The blues-rock song “Black Cloud” by Trapeze, an obscure band from the 1970s, features an infectious guitar riff and the recurring lyric “black cloud’s following me” – a sentiment that captures how the third quarter felt to us. And in a nod to the band's name, the sharp reversal in our AI-related holdings, from a steep second-quarter upswing to a rapid third-quarter downswing, made the past six months feel like a trapeze ride. While the third quarter was challenging for small- and mid-cap stocks broadly, the SMCO strategy had a particularly difficult quarter. Below, we take a candid look at what drove our underperformance, where we could have done better, and the adjustments we have made to the strategy.
Sticking with the weather theme, we borrowed this section's title from the Jerry Garcia/Robert Hunter song “The Wheel” because it captures how things progressed from the second quarter into the third. The second quarter’s “thunder” partially got us. Our AI exposure helped generate a strong absolute return, but it was not enough to keep pace with the Russell 2500 Index. Then the third quarter’s “lightning,” a sharp reversal in AI-related stocks, hit the strategy particularly hard.
The market’s enthusiastic embrace of companies tied to the AI buildout, including some only tangentially related, gave way to growing skepticism about the sustainability of the spending cycle. We believe concerns surrounding circular financing arrangements, severe component shortages, and potential data center moratoria were compounded by the unwinding of a leveraged AI-focused hedge fund, contributing to a rapid and severe contraction in valuation multiples. Importantly, in our assessment, the fundamental outlook for many of these businesses remained strong, with ongoing projects and substantial backlogs supporting near-term earnings expectations. We believe much of the repricing reflected a shift in investor sentiment, as the market began to question whether AI-related spending was approaching peak acceleration and whether future earnings revisions might turn negative.
The resulting selloff was a major driver of our third-quarter performance, with the Small and Mid Cap Opportunities composite declining 11.3% gross and 11.5% net (preliminary), compared with a 6.4% decline in the Russell 2500 Index. Industrials and Technology, home to most of our AI-related holdings, accounted for a significant portion of the underperformance, particularly within the Semiconductor/Semiconductor Capital Equipment and Engineering/Construction industries. Both industries are inherently cyclical, and their valuation multiples have historically contracted as investors anticipate a peak in earnings growth. Our view was, and to some extent remains, that the secular tailwind from AI investment could create a prolonged spending super-cycle, potentially moderating that traditional cyclicality. While that thesis may ultimately prove correct, the third quarter demonstrated that even strong underlying fundamentals offer limited protection when investor sentiment shifts abruptly.
We are constantly looking for ways to improve as portfolio managers and periods of underperformance can offer particularly important insights. Looking back at the quarter, we see things we did right, but also areas where we could have done better. Our AI-related holdings weighed heavily on third-quarter performance, but they had been meaningful contributors in prior periods, and we continue to believe in the underlying investment thesis. Where we fell short was in managing the size of that exposure as enthusiasm for AI accelerated. As earnings expectations rose and valuation multiples expanded, we were actively trimming positions. However, those reductions were not sufficient to prevent our aggregate AI exposure from increasing modestly over time. We were trying to strike a balance between maintaining our valuation discipline and participating in a powerful secular growth opportunity. In hindsight, we leaned too far toward participation. Rather than allowing our overall exposure to increase, we should have been trimming more aggressively. Tactically, our 25-basis-point trims should have been closer to 50 basis points.
Position sizing was only part of the issue. We also allowed certain holdings to remain at elevated valuations longer than we should have. Our process is disciplined but intentionally flexible. While valuation always matters, we allow some flexibility in how quickly we reduce positions when fundamentals are improving and market conditions are supportive. In this case, we overestimated the durability of momentum in AI-related stocks and underestimated the speed and severity of the subsequent multiple contraction. Importantly, this was not a case of chasing stocks into the recent rally. Most of these positions were established as part of our broader digital infrastructure theme, well before AI became such a dominant focus for investors. We identified companies that we believed were well positioned to benefit from this investment cycle, but should have recognized sooner how much of that opportunity was already reflected in their valuations.
