Performance
For the quarter ended September 30, 2021, the Small-Mid Cap Value Strategy fell -2.20% gross (-2.41% net of fees) compared with a -2.07% decline for the Russell 2500 Value Index. For the year-to-date period, the Strategy gained 20.37% gross (19.64% net) compared to a 20.14% increase for the benchmark.
Macroeconomic Review
The portfolio demonstrated solid gains across many of its equity holdings during the quarter as the U.S. economy continued its robust growth trajectory. After declining nearly 20% in the first quarter of 2020, the market (as measured by the S&P 500 Index) went up five quarters in a row with the smallest quarterly gain being 6.2% and a cumulative gain of 70%. That is the best five-quarter gain in more than forty years. Small-cap and mid-cap stocks did even better. The style indices were mixed as Value outperformed in small-cap but lagged in the large- and mid-cap indices.
As the economy has rebounded from its pandemic lows, so have corporate earnings: Total pretax profits have surged $0.84 trillion from the lows of 2020 and now stand 17% above their pre-pandemic high. Moreover, corporate profits are estimated to grow another 7% in 2022, fueling capex spend as domestic manufacturers scramble to rebuild supply chains amidst component shortages, lean inventory and surging consumer demand.
- Peak Growth - Some commentators express concern about a slowing of year-over-year economic and earnings growth. The US economy su ered a steep contraction in the second quarter of 2020 and began to recover in the third quarter. Recent quarters of year-over-year growth have baselines that are significantly depressed. A more important question is whether we will see as much growth as we currently expect. We believe that the risk to the economy appears to be more on the supply side than the demand side. Many press reports, company presentations, and our own discussions with companies are about the challenges they face in managing their supply chains. Whether it is semiconductors, shipping containers, ocean freight, labor, or other elements of production and distribution, bottlenecks have emerged. It seems the physical economy is not geared to produce the economic growth emerging from the contraction in 2020. It appears that these constraints likely will last into 2022.
- COVID-19 – The US and the World saw another wave of the COVID pandemic during the quarter. Not only did this begin to strain health care systems in some places, but parts of the global supply chain (Mexico, Malaysia, Vietnam) saw significantly higher spikes than they had experienced in previous waves. This wave appears to be ebbing. With vaccination rates increasing and promising new therapies moving through the drug development pipeline, we are hopeful that next year will have fewer COVID-related disruptions.
- Interest rates and inflation – The yield on the ten-year Treasury has been on a wild ride this year; it started strong in the first quarter, faded in the second, and sprang back to life late in the third. The Fed has signaled that it thinks it is nearing the time to remove some of the stimulus it put into place in the early months of the COVID pandemic. This seems to be contingent on two factors. First, the economic recovery continues, which we think is likely. Second, the uptick in inflation which has gone past the Fed’s target proves to be transitory as the Fed has indicated. More strength in the recovery than anticipated or more stickiness to the rate of inflation than expected would likely accelerate the Fed’s tapering actions. Because of the Fed’s involvement in the market for long-term Treasuries, their withdrawal as a purchaser could lead to higher rates. It appears that these worries do not have much impact on small- and mid-cap stocks, but they serve as a headwind for some of the large-cap growth stocks that dominate the S&P 500 and Russell Top 200.
- China – Many commentators expressed optimism when Joe Biden was elected President that our country’s relationships with our major trading partners would improve. While things may be a little better with Europe, the relationship with China remains contentious. No tari s have been rolled back, China continues to take aggressive actions toward its neighbors, and it also seems to be restricting some of its freedoms internally. We do not know how this development will unfold, but it is potentially important because China is not only one of the US’s largest trading partners, but it has also been a significant source of global growth over the last several decades. Slowing growth in China, whether due to internal or external factors, means slower global growth.
- Valuation – While our discipline makes us sensitive to valuations, we are not more worried about multiples now than earlier this year, even with markets near their highs. The reason for this is that while the market is up by a mid-teens percentage through the end of the third quarter, earnings expectations have risen even more. Since the beginning of the year, earnings estimates for the S&P 500 in 2021 have increased by 20% and they are up 13% for 2022. Mid-cap and small-cap earnings expectations have risen even faster. As a result, forward EPS multiples have decreased this year. In the case of the S&P Midcap 400 and S&P Smallcap 600 indices, valuations are not far from historical average. The areas where valuations remain well above average are large-cap stocks and growth stocks. Unfortunately, those dominate the headlines and influence investor sentiment. It seems likely that small caps regain their lead (in the case of the Russell indices) and retain their lead (in the case of S&P). Value stocks also seem primed for outperformance.
Portfolio Results
The Strategy’s performance was essentially in line with that of its benchmark, the Russell 2500 Value index. When we disaggregate the performance into the impact from Sector Allocation and the impact from Stock Selection, we find that Sector Allocation added a little while Stock Selection detracted a little. Within these broad buckets, there was a meaningful positive contribution from the Strategy’s overweight stance in the Energy sector which was partly o set in other sectors. Within Stock Selection, the Strategy saw its holdings in the Consumer Discretionary and Industrials sectors add to relative performance, but it gave it back in the Energy, Technology, and Real Estate sectors.
- While the Consumer Discretionary sector was the worst performing one in the index with an 8% decline, the Strategy’s holdings eked out a small gain. Good performance in Penske (covered later in this report), Victoria’s Secret, and a couple other stocks o set weakness in Kontoor Brands and Aaron’s.
- The Industrials sector was weaker than the benchmark overall, but the Strategy’s holdings held up a little better. Chart Industries and GXO Logistics were two of the Strategy’s better performing stocks and are discussed later in this update. Their gains of 30%+ more than o set declines in other stocks such as Harsco and Nielsen.
