SMID Cap Value – Q1 2018 Commentary
The first quarter of 2018 brought a return of volatility to equity markets, and delivered negative returns for the Russell 2500™ Value Index for the first time in the past 10 quarters. For the quarter, the KCM SMID Cap Value Composite declined -3.22% (gross of fees) and -3.39% (net of fees) compared to a decline of -2.65% for our benchmark, the Russell 2500™ Value Index. Health Care, Financials, and Information Technology were the only sectors to deliver positive absolute returns for the benchmark sectors.
The threat of tariffs and trade wars weighed heavily on many names in the portfolio during the quarter, in particular our companies exposed to the Recreational Vehicle (RV) industry. RVs use a lot of steel and aluminum, and fears of higher prices due to tariffs scared many investors in our opinion. Those companies contributed to the Consumer Discretionary sector being our weakest in both absolute and relative performance. Information Technology and Health Care provided both absolute and relative positive returns for the portfolio.
As we ended 2017, economic fundamentals suggested a continuation of the modest growth that has characterized the slow but steady economic expansion over the past 8 years. Initial data released through the first quarter has been supportive of continued growth expectations. The stimulative effect of the corporate tax cuts has led to increases in analyst estimates for corporate earnings, and the Federal Reserve has incorporated growth expectations into a basis for an additional increase to the target Fed Funds rate.
So why have equity markets broken their steady trend higher? We believe recent action in equity markets is directly explainable by an increase in the discount rate investors are applying to future corporate cash flows. While corporate fundamentals appear to remain quite sound, increasing risk and uncertainty has led to an increase in discount rates, resulting in a quarterly loss for most equity indices. In our last letter, we discussed the “numerator effect” of fiscal stimulus on corporate cash flows, as well as the “denominator effect” of the potential for higher discount rates due to factors such as risk or inflation. While subtle signs of increases in the rate of inflation have begun to appear, we believe the primary factor has been an increase in risk due to increased rhetoric concerning tariffs and trade wars.
We are optimistic that trade tensions will ultimately subside. However, the reaction of equity markets to increases in perceived risk does illustrate the potential impact of increasing discount rates on equity returns. We have talked at length of the tailwind investors have enjoyed as discount rates continued to fall, all of which were consistent with a low interest rate environment where potential returns from other investment options were historically low, and volatility was minimal. With the end of quantitative easing bond purchases by the Federal Reserve and ultimately a shrinking of its balance sheet, we believe company specific fundamentals will play an increasing role in differentiating equity performance. We believe such an environment will reward bottom up stock picking more so than the liquidity driven markets we have witnessed since the beginning of quantitative easing. We believe corporate performance generally remains solid and reflective of a stable economic backdrop. Our analysts will continue to focus our research on companies with the ability to generate superior returns on invested capital coupled with the ability to reinvest earnings back into their business. We remain confident that these companies will continue to create long-term value for shareholders.
We thank you for the confidence you have placed in Kennedy Capital Management, Inc., and we sincerely appreciate the opportunity to manage your account. As always, I welcome any questions or comments you may have for us.
Frank Latuda, Jr., CFA®
Gary Kauppila, CFA®
Assistant Portfolio Manager