel.

For the year-to-date period, relative performance was strongest in the top-performing sectors of Financials and Communication Services. Health Care and Information Technology were the largest detractors to performance.

Outlook:

The macroeconomic environment has reached a pivotal stage, with the path of this unique business cycle still not yet fully determined. Investors remain highly sensitive to inflation data and the implications for interest rates. We have been noting this for the better part of the past year, and it remains true today. The difference now is we have reached the stage where economic growth is anemic and a broad earnings recovery will not be possible until we get the stimulus of loosening capital (i.e., rate cuts). We continue to expect this will be the next stage, but the exact timing and magnitude remains in question. Against this backdrop, we are seeing attractive valuations in small caps and firmly believe our focus on a company’s growth potential over a longer time horizon remains an advantage in these periods of heightened volatility.

Thank you for your continued confidence in the Kennedy Capital team. Should you have any additional questions, please do not hesitate to contact us.

Sincerely,

Portfolio Manager

Assistant Portfolio Managers

Important Disclosures

Kennedy Capital Management LLC (“KCM”) is a Delaware limited liability company headquartered in Missouri.  KCM is registered as an investment adviser with the Securities and Exchange Commission under the Investment Advisers Act of 1940. Registration with the SEC does not imply any level of skill or training. Clients of the Firm include U.S. corporations, pension and profit sharing funds, colleges and universities, trusts, not-for-profit organizations, foundations, and individuals. KCM claims compliance with the Global Investment Performance Standards (GIPS®). GIPS® is a registered trademark of CFA Institute. CFA Institute does not endorse or promote this organization, nor does it warrant the accuracy or quality of the content contained herein. GIPS® are a set of standardized, industry-wide ethical principles that provide investment firms with guidance on calculating and reporting their investment results to prospective clients to ensure fair representation and full disclosure of an investment firm’s performance history.

Although the statements of fact and data in this report have been obtained from, and are based upon, sources that the Firm believes to be reliable, we do not guarantee their accuracy, and any such information may be incomplete or condensed. All opinions included in this report constitute the Firm’s judgment as of the date of this report and are subject to change without notice. This report is for informational purposes only and is not intended as an offer or solicitation with respect to the purchase or sale of any security. A complete list of all securities recommended by KCM in the preceding year, a full compliant GIPS Composite Report, and the list of composite descriptions are available upon request from KCM at 10829 Olive Blvd., Suite 100. St. Louis, MO, 63141.

The SMID Cap Growth Composite invests in growth securities of predominately small and mid cap companies that generally have a market capitalization that is reflective of the Russell 2500™ 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 2500™ Growth Index. The U.S. Dollar is the currency used to express performance.

Composite specific data provided within this presentation has been calculated from accounts that are discretionary as defined in this paragraph. The assets shown are derived only from discretionary accounts. Non-discretionary accounts, as defined by KCM, are accounts that are not included in the composite due to one or any combination of the following criteria: there were significant cash inflows or outflows within the account; the account’s asset level did not meet the minimum requirement to remain in the composite; the account assets are managed by others using our non-discretionary model. The temporary removal of such an account occurs at the beginning of the month and the account re-enters the composite the month after the criteria has been met.

Performance returns are presented gross and net of investment advisory fees and include the reinvestment of all income. Gross of fee returns reflect the deduction of transaction costs and custodian fees but do not reflect the deduction of investment advisory fees. Net of fee performance is calculated using gross returns less the actual applicable annual management fee applied monthly. Past performance is not indicative of future results. A client’s return will be reduced by the advisory fees as described in Form ADV Part 2A and other expenses incurred by the account. For example, an annual advisory fee of 1% compounded quarterly over 10 years will reduce a gross 14.44% annual return to a net 13.32% annual return. Form ADV Part 2A is available upon request.

The performance figures reported herein are unaudited, may be based upon information obtained via electronic data sources (”feeds”) and may be subject to change. Data feeds from many of KCM clients’ selected custodians are obtained through third party sources, and are used to compare custodial data to KCM’s client account records as frequently as daily. Monthly, KCM reviews clients’ account holdings along with cash and share quantities against the custodial statements. In some instances, variances may exist between final audited custodial information and the information KCM obtains via such data feeds. Generally, any such variances are researched and reconciled within thirty days of the period end.

The information provided should not be considered a recommendation to purchase or sell any particular security. There is no assurance that any securities discussed herein will remain in a KCM portfolio at the time you receive this letter or that securities sold have not been repurchased. Allocations among industries, sectors and securities may vary and are subject to change without notice. Any securities discussed do not represent an account’s entire portfolio and, in the aggregate, may represent only a small percentage of an account’s portfolio holdings. It should not be assumed that any of the industry or sector allocation decisions mentioned, or securities transactions or holdings discussed were or will be profitable, or that the investment recommendations or decisions we make in the future will be profitable or will equal the investment performance of the securities discussed herein.

Sector Weightings are subject to change at any time.  Sectors are based on the Global Industry Classification Standard (“GICS”) classification scheme and are measured as a percentage of the total composite in terms of asset value as of the date indicated above.  Individual client portfolios may be different based on variations in security purchase price and date, and individual client restrictions.  Due to rounding, Sector Weighting’s total percentages my not equal 100%.

GICS was developed by and is the exclusive property and a service mark of Morgan Stanley Capital International, Inc. (”MSCI”) and Standard & Poor’s, a division of The McGraw-Hill Companies, Inc. (”S&P”) and is licensed for the use by KCM. Neither MSCI, S&P, nor any other party involved in making or compiling the GICS or any GICS classifications makes any express or implied warranties or representations with respect to such standard or classification (or the results thereof),and all such parties hereby expressly disclaim all warranties of originality, accuracy, completeness, merchantability, and fitness for a particular purpose with respect to any of such standard or classification. Without limiting any of the foregoing, in no event shall MSCI, S&P, any of their affiliates or any third party involved in making or compiling the GICS or any GICS classifications have any liability for any direct, indirect, special, punitive, consequential or any other damages (including lost profits) even if notified of the possibility of such damages.

Allocations to various assets classes change over time and deviate from any stated or targeted percentages of a total portfolio as a result of market conditions and reallocation decisions. Therefore, nothing herein reflects a static portfolio allocation that will remain the same or match stated target allocations of asset classes.

Russell Investment Group is the source and owner of the Russell Index data contained or reflected in this material and all trademarks and copyrights related thereto.  The presentation may contain confidential information and unauthorized use, disclosure, copying, dissemination or redistribution is strictly prohibited.  This is a presentation of Kennedy Capital Management.  Russell Investment Group is not responsible for the formatting or configuration of this material or for any inaccuracy in Kennedy Capital Management’s presentation thereof.   

The Russell 2500™ Growth Index measures the performance of the small to mid-cap growth segment of the U.S. equity universe. It includes those Russell 2500™ 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 2500™ Growth Index is constructed to provide a comprehensive and unbiased barometer of the small to mid-cap growth market. The Index is completely reconstituted annually to ensure larger stocks do not distort the performance and characteristics of the true small to mid-cap opportunity set and that the represented companies continue to reflect growth characteristics.

The Russell 2500™ Growth Index is used as the benchmark.  The Index is unmanaged and represents total returns including reinvestment of dividends.  The benchmark is used for comparative purposes only and generally reflects the comparable risk or investment style of the Firm’s strategy.  The investment portfolios underlying the Index are different from the investments in the portfolios managed by the Firm.  Certain accounts may also use other benchmarks not listed in the GIPS composite report. The Verification and Performance Examination Report does not cover the benchmark returns included in the GIPS composite report.  Investors cannot invest directly in an Index.