SMID Cap Value – Q3 2018 Commentary
Equity markets continued to produce gains during the 3rd quarter with all major US equity indices generating positive returns. During the 3rd quarter, the SMID Cap Value composite declined -0.41% (gross of fees) and -0.58% (net of fees) while the Russell 2500™ Value index increased 2.67%. Year-to-date, the SMID Cap Value composite has declined -1.62% (gross of fees) and -2.14% (net of fees) compared to the Russell 2500™ Value benchmark which is up 5.75%.
This year has proven to be one of the most challenging years we have experienced from a relative performance basis. We have not fully captured the upside present in pockets of the market where growth has continued to outperform value. This has been particularly acute in the Industrials and Consumer Discretionary sectors where concerns over cyclicality have overwhelmed strong corporate performance for many of our holdings. Of note, many of the worst contributors to relative performance for the portfolios have seen expectations for 2019 earnings increase year-to-date, yet have declined in price by more than 20%. It appears that for many companies, the market is pricing in expectations for a recession in 2019. However, the risk of an imminent recession still appears quite low to us. The current economic picture in the U.S. is still relatively strong with business optimism at record highs, unemployment at 40 year lows, and consumer confidence also at high levels. Consumer debt service costs ratio to disposable income is at a 30 year low with delinquencies at record lows as well. Corporate access to credit still appears reasonable as spreads for Baa bonds (lowest Moody’s investment grade) relative to 10 year treasuries have remained stable.
The value of an asset is ultimately determined by the future cash-flows it will generate, discounted back to a present value. Future cash-flows are a function of capital invested, both present and future, and the returns generated on the base of invested capital. In analyzing companies, we seek to identify those that we believe will create value for shareholders through effective deployment of capital. Historically, if our analysis proves correct, these companies do grow in value and typically outperform their peers. Unfortunately, value creation does not always transfer to stock price appreciation in a predictable time frame.
The Federal Reserve has begun the process of slowly shrinking its $4.5 trillion balance sheet that it accumulated as a result of the unprecedented quantitative easing program in response to the 2009 financial crisis. For perspective, the Federal Reserve assets were less than $1 trillion before the massive injections of liquidity through bond purchases swelled the amount to $4.5 trillion. In addition, the Federal Reserve has continued on the path of raising its target for short-term interest rates based upon the strength of the labor markets and the return of 2% inflation. We have been discussing for some time, the potential for rising interest rates to increase investor discount rates, thus pressuring equity valuations. We believe the corporate tax cuts earlier this year have so far provided an offset to the modestly tightening monetary policy.
Looking forward to the balance of the year, we think some volatility is likely as financial markets assess the path to a normalization of interest rates. Trade tensions, particularly with China, continue to create uncertainties with regard to supply chains and global demand. Despite the fact we have lagged in fully capturing the market’s upside this year, we will remain focused on identifying companies that we believe are likely to create long-term value for shareholders through efficient deployment of capital.
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 portfolio.
Frank Latuda, Jr., CFA®
Chief Investment Officer & Portfolio Manager
Gary Kauppila, CFA®
Assistant Portfolio Manager