Stocks opened the second quarter with a precipitous drop but quickly regained their footing and staged an impressive recovery over the remainder of the period. The downturn began during the first quarter, as markets started to price in the anticipated effects of “Liberation Day” and the various challenges expected in Q2. After the first week of April, the overall trend was steadily up and to the right. Once again, the small- and mid-cap market lagged the S&P 500’s strong +10.9% gain, though the Russell 2500 delivered a solid +8.6% return for the quarter. While the Magnificent Seven continued to lead, there were encouraging signs of broader market participation.
“Have a Cigar,” the opening track on side two of Pink Floyd’s 1975 album Wish You Were Here, serves as our first musical reference this time around. The second quarter’s upbeat market performance might warrant a celebratory cigar. But as we tried to make sense of the year-to-date market action, a different kind of “CIGar” came to mind: the basic macroeconomic equation, GDP = C + I + G + (X – M). In other words, Consumption + Investment + Government + Net Exports equals Gross Domestic Product.
At first, the market’s strength in the second quarter seemed puzzling given the high level of uncertainty. However, when you consider how macro forces interact with market behavior, the recovery starts to make more sense. The first half of the year brought serious threats to the C, I and G so let’s break them down.
Even though none of these issues have been fully resolved, the market seemed to sense that the worst of the uncertainty was behind us. That shift in perception was enough to drive stocks higher. What matters most to markets is the rate of change, and in many cases, “less bad” is treated as “good.” There are also tangible signs that conditions are improving:
SMCO modestly outperformed the Russell 2500 during the second quarter, rising +8.99% gross/+8.84% net versus the index’s +8.56% gain. Year-to-date, SMCO has returned +1.34% gross/+1.10% net, ahead of the Russell 2500’s flattish performance of +0.44%.
The year so far has been marked by sharp moves in both directions, requiring a careful balance between offense and defense. In the first quarter, we leaned more defensively, but we did so moderately, which allowed us to remain competitive in the second quarter’s recovery. The strongest performing sectors in the SMID market during Q2 were Technology, Industrials, and Consumer Discretionary. Tech and Industrials continued to benefit from robust AI-related capital spending and steady macroeconomic growth. Consumer Discretionary rebounded after a tough start to the year with early weakness stemming from fragile sentiment and tariff concerns, but valuations had compressed meaningfully. As conditions stabilized, the sector recovered.
Within the SMCO portfolio, Industrials and Technology were our largest contributors. Communication Services also emerged as a meaningful driver of performance, becoming our third strongest sector. Magnite led the way in Communication Services, benefiting from strength in digital advertising.
Other top individual contributors included Dycom, Kyndryl, BWX Technologies, and EMCOR. Dycom and EMCOR continued to perform well on the back of strong construction trends: Dycom in fiber buildouts and EMCOR across multiple categories. Kyndryl rebounded from a weaker March as its turnaround efforts showed solid progress, defying a skeptical market. BWX Technologies advanced on solid defense-related results, but investor enthusiasm around its nuclear energy capabilities was the primary driver. Nuclear power continues to gain traction as both public and private entities seek reliable ways to meet growing electricity demand.
On the downside, SMCO’s largest sector detractors – Real Estate, Staples, and Energy – were also the weakest areas in the Russell 2500. The shift away from defensive positioning weighed on Staples and REITs, while Energy lagged due to declining commodity prices. At the individual stock level, the biggest detractors were: Primo Brands, Americold, Charles River Labs, SAIA Transportation, and Independence Realty Trust.
Primo gave back some of its Q1 gains after weaker scanner sales data was released, likely impacted by unseasonably cool, wet weather in the Northeast. We see this as a temporary issue and continue to believe the long-term case remains attractive, supported by a solid core business and meaningful margin opportunity following its merger with Blue Triton. Americold and Independence Realty underperformed alongside the broader REIT sector. Americold continues to face near-term demand headwinds, but we believe the company is making positive operational progress that is not yet reflected in the stock. For IRT, which operates in B-markets for multifamily housing, the setup appears constructive, and we remain confident in the outlook. SAIA was affected by a weak less-than-truckload market and investor concerns over the pace of its expansion. We continue to believe in their strategy and see potential for both share gains and margin improvement as the cycle turns. Charles River was pressured by reduced drug development spending and a market shift away from animal models. While the franchise remains fundamentally strong, we believe it will take time for earnings to recover and made the decision to exit the position.
Portfolio turnover was 6% for the second quarter and 14% year-to-date. We increased our weight in Consumer Discretionary, adding positions in YETI and Academy Sports. We believe both names offer compelling valuations and appear to be at an inflection point following a period of weak sentiment. We also trimmed several outperformers and redeployed proceeds into more attractive risk-reward opportunities, with Consumer Discretionary fitting that profile. We reduced our Consumer Staples weight, consistent with our desire to pare back defensive holdings.
In addition to these changes, we added one new name outside of Consumer: HealthEquity. As the largest provider of Health Savings Accounts (HSAs) and other benefit-related financial tools, HealthEquity appears well-positioned to benefit from long-term demographic trends and rising healthcare costs. Short-term pressures had pushed the valuation to attractive levels, and we took advantage of the opportunity.
We also exited three positions during the quarter: Charles River, as discussed, as well as elf Beauty and Helmerich & Payne. While we continue to see both elf and H&P as high-quality businesses over the long term, near and intermediate-term challenges appear too significant at this point. We will continue to monitor both and would consider re-entering the positions if conditions improve.
At the beginning of the year, we noted that investors should be prepared for a bumpy 2025. That has proven to be an understatement, with dramatic changes in Federal policy, geopolitical issues, mixed economic data and several other storylines contributing to the volatility.
To frame our second-half outlook, we’re borrowing inspiration from two light rock songs from the 1980s. The first is Steve Winwood’s “Back in the High Life Again,” a track that reflected a personal and professional resurgence. If some of the key challenges from early 2025 continue to fade, including tariff concerns, government spending cuts, and business disruption, investor attention may shift toward the potential for more favorable tax and regulatory policies. If AI implementation starts to generate real productivity and earnings growth, that could further support equity markets. In this scenario, the market could indeed find itself "back in the high life again."
We also believe this environment could mark an inflection point for small and mid-cap equities. After significant volatility, earnings estimates have come down meaningfully and may now reflect overly pessimistic expectations. While absolute valuations in the space are not extremely low by historical standards, relative valuations compared to large caps are near all-time lows. Additionally, with the Magnificent Seven once again driving much of the market’s gains, any cooling in that momentum could lead to renewed interest in the broader market. It would not take a large rotation for flows to meaningfully impact the SMID space.
However, risks remain. This brings us to our last reference: “Walking on a Thin Line” by Huey Lewis and the News. While we remain constructive on the outlook for the second half of the year, we acknowledge the fragility of the situation. A wide range of potential developments, from unpredictable policy shifts to changing economic conditions, could pressure markets.
Given the number of unresolved variables, we intend to maintain a careful balance between pursuing opportunities and managing downside risk. If all goes well, there may be more victory cigars to come.
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