The first half of 2021 was led by lower quality equities. However, Small Mid Cap Core Portfolio Manager and Senior Analyst Julie Kutasov saw some renewed focus on fundamentals during the third quarter.

“The overall picture remains somewhat mixed, particularly when it comes to smaller cap stocks,” Kutasov admitted. The Russell 2500 was still led by names with lower earnings and balance sheet quality in the third quarter, but companies with lower volatility and higher returns on equity did outperform.

Kutasov sees two significant drivers behind the rise of fundamentals. The first is the inevitable post-pandemic return to relative normalcy.

The second is, however, more important — a change in the interest rate outlook. Post-pandemic supply chain disruptions and labor shortages put significant inflationary pressures on input costs such as raw materials, labor, and freight. These problems unexpectedly intensified during the third quarter, in part due to the spread of the Delta variant, and now it seems likely that they will be more meaningful and long-lasting than initially anticipated. These pressures may, in turn, force the Fed to increase interest rates sooner rather than later, putting highly leveraged companies at a disadvantage.

Key Contributors and Detractors in Small Mid Cap Core

Listen to the podcast above to learn more about the top 5 contributors and detractors in KAR’s Small Mid Cap Core strategy for Q3 2021.

Rest-of-Year Considerations – The “I”s Have It

Inflation

Kutasov believes the companies in KAR’s Small Mid Cap Core strategy are better protected from inflation concerns than their competition. “We shy away from capital intensity and direct commodity exposures, and in our view, our companies’ leading market positioning provides them with solid pricing power including the ability to pass through any input costs’ increases to their customers.”

She also points out that the strategy’s companies’ financial strength allows them to hold more inventory on hand, a critical factor during this period of extended supply chain disruptions.

Interest Rates

Kutasov notes that the kind of companies she seeks — strong cash flow generators that don’t rely on borrowing for growth — are in a competitive position with highly leveraged companies in a harsher rate environment.

Learn more about our small mid cap core portfolio today.