Our underlying investment philosophy and process remain unchanged, but a bruising quarter has prompted some adjustments to the strategy. We have reduced our exposure to companies tied directly to the AI infrastructure buildout, tightened our approach to position sizing and valuation, and redeployed capital into other areas where we see attractive opportunities.
We continue to maintain exposure to companies benefiting from AI infrastructure spending. We believe many of these businesses have strong earnings growth prospects, and the recent selloff has brought valuations down from their prior highs. However, multiples remain elevated, and we also see increased uncertainty surrounding the direction of future earnings revisions. As a result, we believe it is prudent to maintain less exposure to this group and manage individual positions more conservatively.
We have redeployed the capital freed up from these reductions across several areas. We continue to find attractive opportunities in the broader industrial space, where our exposure has grown through both additional purchases and appreciation in existing holdings. We have also added to certain areas within the Healthcare sector where we see a favorable backdrop for services businesses and the potential for improvement in research funding.
Beyond these sector-specific opportunities, we have also been adding to two broader groups of companies. The first consists of businesses benefiting from AI in ways that extend beyond simple efficiency improvements. We expect the use of AI to improve productivity and reduce costs to become “table stakes” across most industries. Companies that fail to embrace the technology could find themselves at a competitive disadvantage. What particularly interests us are businesses where AI is creating new growth opportunities or helping their customers deploy the technology. We have discussed this theme in prior letters, and as AI continues to evolve, we are finding more companies that fit this profile. Our exposure to this group has increased from approximately 5% to 15% of the strategy, spread across a variety of businesses in several different sectors rather than concentrated in any one industry.
Finally, we have been adding to earnings compounders, companies whose appeal lies less in the absolute pace of earnings growth and more in the consistency and reliability of that growth. We have always maintained exposure to these types of businesses, which we often refer to as “grinders,” but believe they are particularly attractive in an environment marked by heightened uncertainty. While they may not generate the excitement of some of the market's faster-growing companies, their ability to consistently compound earnings over time remains an important part of our investment approach.
Taken together, these adjustments reflect our effort to build a more balanced portfolio, one that can continue to participate in attractive long-term growth opportunities while placing a greater emphasis on valuation discipline and earnings reliability.
We enter the fourth quarter with the small- and mid-cap market trying to find its footing amid a mix of encouraging trends and legitimate concerns. The war with Iran, persistent inflation, rising interest rates, and pressure on lower-income consumers all present challenges for equities. Until there is greater clarity around these issues, we would not be surprised to see markets struggle for direction.
At the same time, there are meaningful reasons for optimism. In our view, the U.S. economy remains relatively resilient, industrial activity is improving, and an increasing number of companies are finding ways to capitalize on AI. For some, that means improving efficiency and reducing costs, while for others, it is creating entirely new growth opportunities. We believe these trends could support both revenue growth and margin expansion, creating opportunities for earnings to continue surprising to the upside.
One of the more notable developments this year has been the dramatic shift in expectations for Federal Reserve policy. Investors entered 2026 anticipating additional interest rate cuts, but the discussion has since shifted to the prospect of further rate hikes. Despite this reversal, small- and mid-cap equities have held up reasonably well for the year, supported, in our view, by a healthy outlook for earnings growth. We believe the economy and corporate earnings are strong enough that stocks may be able to absorb a few additional, measured rate hikes without a major selloff. In that environment, we would expect investors to place greater emphasis on companies with strong balance sheets, reliable earnings, and durable business models. These are precisely the characteristics we have long emphasized in the SMCO strategy.
All in, we continue to see the potential for positive market returns into year-end and 2027, but the third quarter was a shot across the bow. The speed and severity of the selloff underscored how quickly investor sentiment can shift, even when underlying fundamentals remain healthy. With the outlook for the economy, interest rates, and AI spending still uncertain, we expect the path forward to be uneven. That does not diminish the opportunities we see, but it reinforces the importance of being selective and disciplined in how we pursue them.
