A Letter from Tom Maher: Q3 2022 SMCO Review

In the 1992 movie “My Cousin Vinny” Joe Pesci’s character, Vinny Gambini, is the classic fish out of water.  In an early courtroom scene Judge Chamberlain, played by Fred Gwynne, admonishes Vinny for (among other things) his attire. The next day the judge, once again, is upset by Vinny’s outfit, and when reminded about the prior exchange, Vinny quips “Oh, you were serious about dat?” As I reviewed third quarter market action, this scene came to mind. Only in this version investors played the role of Vinny, and the long-suffering Jerome Powell is the judge. “My Cousin Jerome?” Maybe too much.

A Two-Phase Quarter

I do not mean to make light of the quarter一for investors it was about as much fun as a root canal.  The first half of the quarter was marked by a powerful, if not ridiculous, rise in equity markets. But then in mid-August stocks came falling back down, as reality reasserted itself. I find it instructive to think of the quarter in two distinct phases: Phase I being the summer rally and Phase II being the “Oh you were serious about dat” period. From the end of June through August 16^th, the market levitation that had begun late in Q2 accelerated, carrying the Russell 2500 an eye-popping 17.2% higher. The driver of this rally? The supposedly pending Fed “pivot.” During this phase, the market was also buoyed by feel-good messages like “the consumer is in great shape” and “the economy is incredibly resilient.” The economy, by most measures, did stay strong through the quarter, but ironically that fact made the belief in the “pivot”, the primary driver of the rally, even harder to comprehend. Nonetheless, investors enjoyed a recovery in stock prices, with small and mid-cap stocks participating. SMCO felt some of the love, appreciating +10.7%(gross)/+10.5%(net), but our defensive stance limited our gain. This rally was stronger for the more beaten down stocks which, until the rally kicked in, we were happy to have avoided.  

Phase II of the quarter was a lot less ebullient. Once the Fed made its intentions clear (for the umpteenth time, in language that couldn’t be misinterpreted as dovish), the market quickly returned to earth. The encounter with cold, hard reality led to a 17.1% drop in the Russell 2500. SMCO, down 15.6% (gross & net), regained some of the relative ground lost in Phase I, but not as much as we expected due to two specific issues. First, the utility sector, which rose “only” 10% in Phase I, got destroyed in Phase II, dropping 16%. True, other sectors were down more in Phase II, but we’re talking about utilities here. Best we can discern this was due to the acceleration in interest rate increases which weighed on the sector. Now that we are further into the hiking cycle, we believe the rate increases are mostly discounted in utility stock prices, so they should start to behave more defensively.  Our 6.9% weight in utilities (more than 2x the Russell 2500) did not serve the portfolio well in Q3.  

The other Phase II drag on the portfolio was healthcare. During Phase I, the healthcare sector ripped, fueled by the biotech stocks. We tend not to have exposure to biotech given our valuation discipline, but typically we regain relative performance when healthcare corrects, like in Phase II. But, alas, stock specific issues hit the portfolio late in the quarter. Catalent (an outsourced biopharma manufacturer) was hit hard, delivering wobbly earnings and a lower-than-expected outlook for their June 2023 fiscal year. Since June was the company’s fiscal year-end, they took the opportunity to guide 2023, earlier than most other companies. They guided below the street, which unsurprisingly led the stock lower. Needless to say we weren’t happy with disappointing guidance, but since most of the shortfall was due to an expected 2/3 drop in Covid-related work we see this as de-risking the outlook. We would be surprised if they are the last life-science/pharma related concern to have to lower the outlook, but Catalent took the bullet upfront while others are yet to confess. We view the disappointment as a temporary issue and continue to own the stock. Another healthcare drag was Azenta. Azenta recently split in half, sold its semi-related business and became a pureplay life science products & services provider. When they reported Q2 (during Q3) the results fell short, with lockdowns in China weighing on results. The company also provided a less than enthusiastic outlook. Yes, there has been slowness in China, and yes there are concerns about biotech funding, but we still see a lot of potential in Azenta’s business. Additionally, the proceeds from the semi business sale still sit on their balance sheet, resulting in a somewhat absurd situation where something near 2/3 of the company’s market cap is cash. Patience is required, but we believe the business should recover, and the over-capitalized balance may provide a lot of optionality.  

In sum we did not keep up with the rally in Phase I, and while we recouped some in Phase II we underperformed for the quarter. SMCO had a total return of -6.59%(gross)/-6.74%(net) versus the Russell 2500’s decline of 2.8%. All the underperformance was generated during the rally. We own our performance, and the Phase I & II discussion is intended to provide more insight on the results, not to explain them away. 

