SMID Cap Value – Q2 2018 Commentary
Equity markets remained volatile during the second quarter as tariffs and trade wars have increased global uncertainty. The increased volatility witnessed so far in the first half of 2018 stands in sharp contrast to the relatively non-volatile markets experienced in 2017. For the second quarter, the SMID Cap Value composite increased 2.1% (gross of fees) and 1.9% (net of fees) compared to the Russell 2500™ Value Index which increased 5.8%. Year-to-date, the composite has declined -1.2% (gross of fees) and -1.6% (net of fees) compared to an increase of 3.0% for the benchmark.
While generating positive absolute performance during the quarter, our portfolios did not fully capture some of the upside experienced in certain sectors of the market as breadth narrowed considerably. Additionally, our Energy holdings with exposure to the Permian basin also underperformed due to current production in the basin potentially exceeding near-term pipeline takeaway capacity. As a result, the Energy sector generated the weakest relative performance in the portfolios.
We are seeing some signs of increasing inflationary pressures, particularly with respect to raw materials. However, we believe these are largely consistent with economic growth at this stage. We do believe the Federal Reserve will continue to raise its target interest rate, using strong labor markets and supporting inflation data as continued justification, which does create the potential for some headwinds to valuations in a rising rate environment. Trade uncertainties can create additional noise for our analysts to filter, but we remain optimistic that recent battles over trade issues will ultimately be resolved without leading to material deterioration in corporate performance for our portfolio companies. We believe it will be important to identify companies with the ability to offset increasing costs of capital with improved corporate performance.
On balance, we do remain optimistic for the balance of the year. Overall, economic fundamentals continue to remain sound. Unemployment remains around 4%, capacity utilization continues to improve, and consumer confidence remains near post-recession highs. The stimulative effect of the recently enacted corporate tax cuts is only beginning to be reflected in corporate profits. While we are disappointed to have generated returns below our benchmark for the recent quarter and year-to-date periods, we remain confident that our process of identifying and investing in companies based on long-term returns on invested capital will create value for investors.
As always, we welcome any comments or questions you may have regarding Kennedy Capital Management or our investment process. We greatly appreciate the opportunity you have given us to manage your account.
Frank Latuda, Jr., CFA®
Gary Kauppila, CFA®
Assistant Portfolio Manager