While the third quarter was certainly disappointing, our confidence in the long-term investment philosophy behind SMCO remains unchanged. Our focus on identifying quality businesses, maintaining valuation discipline, and managing risk has served us well over time. Equally important is the flexibility to adapt as market conditions evolve. We have taken a hard look at the quarter, made adjustments where warranted, and believe the strategy is better positioned as a result.
Looking ahead, we remain encouraged by the opportunities we are finding. We continue to see attractive businesses with durable earnings prospects, compelling long-term growth opportunities, and valuations that we believe offer the potential for attractive returns. Markets will inevitably present new challenges, but we remain confident in our ability to navigate them and build on our long-term track record.
Thank you for your continued confidence and trust in SMCO.
| SMCO 3Q26 Review | |
| Composite 3Q26 Return | -11.3% gross / -11.5% net (preliminary) |
| Composite YTD Return | 2.7% gross / 2.2% net (preliminary) |
| 3Q26 Turnover | 10.9% |
| YTD Turnover | 27.7% |
| 3Q26 Positive Contributors by Sector | Healthcare, Communication Services (only 2 positive sectors) |
| 3Q26 Five Biggest Contributors by Stock | Magnite, Revvity, Radnet, Devon Energy, West Pharmaceuticals |
| 3Q26 Three Biggest Detractors by Sector | Industrials, Technology, Consumer Discretionary |
| 3Q26 Five Biggest Detractors by Stock | Dycom, MKS Instruments, Willscot, Tetra Technologies, MACOM |
| 3Q26 New Names | UFP Technologies, Sonida Senior Living, Balchem, Revvity, Paylocity |
| 3Q26 Names Eliminated | BioTECHNE (takeout), Academy Sports, Entegris, Shift4, Planet Fitness |
| Holdings at Beginning of Quarter | 62 |
| Holdings at End of Quarter | 62 |
Important Disclosures:
Hilton Capital Management, LLC (“HCM”) is a Registered Investment Advisor with the US Securities Exchange Commission. The firm only transacts business in states where it is properly notice-filed or is excluded or exempted from registration requirements. Registration as an investment advisor does not constitute an endorsement of the firm by securities regulators nor does it indicate that the advisor has attained a particular level of skill or ability.
The views expressed in this commentary are subject to change based on market and other conditions. The document contains certain statements that may be deemed forward looking statements. Please note that any such statements are not guarantees of any future performance and actual results or developments may differ materially from those projected. Any projections, market outlooks, or estimates are based upon certain assumptions and should not be construed as indicative of actual events that will occur.
All information has been obtained from sources believed to be reliable, but its accuracy is not guaranteed. Sources include: Bloomberg and INDATA (our portfolio accounting and performance system). There is no representation or warranty as to the current accuracy, reliability or completeness of, nor liability for, decisions based on such information and it should not be relied on as such.
The performance information contained herein is preliminary and unaudited, was calculated by HCM and is shown on both a gross-of-fee and net-of-fee basis. The performance results herein include the reinvestment of dividends and/or other earnings, and the net-of-fee performance results are shown net of the actual advisory fees paid by the client accounts in the HCM SMID Cap Composite. In addition, actual client accounts may incur other transaction costs such as brokerage commissions, custodial costs and other expenses. Accordingly, actual client performance will differ, potentially materially, particularly given that the net compounded impact of the deduction of investment advisory fees over time will be affected by the amount of the fees, the time period, and the investment performance. For additional information about the composite, please contact us - info@hiltoncm.com
All investing involves risks including the possible loss of capital. Asset allocation and diversification does not ensure a profit or protect against loss. Please note that out- performance does not necessarily represent positive total returns for a period. There is no assurance that any investment strategy will be successful. All investments carry a certain degree of risk. Dividends are not guaranteed, and a company’s future ability to pay dividends may be limited.
Additional Important Disclosures may be found in the HCM Form ADV Part 2A, which can be found at https://adviserinfo.sec.gov/firm/summary/116357.