SMCO Recap and Q1 23 Markets: Achilles Last Stand?* (*With the market being Achilles in this scenario)

Led Zeppelin’s seventh studio album, Presence, was released on March 31, 1976. As I was organizing my thoughts for this letter that factoid came at me via various social media platforms (you should see what I follow). As improbable as it may seem, I see commonality between Zeppelin’s March 31, 1976 release and the quarter that ended March 31, 2023. Specifically, the ominously titled opening track, “Achilles Last Stand” sonically echoes the past three months of market action. How so? The hard driving track, clocking in at over ten minutes, is characterized by a furious barrage of multi-tracked guitar parts, accompanied by foreboding lyrics. To my ears that is the musical equivalent of the stock market over the last three months: a period marked by a torrent of contradictory data and exaggerated market moves. I did, however, add a question mark to the appropriated title - the song has an end but the market soldiers on. Was Q1 this market’s last stand or will it continue to rise? Has the Fed engineered the mythical “soft landing”, or will we live though a hard landing? Recently the even more appealing idea of a NO landing scenario has been bandied about. We would love to hang our hopes on a soft landing or better, but as we all know hope isn’t an investment strategy. If only it were.

Q1 opened on a positive note and closed on a positive note, but the time in between offered plenty of ups and downs. From January 1^st through early February equity markets galloped higher. The most beaten down stocks were among the biggest winners, but most stocks benefitted (Figure 1). The market’s powerful upward thrust caught many investors by surprise, and the “offsides” positioning provided fuel for the rally. FOMO was rampant, and “Oh good lord I’m gonna start the year way behind” led to chasing, which in turn pushed stocks higher still.

There were, however, reasons for concern: inflation was still running hot, the health of the economy was difficult to discern, and earnings estimates for the year remained stubbornly high. These concerns reasserted themselves in early February. But then some macro indicators started to strengthen, and then there was evidence inflation might be moderating. The remainder of February provided a hodgepodge of mixed data, and choppiness ensued. The Fed’s efforts to be transparent seemed to confuse more than clarify. As the quarter wore on things became increasingly opaque.

In early March, the markets had to contend with a new concern, namely two of the largest bank failures in recent history. The demise of Silicon Valley and Signature Bank alerted investors to trouble at some banks, and increased scrutiny on all banks. This wasn’t a credit problem like 2008, but rather duration mismatch coupled with poor balance sheet management. It appeared the Fed had finally “broken” something, and in response the market dropped back and stayed choppy, with investors flocking back to mega-cap tech for cover. Finally, in the last week of the quarter stocks moved sharply higher once again, driven by a burst of optimism we struggle to comprehend (Figure 2). It appears the market is anticipating decent macro conditions while simultaneously expecting rate cuts in the back half of the year. We can envision one or the other, but we struggle to see how (or why) both could happen at once. We would like to see acknowledgement of increasingly difficult macro conditions, which at the company level would result in a cut to earnings outlooks. Once this reset has occurred we believe stocks could move forward in a more durable fashion.

SMCO 1Q23 Review

SMCO portfolio performance echoed the small and mid-cap market, but with some notable differences. The portfolio rose with January’s optimism but limited exposure to beaten down stocks and beta meant smaller gains. Then, as the market churned with the concerns of February and early March, the portfolio closed nearly all the relative performance gap, getting to within 30bps of the Russell 2500 before last week’s upward burst pushed the index further ahead. We ended the quarter up 2.35% gross/2.18% net, lagging the Russell 2500 total return of +3.39% (Figure 3). We never like lagging, but being process driven we are not willing to simply chase what is working. We view investing as a marathon not a sprint, as such we are pleased to see that SMCO’s one year, three year and inception-to-date returns are all ahead of the index.

Dissecting our performance a little more closely: From a sector perspective our strongest positive contribution came from our Industrials, Technology and Staples holdings. Our biggest negatives were Energy, Communication Services and Financials. At a stock level our best performers were Elf Cosmetics, XPO Fitness, West Pharmaceuticals, Reliance Steel and Clean Harbors. We are encouraged to see contribution from a variety of sectors, with more than one part of the portfolio working. Our worst performers were Cullen Frost and Community Bancorp (our only bank exposure), Helmerich & Payne and Chicken Soup For the Soul.

Our positioning has not changed dramatically since year-end. Turnover for the quarter was just over 12%, and as usual many of our trades were trims designed to manage risk exposures. We did eliminate two positions (American Waterworks and Chicken Soup for the Soul Entertainment) and added two new names to the portfolio (West Pharmaceuticals and Entegris). We continue to be somewhat defensive, and while our quality bias was a relative drag during the January rally it continues to serve us well longer-term. We remain vigilant and will pivot more aggressively if we see developments supporting such a move. Otherwise we will continue as we are. Put differently, should Q1 prove to be Achilles (aka the market’s) last stand we are prepared to protect the downside. If on the other hand conditions improve we will act to capitalize on a more risk-on scenario. We already own stocks that we believe would benefit, and our first move would be to increase their weight within the portfolio. Additionally we are actively researching new names that could provide exposure in different, more constructive market conditions.

We appreciate your continued support and interest in SMCO. If you have any questions or comments please don’t hesitate to reach out.