Throughout the first half of the year, companies grappled with continued supply chain issues, higher interest rates, and diminished visibility.  The current “rolling recession” is impacting companies at varying rates and degrees.  As a result, most managements are issuing cautious outlooks.  We spent the first two quarters of the year determining where the companies in our universe are positioned within the current cycle and when their demand could start to improve.  While we were not perfect in the second quarter, the environment continues to be favorable for our strategy.

After nearly eighteen months of pessimism, stock volatility, rising interest rates, high inflation, war in Ukraine, and slowing economic trends, the market rallied through the first half of 2023 due to two key macro themes and one secular driver.  First, the most predicted recession of the last 20 years has yet to materialize.  Companies are maintaining profit margins better than anticipated, and the US economy is still growing.  Second, the market perceives that the interest rate hiking cycle and rapid inflation period is waning.  This has expanded price-to-earnings ratios and driven most of the stock price appreciation this year.  

The third leg to this year’s rally has been the rapid arrival of artificial intelligence (AI).  The early signs of accelerated investment in AI, and the potential cost efficiencies that could accrue, have bolstered optimism of some equities.  We have spent time with several companies addressing the risk and opportunities from AI, and it will be interesting to watch who the true winners and losers are going forward. 

The markets have skewed heavily towards big tech this year as evidenced by the outsized returns of the S&P 500, and even larger returns of the Nasdaq.  AI captured the attention of investors and played a significant role driving the tight concentration of gains at the top of the market.  Notably, the performance of the S&P 500 is now the most concentrated it has been since the 1970’s, with only five stocks representing nearly a quarter of the market capitalizations of the entire index. 

LOOKING FORWARD: 

Although we expect stocks to face some fundamental and share price volatility in the second half of the year, the extreme pessimism that weighed on stock prices through most of 2022 appears to be easing.  We believe investors have grown more comfortable with some of the uncertainties facing the economy and, to some extent, are discounting most of them as mild irritants to growth.  

Earnings season will ramp up over the coming weeks.  We will be on conference calls and follow-up calls to determine what managements’ assumptions are for the remainder of the year, and where they may be too aggressive or conservative.  We continue to look for company specific catalysts and fundamental inflection points and will position portfolios accordingly.  

Fortunately, SG Capital has a proven long-term track record regardless of market conditions, and we are confident that we will continue to find companies that will yield generous returns for our investors. 

We are happy to speak with any clients or interested investors that have questions about our performance or portfolio positioning.  We look forward to reporting back in a month with our July newsletter.

As always, we thank you for your continued trust and support in SG Capital.

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SG SUCCESSFULLY NAVIGATES A CHALLENGING Q1 ENVIRONMENT:

For the first three months of the year, stocks vacillated back and forth driven by the second and third largest bank failures in U.S. history, as well as the continued speculation surrounding the Federal Reserve.  While all four major US indexes logged gains, a narrow breadth of companies buoyed the positive returns.  Looking below the surface revealed the challenging performance for the overwhelming majority of U.S. traded companies.

The 10 largest stocks in the S&P 500 were responsible for 90% of the index’s first-quarter increase.  The entire gain for the S&P 500 came from the top 15 largest companies, and the remaining 485 companies actually lost value through the end of March.  Mega-cap tech stocks’ P/E expansions, not positive earnings estimate revisions, were the key drivers to the index’s performance.  Since the start of the year, forward EPS projections for the S&P 500 have fallen by -1.0%, while P/E multiples have increased from 16.7x to 18.0x.   We believe the speculation that the Fed is coming to the end of their interest rate hikes, combined with the high volatility of treasury yields, sent investors flocking back to the perceived safety and secular growth of the mega-cap tech stocks.  

At SG Capital, our focus remains on small and mid-sized companies, which dramatically underperformed large caps in the first three months of 2023.  Through the end of March, the average stock in the Russell 2000 was down -35.2% from their respective 52-week highs.  Notably, we were able to produce positive returns despite the continued downward pressure across many of the names in our universe.  

