Small Cap Fund

(As of 6/30/22) — The stock market extended year-to-date losses during the 2nd quarter. Inflation, rising interest rates, and economic uncertainty continued to be major headwinds for investors as recession talks gained traction. The S&P 500 Index fell -16.10% during the quarter, bringing the total return for the first half of the year to -19.96%. News headlines, which included energy shortages, the war in Ukraine, China’s COVID lockdowns, and the potential for softer corporate earnings next quarter, added to the pessimistic market sentiment. However, the Federal Reserve’s hawkish stance on inflation, expectations for additional interest rate increases, and a reduction in the size of its balance sheet, continued to signal confidence in the U.S. economy moving forward.

The broad-based Russell 3000 Index declined -16.70% in the quarter. Value stocks fell less than growth stocks as the Russell 3000 Value Index returned -12.41%, versus a return of -20.83% for the Russell 3000 Growth Index. Relative performance slightly favored market cap size as large caps outperformed small caps in the quarter. Larger cap stocks, as measured by the Russell 1000 Index, returned -16.67% compared to the smaller cap Russell 2000 Index return of -17.20% and the Russell Microcap Index return of -18.96%. There were no advancing economic sectors for the quarter, but Consumer Staples, Energy, Utilities, and Healthcare held up better on a relative basis. Consumer Discretionary, Information Technology and Communication Services areas lagged.

(As of 6/30/22) — With the worst first half performance for small cap stocks since 1973 now in the books, we believe that investors are close to pricing in a recessionary scenario for small companies that may or may not happen over the next 12 months. Historically, small caps underperform large caps going into a recession and outperform coming out of one. If small cap stocks have indeed nearly priced in a recession, as the historical data suggests, we could be entering a period where allocators might want to warm up to the asset class.

According to data from Jefferies (the investment banking and financial services firm), the small cap market as a percent of the total market is now less than 4% — a level unseen since the 1930s and a sharp contrast from the peak of nearly 14% in 1984/1985. When relative performance between small caps and large caps has been this low, it is typically followed by a five-year period where the small cap asset class outperforms. Additionally, according to BofA Securities, the Russell 2000 Index’s price-to-earnings ratio (P/E) is at 11.6x, the lowest since the market bottom of the global financial crisis in February/March of 2009.

There has also been a severe correction in high valuation areas such as medical technology and software. As a result, our investment opportunity universe has increased as many of those companies are now trading at more reasonable price levels. We believe near-term market volatility will remain high, especially entering the second quarter reporting period, where estimates for many companies will need to come down. For patient capital, willing and able to ride out near-term volatility, the market could be setting up a nice entry point into the small cap asset class.

At the portfolio level, we continue to focus on companies that benefit from long-term trends with a focus on higher quality characteristics, as measured by return on equity and balance sheet strength, that can withstand a period where access to capital may be constrained. We continue to look for companies with unique product cycles, pricing power, and those that can take market share, which should produce additional opportunities for growth.

As always, thank you for your continued trust and conviction in our capabilities over the long haul. We look forward to proving updates on better times.