Small Mid Cap Portfolio 2022 Performance Review

Today, I would like to briefly review the KAR SMID Core portfolio for 2022 and highlight the outlook for Small-mid cap stocks and discuss what we believe are the benefits of investing in quality which is the cornerstone of our philosophy.

Despite the relative outperformance of the KAR Small-Mid Cap Core portfolio in the fourth quarter of 2022, we could not overcome the underperformance experienced during the first quarter of 2022 which resulted in an underwhelming absolute and relative performance for the full year in 2022.

Russia Ukraine Conflict and Rise of Small Mid Cap Energy

So, what happened in the first quarter of 2022 that so dramatically impacted performance for the rest of the year? It was a combination of already accelerating inflation trends supercharged by the Russian invasion of Ukraine that led to a spike in commodity prices. Our lack of direct energy exposure in our portfolio and the stickiness of the higher commodity prices put us at a distinct disadvantage for the year.

As the year progressed in 2022, the market continued to favor more commodity-oriented businesses, many of which are found in the Energy sector. Given our focus on high-quality businesses with low capital intensity, our portfolio is underweight energy given that these types of companies typically have high capital intensity and are highly commoditized. Energy was the only sector that had a positive return in the Russell 2500 Index in 2022.  And by a wide margin.  While the overall Russell 2500 Index ended 2022 with a negative return of -18.36%, the energy sector within the Russell 2500 Index had a positive return of over 50%.

Underperforming Tech Stocks and Outlook for 2023

Our largest detractors from the portfolio were consumer discretionary and technology names which are long-term holdings and outperformed in 2020-2021. While the market sold off aggressively in 2022, after careful review of all of our holdings, we decided to continue to hold despite the sell-off, believing that the situations for these companies are more cyclical in nature rather than challenges to the structural advantages that these companies have relative to their industries or potential competitors. We are encouraged by the fact that these have been strong performers at the start of 2023 and we maintain high conviction in these companies.

Looking forward, we believe that after a period of underperformance, the valuations of smaller market cap companies are looking more attractive relative to larger market cap companies.  In the following charts, you can see the past 20 years of the Russell 2500 Index relative to the larger market cap Russell 1000 Index as measured by price to sales, price to cash flow, and trailing price to earnings.

We also believe the unprecedented monetary and fiscal stimulus that has been put into the system since the Global Financial Crisis has disproportionately benefited large cap U.S. stocks.

The top-heavy S&P 500 companies like that of Meta, Apple, Microsoft, Amazon, and Alphabet are having significant fundamental growth issues which has not been the case since 2008, partly evident by the recent slew of headcount reduction announcements by some of the largest S&P 500 companies.

Whereas now we are in a situation of global tightening and more normalized rate environments which in our view should bode better for stock selection and a greater focus on earning durability, debt, and long-term sustainable business characteristics. In turn, we believe this trend may reverse and we could see multi-years of outperformance by smaller market cap stocks which can continue to grow in a lackluster economic environment.

Energy Effects of Fed Rate Hike and Inflation on the Stock Market 

Lastly, I want to emphasize the importance of quality particularly in a continuing inflationary and higher interest rate environment.  The Federal Reserve’s hawkish monetary policy combined with improving supply chain issues appear to be working in reducing the core inflation rate.  Inflation concerns, however, have been replaced by impending recession fears in the market.  We certainly have witnessed a growth slowdown over the past year and we are likely to see a continued growth slowdown over the next six-to-twelve months.  The stock market seems to be already pricing in a moderate recession for 2023.

Though as stated previously, the Fed is working on reducing the inflation rate and we believe it will eventually be successful.  However, reduced inflation does not automatically equal lower interest rates, or at least back to the near zero rate environment that persisted previously.  It is unlikely that the Fed will reduce the Fed rate near-term in fear of reinflation, after working so hard to quell inflation.  Thus, it is possible that we can see a medium-term scenario where interest rate stays consistent at current levels.  After all, we are still well-below the long-term interest rates seen over the past 50 years as evidenced by the following chart.

And as the inflation rate normalizes along with interest rates going forward, we believe it is prudent that we continue to focus on companies with good balance sheets.  In the following chart of high yield spreads, one can see it is currently only near long-term averages.

And one can also see that historically, this high yield spread tends to spike during recessionary times as seen over the last two recessions.  If we are indeed headed for another recession, then the typical spike in the spread rates will be much more harmful for highly leveraged balance sheets, a trait that is typical of low-quality businesses.  In our experience, high quality businesses with strong balance sheets tend to benefit on a relative basis during higher spread environments.

Therefore, as lower quality businesses with highly indebted balances see their debt come due over the course of the next few years, the interest rate costs could be substantially higher and thus pressure net margins.  Growth for these companies will also be harder to come by as the cost of debt funded acquisitions and reinvestment becomes more costly.

High Quality Investment Strategies Amidst Looming Recession

From our perspective, slower growth, higher interest rates, looming recession fears, should all support high quality investments with advantaged business models that can deliver more meaningful revenue growth, solid returns, and with better balance sheets to protect against the potential of more severe recessions of other unknown economic events.

As always, we thank you for your continued confidence and we appreciate your interest in our Small-Mid Cap portfolio. Please feel free to reach out to your KAR representative with any questions or for any additional insights into our investment strategy.