SG Capital is pleased that our disciplined investing has helped us successfully navigate a particularly volatile and challenging period in the US Stock Market. Select Cedar Street products are having outstanding performance, significantly outpacing the broader market. The Teton Strategy has minimized losses and is down considerably less than the broader market, which is having one of the worst starts to a year in the stock market’s history. With such a large number of concurrent challenges, we are pleased that our risk management has effectively managed the size of losses while adding valuable alpha to our portfolios.
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.