The stark difference in performance between smaller capitalization companies and larger companies can sometimes create challenges for fund managers who have market capitalization mismatches.  Fortunately, we have learned this lesson over the last twenty years and pay close attention to this factor risk.  The difference in performance had no material impact on our portfolios in the March quarter.    

Similarly, the first quarter also witnessed a significant divergence between the growth versus value factors.  Growth names greatly outperformed, with the revised market expectation of interest rate cuts coming earlier than previously expected.  We are pleased that our risk management disciplines again helped us avoid  being caught on the wrong side of the growth vs value performance differences.  

Finally, the regional banking industry’s blowups created a number of challenges that we managed through relatively well.  SG Capital did not own any bank stocks, but the tightening credit conditions had implications for many other industries in which we traffic.  We quickly identified our risk exposure and took action to minimize the impact to the portfolios.  Overall, the March quarter is one that required disciplined risk management.

LOOKING FORWARD: 

At SG, we continue to manage risk exposure tightly while taking advantage of dislocations in stock prices.  Notwithstanding the challenging markets and exogenous events, we are confident that we are well positioned for the upcoming earnings season and will continue to strive to deliver positive performance for our investors.

Going forward, we will continue to focus on generating new ideas while also revisiting companies that we have followed for years.  As was the case in the first quarter, we will be on the road attending company conferences, calling on managements, and doing channel checks to guide our fundamental perspective. 

Thank you for your support and for trusting SG Capital.   We will continue to work hard to provide our investors with strong performance over the coming months.

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Our focus on bottom-up fundamental analysis led to the alpha contribution we achieved throughout the year.  We believe the fluid market and fundamental environment continues to favor our active management approach, and we are hopeful that we can continue to post strong results in 2023, regardless of the broader market performance.  

2022 BIG PICTURE MARKET ENVIRONMENT:  

US equities suffered some of their steepest losses since 2008.  The simultaneous collapse of both the stock and bond markets was likely the result of the Federal Reserve’s aggressive policy to fight inflation.  The US Federal Reserve, along with central banks around the world, issued an unprecedented series of large interest rate hikes in attempts to combat stubbornly high inflation.  The high CPI and PPI numbers were likely fueled by an economic recovery driven by accommodative monetary and fiscal policy, a surge in oil prices and other commodities, as well as supply chain disruptions that resulted from the 2020 Covid crisis.  

The sustained 2022 downdraft was speckled with bursts of investor optimism, but the few sporadic market rallies were fleeting.  Through the second half of 2022, both increasingly negative economic data and positive indicators of peaking inflation drove flashes of investor hope that the Federal Reserve would have to pivot from its aggressive interest rate hikes.  However, as the Fed restated its commitment to hold interest rates high, concern mounted in the fourth quarter over a seemingly inevitable recession and a deteriorating corporate earnings outlook.   

LOOKING FORWARD: ENTERING 2023 CAUTIOUSLY OPTIMISTIC 

Fundamentals were resilient in 2022, but we do not think this will last into 2023 as financial conditions continue to tighten and global demand weakens.  Consumers and corporations are poised to cut discretionary spending.  In 2022, companies had pricing power, and could pass higher prices along to customers which boosted overall sales growth and profit margins.  However, as demand weakens, we believe additional price increases will be difficult, and sales growth for many industries will be pressured.  

Through the third quarter of 2022, corporate earnings were relatively healthy, providing some support for stock prices.  While the earnings for the S&P 500 companies only fell 1.2%, the index ended the year down -18.11%.  The S&P 500 P/E multiple started the year 21.3x and ended at 17.4x as the risk to future earnings became discounted, and higher interest rates increased discount rates.  The multiple that investors were willing to pay for future earnings accounted for 95% of the Index’s decline.  Meaning, the stock market losses were driven primarily by multiple compression and not earnings deterioration.  

