Only a few short months into 2022, volatility has fulfilled, so far, our “challenging but ultimately positive” outlook for the year from our previous commentary at the end of last year. Investors are facing a more nuanced environment as an increasing number of economic and geopolitical crosscurrents cloud visibility. Economic data continues to be positive on a number of fronts as have been indicated in employment, housing, corporate earnings, industrial production, and other data. The Conference Board US Leading Index also continues to be at a positive level. In short, demand is positive.
On the other side of the ledger, there continues to be disruption around the world. COVID restrictions, a lower global working age population, Russian sanctions and other factors are combining to complicate and lengthen supply chains around the world. This combination of high demand and disrupted supply is resulting in the highest level of inflation in decades. Additionally, we now know with certainty that it is not transitory and the Federal Reserve has begun the process of increasing rates and will be simultaneously reducing their balance sheet, thus embarking on a process of tightening money supply.
Looming large in investors’ minds is whether the Fed can orchestrate these policy changes without triggering an economic decline. A recent but brief inversion of the yield curve of 2-year and 10-year treasuries is causing further angst. Though it’s confidence as a predictor is mixed, it can be interpreted as an indicator of a possible recession.
With all the uncertainty, major market indices declined during the first quarter. Representing our world of small company stocks, the Russell 2000® declined by 7.53%. Our Small Companies portfolio outperformed with return of -5.26%, net of fees.
Our leaders during the fourth quarter were as follows:
PDC Energy (PDCE), an oil and gas producer, led performance for the quarter. A beneficiary of higher commodity pricing, the company has been driving high rates of cash flow and earnings on higher pricing while aggressively paying down debt, buying back shares and initiating a dividend. Additionally, management announced an accretive acquisition that should enhance production and cash flow based on conservative oil and gas pricing.
Aerovironment (AVAV), a designer and developer of small unmanned aircraft (drones), has benefited from potential anticipated defense spending increases due to the geopolitical events unfolding in Europe which should continue to drive positive fundamental growth. Additionally, management has been expanding their platform with acquisitions which have added artificial intelligence capabilities, unmanned ground vehicles and medium sized unmanned aircraft to their solutions offerings.
Clean Energy Fuels (CLNE), a provider of natural gas fueling stations, was also among our leader board for the quarter. A relatively new holding within our portfolio, we have followed its progress for a number of years. The company has cleaned up its balance sheet and entered into sizable supply agreements with marquee customers such as Amazon, UPS and FedEx. Further, they are involved in production of renewable natural gas projects with large E&P companies that will allow them to profit from both production and delivery of natual gas fueling. Though electric vehicles grab the most attention for future potential, CLNE is providing increasing levels of natural gas as an alternative fuel that is positively impacting the trucking industry’s carbon footprint today.
Computer Programs & Systems (CPSI), a electronic healthcare solutions and services company, has been a solid performer for our portfolio for some time. Management began an effort to drive efficiencies and improve their growth opportunities over a year ago that is proving to be successful. A number of acquisitions have expanded their offerings, increased the total addressable market and improved their growth profile.
Artivion (AORT), rounded out our top performers for the first quarter. AORT is a medical device company focused on the cardiovascular market. Having brought his experience and expertise from his time at Medtronic, the CEO reinvigorated AORT (formerly known as Cryolife) with acquisitions which have added complementary products and expanded their product pipeline. Higher spending on clinical trials and development over the next 12-18 months should begin to drive a higher revenue growth rate and higher margins as product approvals in the U.S. are anticipated.
Activity During the Quarter
With the increased volatility, we had a slightly higher level of turnover than usual. From a selling perspective, we exited our holding of Bottomline Technologies (EPAY) due to their announced acquisition by a private equity firm. Additionally, we trimmed our holdings in PDCE and Ameresco (AMRC) as their strong relative performance in the quarter drove their position weights higher.
Proceeds from our sales were deployed into existing holdings of CalAmp (CAMP), Akoustis (AKTS), and CLNE. We also added three new positions which included Telos Corp. (TLS), a cyber security software company; Cambium Networks (CMBM), a wireless broadband networking infrastructure provider; and Cryoport (CYRX), a vertically integrated cyrogenic logistics solutions provider for the life sciences industry.
To begin the new year, we are overweight Consumer Discretionary, Financials, Energy, Healthcare and Technology. Our sector weightings in Consumer Staples, Materials and Real Estate are less than our benchmark. Finally we are in-line with our Industrials exposure and continue to have no holdings in Communications or Utilities.
General Outlook, Current Positioning/Strategy
As indicated above, economic data does continue to generally indicate economic growth for the year, albeit at a more moderate rate than experienced in 2021. Consensus GDP growth of approximately 3.5% for the US market this year generally correlates to positive corporate profit growth and positive market returns. Then of course we continue to have inflation pressures throughout the economy from supply and demand imbalances which is requiring the Federal Reserve to increase interest rates and embark on quantitative tightening.
On the supply chain issue, we are hearing from some companies that issues in certain areas are moderating. For instance, in-bound shipping costs are seeing some moderation stemming from lower containerized freight pricing and some of the bottlenecks at ports are starting to get better. There is also some evidence that pockets of semiconductor availability is getting better and some companies are beginning to have better visibility of supply.
To be clear, however, we are certainly not in a back-to-normal situation but constraints do seem to be off from their worst disruptions and though improvements are occurring in some areas, that progress may be offset in another. A specific example comes from one of our portfolio holdings which has discussed easing cost pressure with their in-bound freight but that progress has been negated by outgoing and ‘last mile’ delivery costs from higher fuel costs. But in general, the broad message we are hearing is that there should be incremental improvement throughout the year.