Zooming out: The Longer Term, Outlook and Positioning

We manage SMCO for the long term, looking to generate attractive risk adjusted returns over time.  Our disciplined approach also means we don’t chase short-term performance if we don’t see the right fundamental underpinnings. There will be periods of time where SMCO lags, and Q3 was such a time. And while SMCO lagged in Q3, it continues to be ahead of the index on a year-to-date basis, down -21.36%(gross)/-21.78%(net) vs a drawdown in the Russell 2500 of 24.03%. On a nine-month basis our top contributors have been some energy holdings (Coterrra, Helmerich & Payne, EQT Corp.), Mandiant (a takeout in the cybersecurity space), and Booz Allen Hamilton in the government services space. The detractors aside from Azenta and Catalent have been two real estate holdings (Digital Bridge and Innovative Industrial Properties) and Burlington Stores in the retail space.  Stepping back a little further, SMCO’s trailing twelve-month return of -15.04%(gross)/-15.64%(net) is even further ahead of the Russell 2500’s return of -21.11%. A 15% plus drawdown is nothing to be excited about, but 607 bps(gross)/547 bps(net) outperformance illustrates a level of success in our efforts to limit the downside in negative markets.

We enter the fourth quarter still in a defensive stance. During the third quarter we did make some changes, and while turnover picked up it was a still modest 8% for the quarter. On the sell side we eliminated one fundamental disappointment and had a takeout. The other sales were incremental trims to manage position sizes. These trims were in a variety of different sectors, but one notable area was energy where we have diligently sold back appreciation. On the buy side we added to a variety of existing positions where the risk/reward had improved. We also added some new names:  a few healthcare names, an industrial, and even some small starter positions in consumer-related names. 

Looking at the portfolio holistically, our 35% weight in cyclical stocks may seem inconsistent with our view, but it is not. The weighting in cyclicals is driven by holdings that will benefit from 5G, fiber,  and general infrastructure buildout. Some of these stocks will also benefit from “re-shoring”, though this likely is a longer-term consideration. These companies do indeed operate in cyclical industries, but multiple government spending bills, rural fiber initiatives, and the secular move to 5G all offer strong, and perhaps even recession resistant funding.

We carefully assess each rally, and though we are not yet convinced the tide has turned we will be ready to adjust when it is appropriate. Once we believe it makes sense to get more aggressive we expect to alter the complexion of SMCO in two ways. The first move will be to recalibrate the weights of stocks we already hold. Many of our larger positions are companies with recurring revenues and low volatility business models. We see these as solid long-term investments, so it’s unlikely we’d jettison them completely, but rather would cut them down in size to make room to increase the weight of more aggressive names currently held at lower weights. The second part of repositioning would be the injection of new names, likely in the areas of consumer, technology, and industrials. We’ve been busy working on what we see as quality stocks that have been discarded along with the junk during the bear market.  Some of these companies stumbled, but in other cases their shares are down simply because of their industry and/or because they had risen to unsustainable valuation levels. At times like this our valuation discipline can be helpful in finding babies that have been thrown out with the bath water.  

We see four critical items that will keep markets roiled: inflation, the Fed, macro concerns, and earnings estimates. Inflation has shown some signs of plateauing but remains stubbornly stuck at too-high levels. The Fed has made it clear it's willing to dampen growth (and jobs) to get inflation under control. We will see if it keeps its nerve, but those “hoping” for a pivot may want to be careful what they wish for. A pivot anytime soon might mean something has broken in the economy or markets, unlikely a positive development for equities. Any market pop fueled by a dovish change in Fed stance might burn off quickly once the attention turns to the state of the economy. The last two items, macro slowing and earnings estimates, are intertwined. Our base case is a slower economy, and even if we avoid recession current earnings expectations seem too rosy. We concede that Q2 results (and outlooks) weren’t as bad as feared, but we believe that may have been a temporary reprieve. Going forward, a challenging mix of slower revenue growth and still-high material, logistics, and labor costs is the likely scenario, in our opinion. Modest cuts have been made to 2023 (and 2024) earnings estimates, but we expect more to come. Without resolution to these issues we struggle to be more constructive on the market.

As always we remain vigilant.  

Please see this document, which contains full performance since inception and important disclosure information. Past performance is no guarantee and is not indicative of future results. All investments and strategies are subject to the risk of loss. All performance is preliminary and unaudited.

The information set forth in this article should not be construed as personalized investment advice. There is no guarantee that the views and opinions expressed in this article will come to pass. Investing in the markets involves gains and losses and may not be suitable for all investors. The information set forth in this article should not be considered a solicitation to buy or sell any security.