Going into 2023, P/E multiples are more reasonable than a year ago, but we think earnings have more downward revision risk.  Interest rates, inflation expectations, and Federal Reserve policy could continue to drive P/E multiples in either direction in 2023, while we believe corporate profit estimates will generally be revised lower through the year.  We think it’s likely that management teams in many industries will set a lower bar for profits in the upcoming earnings season.  Our job will be to determine if the bar was set low enough as we move through the year.

We are optimistic heading into 2023.  Similar to the last few years, we believe the current environment favors our fundamental focused investing style.  As companies have been plagued by unprecedented macro and geopolitical shocks, it has been difficult for them to accurately predict both demand and costs.  The result has been greater earnings surprises as management assumptions have been wrong.  This is an optimal environment for us as we take advantage of the inefficiencies  that are created by this fundamental business volatility.   

As economic conditions have changed for the worse, our research effort is more focused than ever on balance sheets and competitive advantages.  Higher interest rates and slower demand can separate companies that are well managed from those that have weak balance sheets or poor market share positions.  We believe this environment creates a more favorable backdrop for individual security selection, SG Capital’s specialty. 

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The sell-off in the small and mid cap equities has created select opportunities and pockets of undervaluation.  With the small cap Russell 2000 trading near record-low forward earnings, many of the companies we are buying are fundamentally solid and have had their valuations reset to inexpensive levels. 

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SG CAPITAL THIRD QUARTER REVIEW 

Volatility in the US markets was severe in the third quarter.  Equities fell sharply in September resulting in the third consecutive negative quarter of performance for the general market.  While we consider ourselves to be fundamental, bottom-up stock pickers, the global economic outlook is certainly a key variable today.  Not only do we need to consider the potential changing demand environment but also how to manage risk in the portfolio under a recessionary environment.  Fortunately, we have been through several macroeconomic cycles in our careers and have learned many valuable lessons.  We believe our years of experience managing portfolios through difficult market environments contributed to our strong performance in the month of September and year to date.

Much of the volatility in the last three months was driven by uncertainties around interest rates and monetary policy.  The unrest in the global economic market added to the list of investor concerns. 

The result of the global turmoil and an aggressively tightening Federal Reserve has been a very strong US dollar.  The US dollar has appreciated against the euro, yen, and pound by at least 15% in 2022 which is causing a ripple effect around the world.  Given that 40% of S&P 500’s earnings originate from overseas , the dollar’s strong increase is significantly pressuring many US corporations’ bottom lines at a time when profit margins are compressing, and demand is slowing.  

We are scrutinizing companies’ geographic exposure to understand the currency translation risk to their income statements but also the potential disadvantage if they have local competitors in a given international market.  

SG DEFIES SMALL CAP WEAKNESS: 

The majority of SG Capital Cedar Street and Teton Strategies’ exposure is to small and mid capitalization companies.  This universe has experienced incredible volatility in 2022 with the average member of the Russell 2000 index seeing a 46% decline from their 52-week-high.  While the Russell 2000 experienced a dramatic up and down during the quarter, select Cedar Street and Teton Long Short Strategies produced consistent returns to end the quarter with positive performance.  We were able to generate alpha in the portfolios and our strong stock selection helped drive results. 

LOOKING FORWARD to Q4 2022: Narratives worth considering 

Will the market’s anxieties about corporate profitability come to fruition this earnings season?  So far, most of the damage in the market has been a result of valuation compression as opposed to earnings weakness.  The question now is will earnings revisions down be more severe than the market has already priced in?  Importantly, if economic numbers start to show signs of a slowdown with inflation retreating, will the Federal Reserve pivot?  Our view is that a less-hawkish Fed could result in a market rally, but we have no view on when or if this will be the case.  Despite plenty of near-term market uncertainty, we have long-term confidence in our investing strategy and ability to produce positive performance regardless of the macro environment.  

Our investment strategy never hinges on timing the market, and we have been successful in producing alpha despite market conditions. 

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The first half of 2022 can be summarized by a sustained downdraft in equity prices with sporadic rallies that have, so far, proved unsustainable.  Persistent inflation, aggressive rate hikes, a war in Europe, and continued lockdowns in China are driving recession fears that have prompted investors around the world to take a risk-off approach. The market multiple has contracted, and earnings revisions are likely to come down further going forward.