Next, as we are all well aware, from the gas pump to the bread aisle there are inflationary pressures. Though the headline Consumer Price Index measure of 7.9% gains the most attention as it sits at a 40-year high, other measures are equally impressive. The Federal Reserve Bank of Cleveland Trimmed-Mean Index and Atlanta Fed Core Sticky CPI ex Shelter Index, both of which seek to factor out volatile factors, are also at decadal highs. These costs threaten a number of aspects of the economy, most notable at the moment is that consumer sentiment is down from its highs last year as is small business optimism. So far, companies have pricing power to maintain margins but from raw materials to labor it is a challenging environment that requires constant operational diligence.
The Federal Reserve, in an effort to bring inflation under control, just began a rising interest rate cycle, the first since 2018 and up to six more are anticipated this year. For markets, this has multiple affects. Higher rates drive lower valuation multiples and make money more expensive to borrow setting a higher bar to hurdle for corporate investment. Additionally, the Fed has clearly communicated that quantitative easing which increases the supply of money to promote growth is ending. As they shrink their balance sheet and reduce liquidity this will impact available funds for investment and, combined with higher rates, could expose vulnerable areas of asset pricing and investment that are not currently visible.
Finally, our outlook would be remiss if we were to ignore the situation in Ukraine and the multi-faceted global threat which it presents. Not to minimize the horrific human suffering which is occurring, but just as the world seemed to be recovering from the pandemic, the Russian invasion of Ukraine has disrupted energy, raw material and agricultural markets. Sanctions are driving costs higher and making the flow of money more challenging. We could spend pages dissecting the current and potential impacts from this war but suffice to say that it has even further heightened uncertainty, which markets do not like.
The S&P500® based CBOE Volatility Index®, the VIX®, and its counterpart based on the Russell 2000®, the RVX®, are both elevated and in slight uptrends over the past six to nine months. Each suggesting a more challenging market. For the small cap asset class, since they are a proxy for ‘risk-on’ and domestic growth, near term volatility may continue to be elevated. Driving this is elevated levels of inflation, the Fed tightening cycle, supply chain issues, geopolitical risks and tight labor markets.
These are some of the known risks. In an effort to compare the current period to history, we looked at both 6-month and 12-month small cap returns leading up to increasing rate hike cycles. In this effort, we looked at 12 periods during which the Fed Funds Effective Rate was increasing and used historic returns of Russell 2000 returns going back to 1979 and Ibbotson data for five periods back to 1954.
What were returns prior to rate increases as markets likely began to anticipate tighter monetary policy? Our analysis of the 6-month and 12-month periods prior to rate increases showed positive returns, on average, of approximately 16% and 19% for the 6-month and 12-month periods respectively. Possibly reflecting positive economic activity that led to the need for higher interest rates. It’s important to note that these periods were not without volatility as they experienced interim corrections which averaged almost -12%.
Today, leading up the end of the current quarter the returns of the Russell 2000 over the previous 6-months and 12-months are approximately -6% and -7% respectively. Also included in this full period, on January 27th, the index was down 20.57% from its all-time high on November 5th, 2021, hitting the technical definition of a bear market. In short, returns of the past 12 months are on the low side of historic pre-rate hike periods, but not unusual.
In an effort to inform our expectations looking forward, we also analyzed what history suggests for returns during the rising interest rate cycle. Using the same data, on average, annualized returns during rising interest rates for the small cap asset class are a little over 10% from start to finish. However, within these periods, small caps have experienced periodic negative returns that average approximately -22%. At times they occur as low points from the beginning of rate increases and other times they are downward corrections from highs reached within the time span of analysis. How all the current risks comes together to impact the path which markets take and the end result for this year’s returns are unknown and uncontrollable.
But what is controllable is our team’s efforts to best navigate the volatility markets will likely experience. With rates trending higher, we are looking at our company debt levels with higher scrutiny. Inflationary pressures offer both risks to margins and opportunities for those companies with pricing power and who are able to better manage supply chains and material costs. Valuation multiples may also take a heightened role in the current market. Where these research efforts meet portfolio management, we may be more quick to trim or sell holdings and more cautious in putting funds to work.
Yet, as we have highlighted over the years, with risk comes opportunity. With heightened geopolitical risks and continued supply chain challenges, a reversal of the globalization of the world economic order is being evaluated. In fact, searching ‘deglobalization’ in Google Trends and Google Books Ngram Viewer, shows the highest level for that term in years. As a more domestic asset class, small companies may be long-term beneficiares. This is clearly not a certainty but should the trend persist, it could potentially increase the interest in the asset class.
As we sought to summarize our view of the market for this letter, we concluded the best way to describe our current outlook is that we are in a state of perplexity. This is not to say we are negative in our outlook nor are we suffering from a lack of ideas. But with the numerous economic cross currents and geopolitical risks, we are in a state of mental uncertainty. At a recent conference, the first in-person event we have attended in two years, many of our fellow professionals we spoke to are similarly disposed as they wrestle with all the various risk impacting markets.
So, as we manage client assets, we remain attentive to the things we can control and humble in our acknowledgement of risks which exist that we cannot foresee. Our long-term commitment to the fundamental aspects of the strategy have proved to result in a repeatable process resulting in competitive returns for our clients and remain committed in these efforts.
As always, we appreciate your continued confidence.
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