Performance Attribution
Much like the prevailing narrative throughout the year, the fourth quarter saw market performance influenced by the "AI trade” with continuing debate over whether a bubble exists. As we view the positive opportunities for this emerging technology on corporate productivity and the economy, we view the current state as a kind of ‘rational exuberance.’ Though valuation multiples may be on the high side, the companies that have been, to this point, the main drivers of market returns are supported by cash flows and earnings growth.
Supporting investor enthusiasm, the macroeconomic environment continued to provide a favorable tailwind. Contrary to the recessionary fears that lingered earlier in the year, the U.S. economy displayed remarkable resilience, with Gross Domestic Product (GDP) data showing an annual rate of 2.1% real growth in the third quarter and consensus fourth quarter growth estimated at approximately 1.8%. This growth has been further supported by a continued moderation of inflation as the Consumer Price Index (CPI) cooled to 2.7% year-over-year in data released for November. The government shutdown introduced some delay and debate around the reliability of the most recent data, but the trends support market optimism.
The employment picture also remained steady, with recent unemployment data holding at roughly 4.4% as the year ended. Though this is the highest rate in 4 years, it remains relatively low in a historical context. The mix of steady economic growth with moderating inflation allowed the Federal Reserve to continue its easing cycle with a further 0.5% of easing during the quarter. Thus far, the Fed has helped guide the economy to a soft landing, which has continued to support corporate earnings and investor optimism.
Though large caps did better, during the fourth quarter, small caps delivered similar gains, though with continued volatility and frequent shifts between themes. Encouragingly, the Russell 2000® hit a new record while the other main small-cap index, the S&P 600®, got within a few points of its prior all-time high. Within our corner of the market, we continue to see rapid swings of performance within certain industries with lower quality stocks tending to do better, particularly when zooming out for the full year. We will touch on this further below.
For the quarter, major market indices posted low single-digit returns. The S&P 500® delivered a 2.66% return for the quarter while the Russell 2000® delivered 2.19%. Our portfolio underperformed as lower quality stocks led and we saw profit taking in some of our better performers for the year.
Our top three contributors to performance for the quarter were as follows:
Omnicell (OMCL), a leader in the automation of pharmacy and hospital workflows, led performance for the quarter. A long-term holding within the portfolio, we added to our position around mid-year and were rewarded as tariff impacts have turned out to be less than anticipated, a combination of rates less than anticipated and mitigation efforts by management. The company most recently delivered results above analyst expectations, raised full-year revenue guidance, and completed a sizeable stock buyback program while also paying down debt. Its platform approach in the automation of hospital pharmacy and a new product cycle continue to bode well for their growth prospects, in our opinion.
Harmony Biosciences (HRMY), a commercial stage pharmaceutical company focused on neurological disorders, performed well for the quarter. Its primary driver of results, which is the only non-scheduled treatment option currently approved for narcolepsy, has continued to increase treated patients and gain market share. Strong revenue growth, cash flow and solid balance sheet allow the company to internally fund additional discoveries. Though periodically volatile on clinical trial results, their primary driver of results is approaching the $1 billion annual revenue mark, with additional formulations anticipated to continue positive results.
Healthcare Services Group (HCSG), a provider of environmental and dining services to healthcare facilities, rounded out our top performers. With the company's focus primarily on nursing care facilities, the past year has been a welcome return to growth after a period of lower occupancy, operator challenges, and elevated costs. Forward projections are favorable as management shifts focus from macro and operational challenges to driving higher growth in an addressable market where they hold a market leading share.
Holdings within the portfolio that were negative contributors of performance were as follows:
Varonis Systems (VRNS), a data security software platform company, led underperformance for the quarter. The company has been undergoing a transition to a software-as-a-services (SaaS) model over the past couple of years, which introduces volatility to results. The company has largely completed this process a year earlier than management originally guided. In their recent earnings call, a lower-than-expected conversion in some industry verticals, particularly federal, and a decision to fully exit some business by the end of next year did introduce near term uncertainty. The company focuses on the automation of the protection of data and recognition of their platform as a leader in the space keeps us constructive on the company’s growth prospects.
Phreesia (PHR), a healthcare software company that addresses patient engagement and intake processes, weighed on performance. Management reported quarterly results better than estimates, but was measured in their forward guidance on an uncertain and shifting macro environment. We currently maintain our conviction as management has executed over the last several quarters on their projections, fundamentals are trending positive, their software addresses a pain-point for healthcare providers, and there has been improving sentiment on the company into the new year, though not yet reflected in the stock price.
Aerovironment (AVAV), a drone manufacturer, rounded out our more challenged names for the quarter, having been a leader in the second quarter. The company’s products and services of unmanned aircraft and space technology are in the key areas of emphasis for the US defense budget, to which it has a solid history of wins across numerous divisions of the military. As a long-term holding in the portfolio, we have traded around the position on volatility of stock movements, but have been consistently confident in management execution and the expanding opportunities for the company.
Activity During the Quarter
Turnover of the portfolio approximated slightly over 11%. We exited names that have not been performing to our original outlook, particularly Global Medical REIT (GMRE), Frestpet (FRPT), and SM Energy (SM). We also exited CyberArk (CYBR) as it has been acquired by Palo Alto Networks (PANW) while we further locked in gains with trims of Credo Technologies (CRDO), Ameresco (AMRC), Artivion (AORT), and One Gas (OGS).
We increased our holdings of UMH REIT (UMH), Simply Good Foods (SMPL), Varonis (VRNS), Phreesia (PHR), Albany International (AIN), Brightview (BV), Hillman Solutions (HLMN), and Simmons First National (SFNC). From a new holdings perspective, we initiated security software focused SentinelOne (S) and building materials company Tecnoglass (TGLS).