SG’S POSITIONING MID-YEAR 2022: Braced for volatility

As economic uncertainty surges, powerful and unavoidable macro pressures are having real-time implications for many of the small and mid-capitalization companies we follow.  While we do not invest based on macro forecasts, we do weigh overall investor sentiment and consider key market drivers as we reposition our portfolios to limit our risk.

Our core strategy will always concentrate on individual company fundamentals. However, considering the highly inhospitable economic climate, we wanted to run through some of the factors and considerations we are currently focused on as we build our portfolios.

• Scrutinizing Capital Structure: We are paying very close attention to how much leverage companies are using, debt maturity timelines, and potential upcoming refinancing needs. With the cost of borrowing rising, companies’ capital structures take on heightened importance, and we scrutinize them before purchasing a company’s stock.
• Pricing Power: In recent quarters, we have been focused on companies that can pass on increased costs to their customers and maintain margins during inflationary periods.  Many industries have experienced multiple rounds of price increases, and some are at the tipping point where the elasticity of demand is being tested. Understanding how companies manage rising input and labor costs and how durable their customer demand is crucial.
• European Exposure: We believe Europe is particularly vulnerable based on field checks and their reliance on imported energy. Europe has major structural challenges ahead as they wean themselves off Russian oil and gas.
• Service Industries: We are sifting through companies in industries not as susceptible to supply chain issues and the slowing economy. We have found companies we like in the commercial and professional services, consumer services, communication services, consulting, and education subsectors. The June ISM Services Index reported stronger growth in June than expected, which helps support our thesis.
• Interest Rate Sensitivity: With aggressive rate hikes on the horizon, we are focused on limiting our exposure to highly rate-sensitive sectors or business models that require high levels of capital expenditures.
• Increasing Face-to-Face Management Meetings: In June, we participated in over a hundred in-person management meetings through conferences, in-office meetings, and visiting company headquarters. We find a face-to-face meeting with company management an invaluable part of our research process.
• Peer Group Monitoring: We are closely monitoring how companies that are correlated to our holdings are reacting to earnings news. Fundamentally, what are these companies saying and how are their stocks reacting?

EMERGING OPPORTUNITIES: Valuations are low, and prices for companies with solid fundamentals are attractive

Looking at the first half of 2022, it is clear that earnings momentum has remained strong, and that valuations have been the major headwind to stock prices. The Russell 2000 declined -23.43% in the first half of 2022.  EPS contribution has been positive for the Index, and the entirety of the detraction has come from P/E compression.

Even though the small-cap index fell over the last 12 months, the profits for small-cap companies grew by 53.5%, (as measured by the trailing 12-month EBIT for the Russell 2000).  The key question going forward is now that valuations (multiples) have reset lower, do the earnings estimates for company profits need to be reset lower too? Our research process is geared for this type of analysis, and we are spending time discerning this for individual companies.

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2021 was by all accounts a very successful year for SG Capital, with all strategies handily beating their respective benchmarks.  We are thankful to have performed well for clients and for the good health of our employees and their families.

While the equity indexes were broadly higher, there were mine fields that we were pleased to have avoided over the last twelve months. We navigated the rotations in and out of the perceived Covid beneficiaries and the re-opening trades well this year, as many of last year’s winners became this year’s losers. While November brought a steep pullback in highly valued growth names that hurt performance for many of our peers, we performed well in the month.

Throughout the year, we added significant alpha with our stock picking strategy that focuses on company fundamentals and earnings surprises. Our bottom-up research effort allowed us to uncover opportunities where stock prices were dislocated from their earnings performance resulting in strong alpha.  

As we enter 2022, the environment remains fluid with many variables impacting companies’ profitability.  Over the last several months, companies have faced demand fluctuations due to Covid and stimulus impacts, commodity inflation, supply shortages, logistics congestion, and labor issues. We are hopeful that our investing strategy will continue to benefit from these existing dynamics over the coming year.

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