SMID 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 2500™ Value (R25V) Index fell 15.39%, outperforming the Russell 2500™ Growth and S&P® 500 indices, which declined 19.55% and 16.10%, respectively.  The Kennedy Capital SMID Cap Value (SMCV) composite declined 14.63% (Gross) and declined 14.79% (Net) during the quarter, outperforming the R25V.  For the rolling 12-month period, the SMCV composite declined 10.46% (Gross) and declined 11.15% (Net), compared to the R25V’s decline of 13.19%.

Within the R25V, Communication Services and Materials were the two worst performing sectors, down 25% and 22%, respectively.  Utilities and Consumer Staples, which tend to be more defensive during market downturns, were the top performing sectors in the index, down 4% and 8%, respectively.  On a relative basis (vs. the R25V), the best performing sectors in the SCV composite were Consumer Discretionary and Energy.  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® (CIO) & McAfee Burke, CFA®

Portfolio Managers

Gary Kauppila, CFA®

Assistant Portfolio Manager

Please click here for Important Disclosures.

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