To begin the new year, the portfolio is overweight Technology, Industrials, Utilities, and Staples. The portfolio is underweight Financials, Real Estate, Materials, Energy, Consumer Discretionary, and Healthcare, and currently have no exposure to Communication Services.
General Outlook, Current Positioning/Strategy
For the year ahead, our team sees broadly supportive themes for continued market gains, though volatility is also likely. Most importantly for corporate earnings, economic growth is anticipated to continue, with current 2026 consensus estimates at approximately 2%. Some recent data suggest there could be upside to this estimate as the year progresses, but generally growth is supported by several factors.
Liquidity, the lifeblood for the economy, will continue to be supported with the Fed estimated to cut rates further by approximately 0.5% by year's end and their stated shift towards a supportive stance of banking system reserves with purchases of short-term treasuries. Lower rates also spur corporate investment, which should also support employment. Lower interest costs also provide a tailwind for margins for those companies with floating rate debt, particularly in the small-cap space where debt is more prevalent.
On the legislative front, the new year also brings the positive impact of expected fiscal measures and tax legislation set to take effect. These policies should also provide a tailwind to GDP growth and provide a subset of consumers with higher tax refunds that should support spending, particularly at the lower end of the income range. Corporate tax changes around depreciation and research and development further benefit corporations and should positively impact cash flows. All said, changes are targeted to provide a tailwind towards domestic investment and a higher level of economic activity.
We would finally note a continued and broadening effect from AI investment. The largest companies continue to indicate high levels of capital spending as they compete to release better models than their competitors. There is also a broadening of the benefits from this technology as it migrates from the data centers and into corporate workflows, supporting more use cases and bolstering a broader set of companies. This is not only from a sales perspective but also efficiencies that improve productivity and thus margins.
While there are numerous positives, we continue to evaluate offsetting risks. Despite a growing economy and solid market returns, consumer sentiment is quite low as price increases remain sticky, and employees worry about job security because of AI advancements. As noted above, unemployment is slowly rising, and job growth has slowed. Further, tariffs and trade policy seem likely to continue a less stable path than the previous decades.
Political narratives may also spur volatility this year with mid-term elections slated for November. Gridlock and rancor are high, as evidenced by the longest government shutdown in history, and the temperature is not likely to cool in an election year. Because of a lack of political compromise, a sizable portion of the population may now be subject to a dramatic increase in healthcare costs. There may also be consequences of the shutdown revealed from delayed data, which may spur economic uncertainty.
Finally, global risks persist and may perhaps heighten. As we write this letter, the administration has forced regime change in Venezuela, continues to provoke our allies with ambitions to take control of Greenland, the war in Ukraine continues, and China-Taiwan relations could escalate.
Specifically in small-caps there are several competing narratives, which help explain their bursts of performance, though without yet, sustained momentum relative to large caps. Valuations are attractive on a relative basis but not at ‘cheap’ levels seen several quarters ago. Positioning in futures data suggests the asset class is not nearly as out of favor, reflecting some positive institutional shifts which can also be seen in some cautiously positive views in commentaries.
Also seen within the asset class has been the performance of lower-quality stocks, particularly coming out of the correction early in the year. Stocks within the industries of quantum computing, digital assets, rare earth mining, nuclear, biotech delivered extreme gains within a risk-on environment. Many of which have minimal current or even forecasted revenues, let alone cash flows or profits. We have evaluated a number of these and believe there are some attractive business models, but many of the speculative runs in performance based on optimistic projections, in our opinion, seem to be excessive exuberance on yet to be proven results.
Concerning positioning, we have increased our industrial exposure to overweight to be more pro-cyclical, given the economic tailwinds and potential for positive economic upside. This additional exposure came from trimming our utilities and staples. We also remain overweight technology, particularly in software (which was out of favor this past year). This reflects our belief in the expansion of AI out of the data center capex investment dynamic and into implementation within the broader economy.
In conclusion, we see a continuation of positive economic and corporate profit trends, upside of which could further spur interest in the small-cap asset class. We do anticipate volatility and will be active in our efforts to capture both up and downside opportunities. Though lower quality has been leading and some pockets of excessive enthusiasm continue, history supports a continued focus on quality companies with solid financials and good management teams.
We are available to discuss the portfolio and our outlook in more detail.
Important Disclosure Information
Please remember that past performance may not be indicative of future results. Different types of investments involve varying degrees of risk, and there can be no assurance that the future performance of any specific investment, investment strategy, or product (including the investments and/or investment strategies recommended or undertaken by Connors Investor Services, Inc. [“Connors]), or any non-investment related content, made reference to directly or indirectly in this commentary will be profitable, equal any corresponding indicated historical performance level(s), be suitable for your portfolio or individual situation, or prove successful. Due to various factors, including changing market conditions and/or applicable laws, the content may no longer be reflective of current opinions or positions. Moreover, you should not assume that any discussion or information contained in this commentary serves as the receipt of, or as a substitute for, personalized investment advice from Connors. Please remember, if you are a Connors client, to contact Connors, in writing, if there are any changes in your personal/financial situation or investment objectives for the purpose of reviewing/evaluating/revising our previous recommendations and/or services, or if you would like to impose, add, or to modify any reasonable restrictions to our investment advisory services. Unless, and until, you notify us, in writing, to the contrary, we shall continue to provide services as we do currently. Also, remember to advise us if you have to been receiving account statements (at least quarterly) from the account custodian. Connors is neither a law firm, nor a certified public accounting firm, and no portion of the commentary content should be construed as legal or accounting advice. A copy of the Connors’ current written disclosure Brochure discussing our advisory services and fees continues to remain available upon request or at www.connorsinvestor.com.
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