I. Fourth Quarter 2023: Keeping up with the Russells
Ok, let’s get this out of the way right away – we did not keep up. SMCO did end the year on a strong note, generating a +10.5% gross/+10.3% net return in the fourth quarter, but Mr. Market embraced the softening inflation and positive economic data sooner and more completely than we did. The dovish December Fed presser served as the cherry on top, broadening the rally and pushing stocks higher still, spurring a nearly autonomic rise into year-end. The portfolio benefitted from strong moves in technology, industrial and financial names, with Cyberark, Kyndryl, Dycom and Entegris providing solid contributions. The single stock drags were smaller, with Xponential Fitness, Helmerich & Payne and RH being the worst of the lot. Our under allocation to financials and consumer discretion, more than single stock hits, is what limited portfolio returns.
II. Full Year 2023: Over Under Sideways Up
SMCO (White) And The Russell 2500 (Orange) In 2023
The stock market seesawed throughout the year, with three peaks and two well defined valleys. SMCO mirrored the directional moves, but to a lesser amplitude on the ups and the downs. This reflected our positioning, from both a sector perspective and a stock profile perspective. Reviewing the year it’s clear our concern for the consumer proved overblown. She remained resilient, and consumer stocks fared better than we expected. Our under allocation to financials into the fourth quarter was also off, with the expectation of lower rates powering bank stocks higher into year-end. On the positive side we identified themes that worked: Infrastructure (physical and digital), what we call the “new consumer” (focus on health, beauty and wellbeing), cybersecurity and environmental/energy transition. We see these themes as durable and continue to have good exposure.
For the full year SMCO returned 14.0% gross/13.1% net, short of the Russell 2500’s +17.4%, but a still respectable gain in our opinion. We entered the year cautiously, and though that stance served us well during choppy periods, it cost us relative in the end. That said, we had plenty of gainers for the year, with Elf Cosmetics, nVent, Cyberark, Ares Management and Clean Harbors being the biggest contributors to performance. We had some laggards as well, with Concentrix, Xponential Fitness, Wolfspeed, Ashland and Azenta being the dogs. We continue to hold Ashland and Wolfspeed, but Concentrix, Xponential and Azenta have been eliminated. Patience is a virtue, intransigence is not.
The stock market priced in a lot of goodness during the fourth quarter. For the fourth quarter energy was the only sector with a negative return, and for the month of December every sector was positive. A rocky start to 2024 notwithstanding, a soft landing appears to be the prevailing expectation, and for good reason. Inflation indeed does appear to be coming down, and while the macro is cooling we’ve yet to see anything indicating kind of the sharp drop-off that would herald a recession. If we do get a soft landing further stock gains are possible. We were skeptical of a soft landing, and admittedly came around slowly. Now the data appear to support this outcome, but alas, unlike death and taxes, a soft landing is not a given:
- The Fed has to respond to slowing inflation with cuts. If not the effect will be a rise in real rates and restrictive conditions could push the economy into recession.
- Macro growth must slow, but not dip into the red, and the consumer must remain active.
- Wages and employment can moderate, but labor market conditions must hold up reasonably well.
- The “almost always” right recession indicators that kept us cautious in 2023 are still concerning. This time may indeed be different, but to ignore these flashing lights seems unwise.
- Company commentaries have been less than encouraging, not a total surprise given slower macro growth, but still worth monitoring. One issue we’re keenly focused on is pricing power. We saw it as important as inflation rose, but with broad inflation moderating we will see which companies have real pricing power.
So a number of things have to break right, else the soft landing could keep softening and become… a hard one. We believe we are positioned to capitalize on the currently supportive conditions but stand ready to lean in further should confidence increase, or to lean back the other way if conditions deteriorate.
III. Back Turned, Looking Down The Path: The Long View
Though we lagged the market in 2023 we are gratified to have posted superior returns over a two, three, four year and inception-to-date basis. Years ago a senior colleague said “the long term is made up of a series of short terms.” This Yogi Berra-like statement is relevant to how we manage the portfolio. We are long-term investors but do consider market and macro conditions in our search for new investments. So how can we claim to be long term investors and listen to market and macro indicators? Broadly speaking our investments fall into two categories. The first group is secular investments, where a powerful company-specific story draws us in. The investment case for these stocks is not dependent on macro or market conditions. The bulk of our efforts are aimed at identifying these secular winners, but they are few and far between. When we do identify one it becomes part of the portfolio for a prolonged period, in many cases for years. But we also constantly monitor market/ macro conditions and seek ways to capitalize on prevailing conditions. This leads to the second type of holding: companies that exhibit similar attributes to our core holding but may have more dependence on prevailing conditions. We stick to our process – these names still must clear the same rigorous selection process – but typically end up being held for a shorter period. Occasionally the positive fundamental changes we identify persist to a greater magnitude, or last longer than we expect. This is our favorite outcome, and these stocks morph into core holdings. Owning both - secular core holdings along with stocks benefiting from current conditions - helps us accomplish our goal of attractive long-term risk, adjusted results.
The end of January will mark a very important milestone for SMCO: a five-year track record. For anyone who operates in the financial markets the last five years feel more like twenty. It’s a been an eventful half decade, and while we wouldn’t wish it on our worst enemy, we take away something positive. The wild swings, stresses and excesses of the last five years have put our process through the paces. SMCO has come through intact, with respectable returns, particularly in light of the risk taken. It has performed as designed though a turbulent period. We thank those who have been with us for the ride, and for those who needed a five year track record before joining us – GET READY!
IV. Those music references …
It’s been fun incorporating music references into our letters this year. Perhaps it’s a bit hokey, but hopefully it makes the reading a bit less dry. As such we decided to continue the practice with a few more in this letter. First, fans of the 1960’s London music scene might recognize that the title of Section II is a slightly altered version of a Yardbird’s, “Over Under Sideways Down.” To us the title does a good job describing market action in 2023 but given how the year closed we chose to change “down” to “up.” Second, the title of Section III is a song off of Warren Zevon’s second self-titled album. Well technically it was his second album, but it was his first major label release, and put him on the map. The song captures a moment in his life when he’s putting a turbulent past behind him and looking optimistically towards the future. We’ve managed SMCO through a turbulent few years and are very much optimistically looking forward. And lastly, for new readers the main title of this quarter’s letter bears explanation. In our Q2 commentary we mused whether it was Achilles last stand, and for August through October it appeared as though he had indeed fallen. Then, in our third quarter wrap we wondered if the sun was about to break through or if the rain would keep falling. 2023 closed with the sun shining brightly on the stock market. And our Greek hero? He lived to fight another day.
Here’s to a successful and prosperous 2024.
