Q3 2023 Update – Notable Themes and Market Drivers

SG Capital Portfolios Hold Up Well Amidst a Turbulent Third Quarter in the US Market

The stock market closed out September on a negative note with the Russell 2000 down -5.89%. September was the second consecutive month that stocks ended lower and so far, is the worst month of the year. After a blistering start to 2023, the market was notably weaker in the third quarter as equities contended with numerous headwinds. The surge in Treasury yields (and have moved even higher in early October), the strength of the U.S. dollar and rising oil prices have all exacerbated concerns about inflation and where the economy is heading. Further, the recent economic data has stoked fears of a “higher for longer” restrictive Fed policy despite a global economic slowdown. The economic concerns coupled with the UAW strike and the risk of the US government shutdown created a risk off mentality in September.

As has been the case for most of the year, small capitalization equities have underperformed larger cap indexes thanks to the handful of mega cap tech names that have buoyed the S&P and Nasdaq. As we have highlighted in the past, this is a market environment that we feel confident that our strategies can continue to perform well in.

The SG Research Team met with over 250 managements in person in addition to over 450 phone calls with companies during the third quarter. Some key themes we are picking up on include incremental deterioration in demand out of China. Many U.S. companies have large operations in China for products that are then exported. For the products that are consumed domestically in China, we are seeing demand fall off more quickly than most companies expected. Additionally, we are picking up on continued pressure on demand across Europe. We screen our companies by geographic exposure and are finding that companies with more U.S. centric revenue are holding up better than those with significant international sales.

Another quickly developing theme is a derivative of the highly publicized Artificial Intelligence (AI) wave. Computing beneficiaries like Nvidia (NVDA) are well known, but we are finding less covered companies we think will be impacted. AI computing requires 4x the amount of power and generates 4x the amount of heat versus typical cloud computing. This will force data centers to reconfigure cooling and other systems in ways they had not anticipated just a couple quarters ago. We are identifying HVAC and other cooling system companies that we think will see accelerated orders in the near term as AI computing companies adapt for higher heat and energy consumption processing in their data center facilities. We also have identified a contract manufacturing company we think is well positioned with significant exposure to Google (GOOG) and Meta (META) who are accelerating their investments in AI capacity buildouts.

Earnings season kicks off in a few weeks, and we will again be listening to management commentary about demand and where company profits might be different versus street expectations. Similarly, we will be listening to what impact higher interest rates and costs of capital could have on forward capital expenditure budgets. As mentioned, we were on the road a good chunk of September and had many company touch points resulting in strong idea generation. We look forward to implementing these alpha long and short ideas across the portfolios in the coming weeks.