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
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.
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.
This information is being provided by Kayne Anderson Rudnick Investment Management, LLC (“KAR”) for illustrative purposes only. Information contained in this material is not intended by KAR to be interpreted as investment advice, a recommendation or solicitation to purchase securities, or a recommendation of a particular course of action and has not been updated since the date of the material, and KAR does not undertake to update the information presented should it change. This information is based on KAR’s opinions at the time of the recording of this material and are subject to change based on market activity. There is no guarantee that any forecasts made will come to pass. KAR makes no warranty as to the accuracy or reliability of the information contained herein.