A Letter from Tom Maher: 2021 SMCO Review

2021 proved to be a positive year for small and mid-cap stocks, and SMCO ended the year with strong Q4 performance, both absolute and relative to the Russell 2500® Index. The year saw several ups and downs, but the end result was an 18% total return for the smid market as measured by the Russell 2500 Index. We navigated this changing market well, generating a total return of 23.5% gross/22.7% net. Specifically in the fourth quarter we generated a positive return of 8.05% gross/7.86% net vs. 3.82% for the Russell 2500®. While the return for Q4 was solid the quarter was choppy. We were able to use the turbulence to widen our performance advantage for the year.

Portfolio turnover, 34% for the year and under 5% for Q4, was low for SMCO. We generally expect turnover to fall between 40 and 70% per year, but we are perfectly happy to come in below that range when possible. We tend to take a long term perspective on most of our positions, and hold many stocks for multi-year periods. Much of our trading in 2021 was incremental, either adding to or cutting positions based on portfolio management considerations or changes in risk/reward expectations.

See the end of this letter for performance details on the quarter and the year. We consider ourselves stock pickers, so we were encouraged to see the bulk of overall outperformance was driven by stock selection rather than sector allocation in 2021. That said, we benefitted from the macro work done here at Hilton, as it informed our efforts in terms of where to search for new ideas, how to manage position sizes and where to alter the overall exposures in the portfolio.

Beyond the typical sector analysis we also consider some other breakouts, such as cyclical/sustainable/secular, high/medium/low quality, risk on/off and value/growth. Our results for 2021 were consistent with the overall market – we saw outsized contributions from cyclical, medium/low quality, risk on and value. Keep in mind we use our own definitions for these categories and may vary from other data sources. For instance stocks in our “low quality” category are described as low quality primarily due to the nature of their industries. Generally we avoid what would more broadly be considered low quality stocks.

A Longer View: What A Long, Strange Trip It’s Been

As we approach SMCO’s third anniversary (this February) I thought it was worth reflecting on the last few years. After a long tenure at a large mutual fund complex I joined Hilton in January 2019. I wanted to focus more on investing, and Hilton offered the right culture and the right platform: A capable and supportive team, ample resources and the desire to add products with a similar investment profile. This, along with decades of experience, enabled us to launch SMCO. To be honest early 2019 feels like a thousand years ago. The first eleven months were generally smooth. We generated solid returns, and proved that Hilton was indeed the right platform. An added bonus? We modestly outperformed.

Enter 2020. For the first few months the market was flattish, but overall was moving modestly higher, with SMCO exhibiting a similar pattern. Then the pandemic hit - The music stopped and everything slid off the page. SMCO declined, but held up better than the overall smid market (as measured by the Russell 2500® Index). The performance gap was starting to widen but then the Fed decisively intervened, providing massive liquidity and support. Soon after fiscal stimulus was added as well. This combination stopped the market decline, and sent the market upward. We followed suit, but lagged as the market was led by two cohorts that we tend to avoid. On one side many business types we look to avoid – highly cyclical, highly leveraged and macro-dependent businesses – became sought after. It was early cycle on steroids, with little concern for the potential downside given massive government support and available liquidity. On the other side the Fed’s efforts to lower rates provided a green light to invest in highly speculative stocks, or in other words growth at any price. Valuation appeared not to matter at all. We had built up a lead into the market collapse, and though we rallied off the bottom our discipline kept us from fully embracing what was working. It did not surprise us that we lagged the Russell 2500 Index in 2020, rather we were encouraged to stay close.

2021 started with more of the same. We lagged in the first quarter, as the up-and-to-the-right market of 2020 rallied on. Similar to the later part of 2020 we generated solid absolute returns, but lagged the Russell 2500 Index. But then conditions started to change, particularly in the small and mid-cap space. The market environment and economy were both still supportive, but markets were well off the bottom and investors started to contemplate what comes next. Gains became harder to come by, and the smid market flattened out. It appeared the market was starting to apply more scrutiny to the things we see as critical for long term performance: attractive business models, strong management teams, good market positions and solid end markets. The conditions enabled us to catch up and by the end of the year generate solid relative outperformance.

The wild ride of the past few years vividly illustrates how we manage SMCO. First and foremost, we are disciplined investors. We have a philosophy and process that has worked over business cycles, and we stick to it. We want to participate in all markets but will remain true to our discipline. There will be periods of time where quality and/or valuation don’t matter, but eventually they do. Importantly we can and do adapt to changing market conditions without throwing the playbook out. We tilt the portfolio this way and that, but the underlying philosophy and process remains constant. For stretches over the last few years an adherence to quality hasn’t been a help, but actually a hindrance. We will not chase what we see as short term market trends, particularly if those trends run counter to what we see as important to generating value over the long term.

Second, valuation matters to us, but we are not value investors per se. We don’t buy stocks simply because they’re cheap – we need to see growth in earnings and something the market hasn’t fully priced in. We like quality because over the long term those are the businesses that last. This approach avails us of attractive investment ideas across the spectrum of growth, core and value stocks.

Third, we manage the portfolio actively. This doesn’t mean we trade excessively, but does mean we sell stocks if results disappoint or valuation looks full. This is not a binary process - as mentioned in the 2021 performance review a lot of our trades are incremental adds or trims to existing positions. Thoughtful position sizing is an important part of this process.

Fourth, boring can be beautiful. SMCO is not managed to shoot the lights out in any single year, but rather looks to generate attractive, risk aware results over the long term. As borne out over the 2020 – 2021 period we look to participate in up markets and protect in down ones.  

Looking Forward: 2022

As we look forward into 2022 we are both cautious and encouraged, in nearly equal measure. We see a complex mix of conflicting conditions. There are plenty of positives, including a solidly growing economy and a lot of money still on the sidelines. But the negatives are daunting. The Fed has gone from seemingly limitless support to a tightening posture in very short order. Of course a resurgent Covid pandemic adds to the uncertainty. Where will all this lead? Of course it’s unclear. We will continue to listen to the macro data for a sense of the conditions, but the strategy will remain consistent: look to invest in solid businesses in attractive markets with superior management teams and strong market positions. Whereas our “quality bias” was a drag during the raging bull market that began in March 2020 it may become an important asset in 2022. Finding companies that can make their own weather will become more challenging, and success in that pursuit may be rewarded by investors. In all, we have concerns about the direction of the smid market in 2022 but see a market that may put more emphasis on companies rather than sectors or industries. Now that rates are off zero we’re seeing valuation reenter the conversation. We welcome these changes.

As always feel free to reach out to me or any other members of the Hilton team to learn more about SMCO. Here’s to a successful and prosperous 2022.

Source: Bloomberg and Indata

Please see this document, which contains full performance since inception and important disclosure information. Past performance is no guarantee and is not indicative of future results. All investments and strategies are subject to the risk of loss.