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Portfolio Manager Commentary


Q3 2022 Small Companies Comments

by Brian G. McCoy, CFA, on October 19, 2022

The macro backdrop has not changed much for investors over the past quarter. Heightened volatility continued to rule the day across all asset classes as inflationary pressures, supply chain challenges, consumer sentiment, and geopolitical events combined (and continue) to increase the uncertainty in the direction of company earnings. Most prominent of concern, domestically and internationally, is when signs of lower inflation will begin to show enough moderation, which would allow the Federal Reserve to pause its dramatic rise in the Fed Funds Rate. Though there has been some moderation, as of now, economic and price data continue to support the Fed’s determination towards higher rates.

We commented in our last letter about the existing debate, which continues, on whether the Fed can navigate the U.S. economy to a soft landing or if a more challenging recession is likely. The jury remains out, but the trend is certainly lower as consensus estimates for this year have declined to real GDP growth of 1.6%. More importantly, as equity markets are forward looking, estimates for 2023 have been lowered to 0.7%. This is because moderating economic growth, cost pressures and higher interest rates have combined to pressure company earnings estimates and the multiples which investors are willing to pay for those earnings.

In an ironic, though not unusual, twist, negative economic data is welcomed with positive market moves. With the heightened concerns over inflation and interest rates, bad news is good news such that lower economic growth would allow the Fed to pause and possibly lower rates. In the short term, such evidence provides some relief. But, conversely the direction of company earnings must be considered in a lower or even negative growth environment and what valuation should be placed on those estimates. The result is heightened volatility as the numerous economic cross-currents and geopolitical risks present a challenging investment landscape.

Reflecting this uncertainty, the Russell 2000® experienced a schizophrenic quarter by rising over 18% into the middle of August, only to move dramatically lower into the end of the quarter, finishing with an official third-quarter return of -2.19%. Our Small Companies portfolio underperformed this benchmark. While not a return that we were positioning for, it is the type which has historically presented an opportunistic buying environment.

Despite the negative returns, our leaders that were positive during the fourth quarter were as follows:

Ameresco (AMRC), an integrated electric energy company focused on energy efficiency and resiliency, led performance for the third quarter. AMRC has been a positive long-term performer for the portfolio though it can prove volatile as large projects can move the forward-looking outlook both up and down. Management has historically executed well, which we feel should continue as they win increasingly larger, more complex projects and expand internationally driving continued growth.

iRobot (IRBT), the leader in robotic vacuuming, was moving positively in the early part of the quarter and then further benefited from a $61 a share acquisition offer from Amazon (AMZN) that was a 22% premium at the time of announcement.

Cambium Networks (CMBM), a wireless infrastructure provider that offers fixed wireless and Wi-Fi to broadband service providers and enterprises, performed well in a tough environment for the technology sector. In our outlook, CMBM offers solutions and services that should drive growth from a global investment cycle by both enterprises and service companies to provide better, faster and expanded WiFi access.

Cyberark Software (CYBR), a provider of cyber security software solutions and services, also defied the recent sector performance challenges. In addition to providing market-leading solutions in Priveleged Access Management, as reflected by Gartner’s placement of CYBR in its “Leaders” category, management has executed well on the company’s transition from licensing to a SaaS revenue model. Increasing security threats and regulatory backdrop should also provide a solid backdrop for continued growth.

Clean Energy Fuels (CLNE), a provider of natural gas fueling stations, rounded out our top performers. Since inclusion in the portfolio, CLNE has delivered strong up-and-down performance as it moves with the volatile energy sector. We have confidence that their sizable supply agreements with Amazon, UPS, Fed Ex and others support continued volume growth in natural gas fueling. Additionally, the company is also building upstream supply opportunities in renewable CNG as they partner with BP and Total. Growing fuel delivery and production should drive improving fundamentals.

Activity During the Quarter
Turnover was a bit higher than usual during the quarter at approximately 8% as we sought to take advantage of both strength and weakness in certain names and emphasize lower debt levels, valuation and dividend yield. After trimming in the previous quarter, we exited McGrath Corp. (MGRC) to lock in short and long-term outperformance. Though we like management in both companies, our lowered conviction of meaningful recovery relative to other opportunites led to us fully exiting CalAmp (CAMP) and Lending Tree (TREE). We also trimmed Cryoport (CYRX) to take advantage of a strong positive move after adding to our position in the prior quarter. Finallly, we exited iRobot (IRBT). Though trading at a discount to the cash offer from AMZN, we were concerned that a heightened scrutiny from the Federal Trade Commission could delay or derail the acquisition.

