In the wake of recent market turbulence, including an abrupt broadening of market leadership, Tom Maher, Hilton’s veteran Small and Mid Cap Opportunities (SMCO) portfolio manager, provides expert analysis on the challenges and opportunities facing investors.
In this exclusive interview, Maher discusses recent market activity, the impacts on small and mid-cap markets, and what investors can expect from SMCO going forward.
Q: How would you characterize the state of the small and mid-cap (SMID) markets these days?
Tom Maher (TM): If we look back at the first half of 2024, we saw a SMID market primarily driven by fundamentals. It was very much a company-by-company story—if a business was executing well, its stock performed well. The market was making clear distinctions between strong performers and those that were struggling.
That changed in July. The macro influence took hold in the SMID space, with outsized swings in direction from day to day. There’s been a whipsaw effect as the prevailing Fed narrative has ping-ponged from a “soft landing” to recession and back again. Investors were trying to find the signal in the noise.
Q: Why is this happening?
TM: In part, the market has been impacted by the pullback from the massive AI trade, which was largely dominated by the "Magnificent 7" tech giants (Alphabet一Google, Amazon, Apple, Meta, Microsoft, Nvidia, and Tesla). When optimism around a soft landing grew, we witnessed a rotation where investors reallocated funds from these large-cap tech stocks into the small and mid-cap space一where companies are natural beneficiaries of lower borrowing costs and a favorable economic outlook.
The AI unwind served as a real shot across the bow, a wake-up call for investors to reconsider concentration risk in their portfolios. Recently, the tech giants have rebounded, but the episode lingers in investors’ minds. If nothing else, it has investors thinking about diversifying their bets.
Another contributor to volatility is the election. It's difficult to predict, but its impact is undeniable. We've seen dramatic swings, from the "Trump trade" with investors bullish on industrials, construction, and manufacturing to the emergence of the revamped Democratic ticket and possible implications.
Q: What is Hilton’s view on potential Fed action?
TM: For now, our view is that the Fed may be a little late, but rate cuts are on the way. The economy is slowing, but not tipping into recession—at least not yet. This puts us in the soft landing camp, and provides a backdrop in which select small and mid-cap stocks can perform.
Q: Does this scenario favor a particular SMCO company profile?
TM: Yes. We don’t think rates will return to the historically low levels of the last decade plus. The cost of capital will be higher, so you’ll want to own companies that can self-fund, not burdened by excess debt that could complicate future access to capital.
We believe this environment is favorable for us because our process is grounded in disciplined stock selection with a strong focus on quality and execution.
Q: What about relative sector performance? How do you see that unfolding?
TM: After an economic reset (usually a recession or slowdown followed by reacceleration), small cap typically outperforms. Early cycle cyclicals, such as machinery, financials, and selected consumer areas, often deliver good performance during this period.
I don’t think we’ve had that reset yet; we’re in the late phases of the economic cycle. But the good news for SMID is there appears to be a few areas holding up quite well anyway.
In the short run, consumer demand, while still strong, is showing signs of stress. Consumers are still spending but are more focused on value. So value-focused retailers, such as BJs, is an area we like, which we think could hold up regardless of whether the economy continues to slow.
Within financials, banks are also an area to consider. With rate declines, a bank’s cost of funds will improve, boosting its net interest margin (essentially the spread between the interest it earns on loans and what it pays on deposits). There’s no question some of the stocks have started to anticipate this dynamic.
But you have to be selective. If the economy is slowing down, loan growth may be harder to come by. You have to identify names positioned to be ahead of market growth, maybe by region, for example.
There may also be banks with bad loans on the books from the ongoing decline in commercial real estate. In our view, banks with more conservative or strict credit cultures are better choices.
In the medium term, over the next six to nine months, we think mergers and acquisitions (M&A) could be interesting. Since mid-2022, the sector has largely been dormant, but there are signs it could pick up. In private equity, there’s a strong demand for liquidity events to close out old funds, and newer money looking to be put to work. Also, if the economy continues to slow, companies may seek to acquire growth to supplement organic growth.
Q: What about over the longer term?
TM: In the long run, we find the infrastructure sector particularly compelling, especially with the support of the IRA (Inflation Reduction Act) and the IIJA (Infrastructure Investment and Jobs Act). These laws will likely remain in place regardless of changes in the White House, driving growth in industrials, engineering, construction, and materials. Add to that reshoring一if that occurs and more semiconductor plants are built domestically一these sectors should continue to prosper.
Q: What are earnings telling us?
TM: For several quarters coming out of the pandemic, companies enjoyed strong price gains but, in some cases, less volume. This enabled strong revenue growth and margin expansion as well.
Then, over the last few quarters, we saw pricing power ebb, but volume growth picked up as economic activity normalized. Now, with inflation declining, the ability to drive growth via price has largely evaporated. The true “value-add companies” will be able to hold price, or even garner some modest hikes, but growth from here will require genuine volume growth. We welcome this development, as it again should highlight the true outperformers.
Q: Finally, how do these themes come together in the SMCO portfolio?
TM: Despite the recent volatility, we haven’t made a lot of changes in the SMCO portfolio一largely because our medium to long-term outlook (six to 12 months) remains unchanged. Instead, we use market chop opportunistically to make adjustments.
If we have a stock we think is reaching the top of the wave as investors are repositioning, we may take that position down. We’ll take advantage of what we think is a spike in the stock price to lower the position weight. Conversely, if there are names we feel are getting unfairly punished, those can be opportunities to add to the portfolio.
In short, we try to capitalize on short-term opportunities during market repositioning, leveraging volatility to enhance our portfolio with favorable entry and exit points, which are crucial for long-term gains.
That said, we think the recent massive selloff, despite some recovery, served as a clear wake-up call. When the market becomes too concentrated, it tends to break, and that money has to find a new home.
As mentioned, we’re in the soft-landing camp, at least more so than a recession. The challenge is that a hard landing can look a lot like a soft landing that keeps on going. So, we remain vigilant.
For the moment, we believe things look pretty encouraging. We don’t see a hard stop to business activity that would cause more concern. As always, we’ll remain disciplined in our approach and will reassess as things unfold.
