“Same old thing in brand new drag comes sweeping into view,” is a line from David Bowie’s song “Teenage Wildlife,” released in 1980. The quote, admittedly taken out of context, provides an apt description of the second quarter: Once again a handful of mega-cap tech stocks outperformed the rest of the market. The proximate driver of this outperformance was the embrace of all things related to generative AI technology, and that embrace kicked into overdrive with Nvidia’s late May earnings report. The deployment of AI will generate meaningful revenues for the enablers but zooming out a bit there is more driving these stocks. These are dominant, cash generating entities that to some extent can make their own weather. Yes, AI is the bright shiny object that caught the market’s attention but given the lack of macro (and micro) clarity these stocks garnered massive investor interest.
The distorting effect of the “Magnificent Seven” clearly can be seen by charting the NASDAQ 100 and the S&P 500 (cap weighted) against the equal weighted S&P 500 (Figure 1) and is a continuation of what we saw in the first quarter as well (Figure 2). Since we focus on the smid cap space we included the Russell 2500 in these charts as well. The 2500’s 5.2% gain in Q2 and 8.8% year-to-date are respectable, but pale in comparison. As smid cap managers you can only imagine how exciting it is to see a handful of giant stocks once again dominate equity markets…
Figure 1
The Second Quarter Brought More of the Same…
Figure 2
… Making The Year-to-Date Outperformance of Large Tech Impressive
As the graphs illustrate the smid space was actually flat to down for about two thirds of the quarter, then moved higher in June. The small and mid-cap participation towards quarter end may prove to be a healthy broadening of the market, but back and forth moves since then make the picture less clear. Time will tell.
Back in college one of my housemates was the captain of the rugby club. For tournaments the team would often have custom t-shirts made, usually with some sort of cheeky caption on them. One memorable shirt read “We may be small, but we’re slow”, an obviously tongue-in-cheek twist on “We may be small, but we’re quick.” The second quarter proved to be a bit of a “small but slow” quarter for SMCO. In a general sense our positioning was too defensive given the optimistic market mood. The defensiveness was manifested at the stock level more so than sector allocations, with lower beta and quality not fully participating in the move higher. So, the omission aspect of our underperformance was the lack of beta and/or lower quality stocks. On top of that we had a few very weak stocks that made matters worse = sins of commission. Our proactive position management is designed to limit single stock risk, but three notable decliners impacted performance in a short time period. During Q2 we had three drags on the portfolio: Xponential Fitness, Concentrix, and Capri Holdings. XPOF was hit by a well-orchestrated short report right at quarter-end. We believe the report is inaccurate and expect the stock to recover, but since the company cannot immediately disprove all the allegations, we held our position but did not add back to it. Concentrix had three issues, namely macro-driven weakness, an ill-timed (in our opinion) acquisition, and the perception that AI will cannibalize their business. We eliminated the position. Concentrix may recover, but it will take time to dispel the concerns, and while we have patience our patience is not unlimited. Capri was hit by weak US wholesale performance and less-than-expected recovery in China. Once again, we stayed with what we own, but did not build back the weight. We have found other attractive names in the consumer discretionary space and have added them to the portfolio, diversifying our exposure.
Our relative defensiveness was informed by several recession indicators, all of which were (and still are) flashing bright red, in our opinion. Figures 3 and 4 below, the ISM and the 2/10 Treasury Curve, are two vibrant examples.
Figure 3
Going Down: ISM Readings In Q223
Figure 4
Now THAT’S An Inversion: The 2yr/10yr Treasury Curve
We are in a period where some “almost always right” recession indicators are juxtaposed against an economy that has proven more resilient than expected. Consumer confidence and Housing (Figures 5 & 6) continue to hold in, leading to consistent consumer spending patterns.
Figure 5
Consumer Confidence Remains Stable
Figure 6
House Prices Climbing in The Face Of Rising Rates
Lastly inflation has started to moderate which has led to a decrease in forward expectations. (Figure 7).
Figure 7
Inflation Expectations Headed Lower
Consistent consumer spending coupled with moderating inflation could suggest a soft or no landing. Our positioning proved overly pessimistic as this view took hold. We believe the US economy is not out of the woods and a recession is still possible, but it looks less likely in the near-term.
We own our mistakes and took our lumps above, but the quarter was far from a disaster. We did generate a positive return and had some strong performers during Q2. Individual stock winners were spread across sectors: Elf Beauty in Staples, Nvent and Dycom in Industrials, and Entegris in technology. Our Industrials position, both the overweight and stock selection, delivered good results. It appears our infrastructure/re-shoring thesis is playing out. Additionally, our Communication Services positions were good performers, with Live Nation benefitting from strong concert demand and Magnite looking like a survivor in the digital advertising ecosystem.
During the second quarter we made some changes to the portfolio, cutting drags, pruning winners and adding new names. We completely eliminated two positions, and another one was effectively exited via a takeout. We added three new names to the portfolio, one each in Consumer Discretion, Industrials and Financials. As always, these moves were accompanied by incremental adds or trims to several stocks. This incremental action is a big part of our process and keeps the aggregate portfolio exposures in line.
Looking at the first half of 2023 in total we have generated about 19% portfolio turnover. This is not high in an absolute sense but is higher than we have been running over the past few years. We have added new names to the portfolio, notably in Consumer Discretion, Technology (semiconductors) and Industrials. We also have eliminated two positions and trimmed several others. Our actions have lessened the defensive tenor of the portfolio, but we have not fully embraced the market’s exuberance. If that sounds like we are somewhere in the middle that is because we are. We were too defensive for the quarter, but the data are still mixed, and the outlook is unclear. The consumer has stayed strong, but we believe the stresses are mounting. The housing sector has shown surprising resilience, even in the face of materially higher interest rates. Inflation is moderating but the Fed remains hellbent on using rates to slow inflation further. The economy is slowing, and though some believe there are no longer lagged effects of rate hikes there may very well be. Stock valuations are neutral at best – not excessive but not overly cheap either. Equity markets appear to be anticipating that mid-year (i.e., now) will mark the bottom of the earnings cycle, even in the face of continued macro slowing. This is possible, but by no means a lay-up. We have made changes to capitalize on current market conditions but need more clarity to move further. We will be closely watching both macro data and upcoming earnings to determine whether this is indeed a soft/no landing or if a hard landing is on the way. We can, and will, tilt in either direction.
Thanks for your continued support. As always, we would be happy to discuss the strategy further.