On the buy side of the ledger, we added to our existing holdings of Global Medical REIT (GMRE), Healthcare Services Group (HCSG), Green Dot Corp. (GDOT) and Calavo Growers (CVGW). New to the portfolio during the quarter were Hackett Group (HCKT), a business consulting firm and Shutterstock (SSTK), a global marketplace for commercial digital imagery.

As we enter the second half of the year, we are overweight Energy and Industrials while our Technology exposure is in-line with our benchmark. We are underweight Consumer Discretionary, Consumer Staples, Materials, Financials, Real Estate and Communications. We continue to have no holdings in Utilities.
General Outlook, Current Positioning/Strategy

Looking forward, market volatility will likely continue to be dependent on the Federal Reserve’s view of inflation and the degree to which rate increases will be required to bring it toward their stated goal of 2%. As of the timing of this letter, CPI data do not appear to allow them to change their restrictive stance. However, this tighter monetary policy will begin to weigh on economic growth, along with higher costs, resulting in pressure on corporate earnings. As the future is unknowable, investors must wrestle with how much these will be impacted and how much they are willing to pay for those future earnings. Simply stated, but not easily answered with certitude. Yet key to all of it in our opinion is the rate of inflation. When there is clarity on its moderation, markets will likely find their bottom.

Evidence that should begin this process is becoming apparent. We are currently seeing numerous commodity and goods inflation indicators roll over as demand and supply have caught up to each other over the past few weeks. Supply chain challenges also continue to moderate as the flow of goods and shipping prices continue to improve. Though this moderation has not flowed through to a great degree in the headline CPI numbers, the data suggest it is just a matter of time before price declines begin to be reflected.

Corporate earnings announcements are coming in the next few weeks and some of the higher costs may not yet be reflected in analyst earnings. Sticky wage costs will likely continue to rise and higher cost inventory will flow through in the next few quarters, pressuring earnings. Until price increases are fully reflected and higher cost inventory is worked down, margins are likely to be negatively impacted. Salaries should begin to level off, moderating year-over-year increases, as slower growth creates slack in labor demand. Unclear at present is at what level all these costs peak and margins bottom.

Add these issues to the undetermined total economic slowdown effect from higher rates and we have an ongoing volatile environment. The impact of rate increases will lead to quicker deceleration of inflation and economic growth, leaving the question as to when the Fed will begin discussing slowing restrictive policies and ultimately cutting rates. Investors currently feel that any timeline for this will be the 2nd half of 2023 at the earliest. As markets are forward looking, they should begin discounting this scenario 6 to 9 months ahead of time, which means possibly in the next few months. Therefore, as we head into year-end, chances of a market rally becomes possible, the question being from what levels.

To navigate this environment, we are working to balance shorter-term market realities while taking advantage of opportunistic declines in companies we believe will prove profitable for the portfolio over time. As earnings season progresses, we will be looking to take advantage of anticipated volatility. We will be intently evaluating existing holdings and new ideas for insights on their ability to pass through costs and/or reduce operating expenses to maintain margins. Valuations, dividends, cash and are deblt levels are highly considered and highly important.. Additionally, we will be listening for possible potential catalysts which may exist to drive positive future returns.

We highlighted in our last commentary that interest in the small-cap asset class is extremely low right now and has been for several years. Small cap valuations relative to large cap continue to be attractive based on historical comparisons, though this is a result of greater price declines. Positively, we have seen further evidence of strategists advocating for the opportunities of the asset class. We certainly agree with this position but the realization of the potential will likely not occur until the Fed pivots in their rate increases and the timing and degree of a recession becomes more clear.

Many studies have shown that missing the top-performing days of any recovery greatly reduces overall long-term performance for investors particularly applicable to the small cap asset class. Though markets are likely to continue to be challenging for the foreseeable future, it is exactly the type of environment which provides the base from which future returns may be realized.

To our investors, we acknowledge the anxiety these markets are creating. Know that our team is working diligently to navigate this challenging market with the experience gained over multiple market cycles. From this, we are cautiously seeking opportunities for our investors and with humility that the future is never certain:, also remain confident in our strategy which has provided solid returns over many years.

Thank you for your continued confidence.

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