- Energy was the best performing sector in the benchmark last quarter, but the Strategy’s holdings did not keep up. While rising commodity prices helped Chesapeake Energy and Oasis Petroleum, double-digit declines in Texas Pacific Land, TechnipFMC, ChampionX, and Delek US more than o set these gains.
- The Strategy’s Technology holdings detracted from overall relative performance. Double-digit declines in some newer holdings including N-able (spun-out of SolarWinds) and Cognyte Software (spun-out of Verint) were the biggest detractors from performance.
- Despite the late-quarter surge in interest rates, the Real Estate sector outperformed the benchmark. The Strategy’s holdings failed to do so however as concerns about rising COVID-19 case counts hurt the shares of our two health care REITS, CareTrust and Sabra.
During the quarter we added six new positions to the Strategy, eliminated five positions, and had one converted in a merger.
Leading Contributors
Penske Automotive Group (PAG, Financial) owns and operates new and used car dealerships, and leases andsells commercial trucks. During the third quarter, Penske posted blowout quarterly earnings due to strong demand for both new and used vehicles amidst tight supply. Auto supply remains tight due to a computer chip shortage and crimped automobile production owing to the pandemic. As a result, vehicle selling prices have been elevated. Penske has done a solid job further benefiting from this current dynamic through recent cost reductions that Penske implemented in the wake of the pandemic, including improved digital capabilities. Penske sees the current supply/demand imbalance continuing into 2022.
Chart Industries (GTLS, Financial) is a manufacturer of equipment for a wide variety of applications but primarilyfor the handling of industrial gas and converting that gas into liquids. On its recent earnings call, management was able to quantify its opportunity in several specialty markets including hydrogen, water treatment and carbon capture. These have a total addressable market of $36.5 billion by 2030. Over the last year, Chart made numerous announcements of partnerships and small bolt-on acquisitions to sustain its presence as an energy transition leader as its customers look for environmentally friendly solutions. The recent spike in natural gas prices globally has also likely led to an acceleration in a handful of liquid natural gas (LNG) projects to serve energy dislocations, particularly in Europe.
GXO Logistics (GXO, Financial) is a provider of e-commerce and fulfillment solutions for multinational customers.The company was spun out of XPO Logistics (XPO - $79.58 - NYSE), a large trucking company, in mid-July. Without needing to compete with XPO’s transportation business for capital, GXO should be able to continue its pursuit of large multinational customers such as Apple and Nike as well as make small bolt-on acquisitions. Globally, customers are looking to capitalize on the growth of the e-commerce channel and are looking to outsource the fulfillment of these orders. GXO is well positioned to serve this market. Furthermore, we do not believe that GXO’s value was appreciated within XPO. As investors come to appreciate its opportunities and its capital e ciency, we believe the valuation should expand over time.
Leading Detractors
Vimeo (VMEO, Financial) provides online video software and services, allowing content creators — specifically,businesses — to host, distribute and monetize their videos. Recently spun o from IAC, Vimeo reported its first earnings release as a standalone company during the third quarter. While Vimeo posted in-line results, the firm also guided to sequentially decelerating monthly revenue growth rates, which pressured shares. Since then, Vimeo has continued to report monthly deceleration in revenue and subscriber growth. Results have remained in line with management’s guidance but nonetheless have not been greeted warmly by investors. Vimeo does not yet turn a profit, and management needs to continue to drive revenue growth while improving Vimeo’s bottom line by limiting spending on growth.
Nielsen Holdings (NLSN, Financial) is the leader in measuring television, radio, online, and mobile audiences andadvertising impressions. Nielsen is in the process of rolling out its much-touted Nielsen ONE initiative, which is aimed at providing the industry’s most reliable and most trusted viewing and listening measurement. Nielsen has brought to market Nielsen ONE in pieces, and Nielsen ONE is not expected to be fully in place until late 2022. Although Nielsen reported strong second quarter earnings during the third quarter and increased guidance, the stock was pressured after a watchdog group found that Nielsen’s ratings had been understated during the pandemic. That resulted in a six-month suspension of Nielsen’s accreditation. The firm will continue to provide unaccredited ratings during the suspension, and it’s doubtful that Nielsen’s ratings will lose much currency with its customers during this suspension. Nielsen plans to use the hiatus to focus on continuing to launch elements of Nielsen ONE.
Lamb Weston (LW, Financial) produces and distributes value-added frozen potato products, most notably Frenchfries, to a variety of customers, including quick-service restaurants, sit-down restaurants, and foodservice operators. Despite rebounding sales, the stock was weak in the third quarter after Lamb Weston cited input cost inflation, higher transportation costs and elevated packaging costs as likely pressuring earnings going forward. The hot weather in the summer of 2021 also sparked concerns about a softer upcoming potato crop, which would lead to higher potato costs for Lamb Weston. The company plans to combat higher costs through a series of price increases, which should fully take effect by the end of the year.
Outlook
As we look ahead, we believe that the global economic recovery will continue, but acknowledge that the path could be a little bumpier in the next year. We expect to use market pullbacks as opportunities to uncover outstanding companies that investors discard for short-term reasons.
In conclusion, thank you for your investment in the Small-Mid Cap Value Strategy. We will continue to work hard to justify your confidence and trust.
Past performance is no guarantee of future results. As with all investments, there is a risk of loss. Any performance and/or attribution information contained herein are based on a representative account of the specific strategy discussed.
Market Performance presented solely for informational purposes. The S&P 500 Index is designed to act as a barometer for the overall U.S. stock market and consists of 500 stocks that are chosen on the basis of market size, liquidity, and industry grouping. The S&P 500 is a market value weighted index with each stock's weight in the index proportionate to its market value.
The opinions expressed in this document are those of Keeley Teton Advisors, LLC as of the date indicated and are subject to change without notice and are not intended as recommendations of individual securities.
