Small & Mid-Cap 3Q24 Market Review & Outlook: It Don't Come Easy

“It Don’t Come Easy”, released by ex-Beatle Ringo Starr in 1970, was a hit and still gets airtime today. Does the song owe its permanence to Ringo’s musical prowess or the inertia of Beatles magic? We’ll be generous and say it’s a little of both.  Regardless, the title aptly describes the stock market during the third quarter: while stocks posted solid gains point-to-point, there was considerable angst along the way.  The quarter began strongly, but stocks weakened as concerns arose that inflation might hinder the Fed's willingness to cut rates. Once inflation fears subsided, attention turned to the other side of the coin, the health of the labor market, further unsettling investors.  The labor market’s history of going from “ok” to “a little bit peaked” to “downright bad” in short order gave investors pause.  Alas, Jerome came to the rescue late in the quarter with a nice fat 50 bps rate cut, accompanied by commentary suggesting more cuts were forthcoming.  The balance of worry had flipped, and he made it clear his focus was firmly on the health of the labor market.  This olio of falling rates, a still-healthy economy and fading inflation provided a favorable environment for risk assets, especially so for small and mid-cap stocks.  We continue to see the potential for the market to broaden sustainably, which could push small and mid-caps to the forefront. In the meantime, we are pleased to see positive performance, notwithstanding the bumps along the way.

We’re only a few days into the fourth quarter, but the latest employment data was reassuring. Payroll numbers were strong, suggesting that a collapse in the labor markets is not imminent.  The strength, or rather the absence of apparent weakness in the labor market, could mean fewer near-term rate cuts, and yields logically moved higher on the news. But stocks did too, with good news being taken at face value, perhaps reflecting the current reality of decent growth, declining inflation and a supportive Fed.  Despite numerous concerns – such as escalating violence in the Middle East, ongoing hostilities in Russia/Ukraine, US elections, and US-China tensions just to name a few – the underlying positive conditions have enabled stocks to climb higher. Investors need to remain vigilant, and we continue to closely monitor both inflation and labor data. For now, markets are climbing numerous walls of worry.

SMCO Strategy Third Quarter Review

SMCO produced a positive +5.1% gross/5.0% net return for the third quarter.  We are pleased to have participated in the positive market action, although we lagged the overall small/mid space, with the Russell 2500 advancing by +8.8%. Despite the slight relative underperformance in Q3, SMCO remains firmly ahead on a year-to-date basis, up +15.0% gross/+14.6% net vs. the Russell 2500 Index +11.3%. Two bright spots for the portfolio during the third quarter were Dycom and Primoris, which underscore the strength in digital and physical infrastructure buildout.  Ciena, another big contributor, also benefits from digital infrastructure development.  Sprouts Farmer Market and Houlihan Lokey were two other top performers, with a differentiated model bearing fruit for Sprouts (no pun intended), and Houlihan trading higher due to their steady model profiting from ongoing restructuring work and a potential recovery in M&A.  However, there were drawbacks in the quarter, as cyclical conditions weighed on Entegris and MKS Instruments in the semiconductor equipment industry and Helmerich & Paine in the Energy sector.  In Consumer Staples, e.l.f. Beauty suffered due to slowing growth and a high valuation – a combination that is never favorable – prompting us to reduce our position significantly. We continue to hold the stock but at a much-reduced weight.  Lastly, Kyndryl declined after its Fiscal Q2 earnings report.  While we viewed the results and outlook as supportive of our investment thesis, they apparently fell short some investors’ expectation.  We took advantage of the weakness to increase our position size.

Trading activity increased from the very low levels of the second quarter but remained below 10%.  In addition to our typical resizing activities, we eliminated three names from the portfolio and added four new ones.  We sold Wolfspeed, RH, and Ulta Beauty due to fundamental concerns.  We added Planet Fitness, which we view as having good exposure to our "New Consumer" theme.  Moelis & Co., a boutique investment bank we have held in the past, was also added.  We believe the conditions are favorable for a pickup in M&A activity, making Moelis a good way to expand our exposure.  The last two additions, Independence Realty Trust and Pool Corp, provide exposure to specific aspects of housing. As more direct housing plays appear fully valued to us, we aim to be selective. Independence Realty’s exposure to improving apartment fundamentals in non-gateway cities and Pool Corp's combination of recurring services with potential new construction are appealing.  Importantly, we think both offer attractive risk/reward profiles based on improving fundamentals alongside potential revaluation.

Built to Last

The Grateful Dead may not be everyone’s cup of tea, but their cultural persistence is undeniable.  Thirty-five years ago, they released the album Built to Last.  On the surface, the title proved ironic – it would be the band’s last studio release. However, in another sense, "built to last" suitably describes their music, which has outlasted much of their contemporary’s music and is still enjoyed by fans across generations.  They created this enduring legacy by offering a unique take on rock music.  Although their music evolved over the years, they never strayed far from their core sound.  While sometimes out of step, they consistently returned to relevance.

Our investment approach shares similar characteristics: we employ a disciplined strategy but adapt to changing markets. There are times when our approach is not the most favored, but we adhere to our discipline. We believe it too is built to last, with a long-term focus as our overriding priority.

Jerry Garcia, the band’s leader, once quipped, “Our audience is like people who like licorice. Not everybody likes licorice, but the people who like licorice really like licorice.” The Dead created a distinctive sound that their fans could rely on. We like to think we are doing something similar in our domain: offering a consistent, proven approach to the small and mid-cap market. We aim for consistency and hope you enjoy our version of "licorice."

Thank you for your continued interest in SMCO.