Miles Lewis: We saw continued volatility throughout the first half of 2023 in regional bank stocks, particularly in May, and we used this volatility to establish new positions in our Quality Value portfolios, each of which presented us with an opportunity to purchase what we see as strong franchises at or near record low valuations.

From a top-down perspective, we were pleased with the ongoing fundamental strength in our holdings. Despite these strong fundamentals, however, the portfolio in aggregate continues to trade at historically low multiples. Of course, storm clouds remain visible on the horizon, and it seems probable that the economy will succumb to the impact of higher interest rates in the future. Though that may sound ominous, it excites us as owners of quality businesses, some of which also are likely to be acquirers. We hold several cash generative businesses with strong balance sheets and, most important, capital allocation prowess that we believe will enable these companies to act opportunistically in a difficult environment. These opportunities range from hiring teams of lenders amid the market disruption caused by failed banks (i.e., market share gains) to acquiring competitors and other assets at discounted valuations across a variety of industries. We believe that capital allocation skill is key to the ability to drive superior, risk-adjusted returns for our investors.

Lauren Romeo: Fortunately, our Small-Cap Premier Strategy that looks for high-quality small cap companies does not depend on us correctly divining near-term macroeconomic tea leaves or trying to time the stock market. Borrowing a line from Warren Buffett in this year’s Berkshire Hathaway shareholder letter, we “are not stock pickers, we are business pickers.” We focus on identifying and owning companies with durable competitive advantages that enable them to generate and sustain above-average returns on invested capital and compound shareholder value well into the future.

One of the many reasons that we like businesses with these quality attributes is that they can not only weather the storms but can also go on the offensive in times of economic weakness, emerging with stronger competitive positions and poised to drive attractive growth as conditions improve. Of course, their stock prices are not immune to near-term market sentiments, but over the long run quality companies within small cap have historically offered solid capital preservation in down markets while also participating strongly when small caps flourish.

We think small caps remain the most attractively valued asset class on an absolute and relative basis, trading below their historical averages on many metrics—and this is especially true among the high-quality company cohort in which we invest. Relative valuations clearly favor small caps given large cap’s dominance not just year-to-date in 2023 but over the past five years. If inflation continues to decline and allow the Fed to taper its rate hike program, the Russell 2000’s 8.1% rise in June may prove to have been the turning point for the asset class, particularly if the U.S. recession forecast by most economists proves mild. Putting all this in context, we think conditions appear conducive for a shift to small-cap leadership, particularly the quality segment.

Jim Stoeffel: We don’t think we’ve yet seen the full, lagged impact of the Fed’s rate hikes over the past year. Moreover, as the attempted coup in Russia showed us, the world remains subject to potential black swan events that are difficult to underwrite. That said, we believe the Fed is closer to the end of this rate cycle as inflation continues to moderate. While employment is another lagging indicator, the trends also remain relatively constructive. In this context, we’re constructive on the outlook for small-cap value stocks, which we believe remain attractively valued relative to the rest of the market.

We also see several trends that we think should favor our small-cap opportunistic value portfolio. For example, the portfolio remained overweight in both Industrials and Information Technology at the end of June. While there’s been considerable hype around Artificial Intelligence (“AI”), we see it as one more long-term trend driving widespread semiconductor adoption. Many of our technology positions look well positioned to benefit from the infrastructure build-out that’s necessary to support AI. We’ve also been adding to positions in advertising technology companies, which are using AI directly to gain market share as media spending moves from TV to more digitally oriented media consumption.

We also anticipate that AI will help certain industrial positions as these companies harness this technology to drive operating efficiency gains. In addition, many industrial companies should benefit from the ongoing re-shoring of industrial production closer to or in the U.S., a shift that should be further boosted by fiscal spending on infrastructure. Finally, we have been looking at select financial companies outside banking that appear poised to benefit as interest rates stabilize and capital markets activity resumes, as well as at telecommunications equipment companies where the backdrop remains favorable even many stocks have been hit hard.

Chuck Royce: Unlike their bigger siblings, small caps remained in a bear market at the end of June, that is, a decline of at least -20.0% from its prior peak. The Russell 2000 was down -20.8% from its last peak on 11/8/21, though a positive July is ushering it out of bear territory. By contrast, the Russell 1000 was down only -6.2% from its last peak on 1/3/22, and the tech-heavy Nasdaq fell just -13.9% from its most recent high on 11/19/21, through 6/30/23.

Yet I’m optimistic. A lot of recent economic data has been encouraging. For example, spending on manufacturing construction accounted for almost 0.5% of first-quarter GDP, its largest share since 1991. And its second-quarter share of GDP is expected to be even higher. Homebuilding rose by 21.7% in May, a record monthly surge that defied expectations of a slowdown. Capex has been steady and has shown signs of improving, and the ISM services index reaccelerated in June. Durable goods orders rose for the fourth consecutive month in that same month, hitting a record high for nondefense capital goods (excluding aircraft or core capital goods, a proxy for business equipment investment). Moreover, retail and vehicle sales rose in June while the University of Michigan’s consumer sentiment measure rose in July. Even better news, however, was that second-quarter GDP came in higher than expected, thanks to resilient consumers and robust business investment, as inflation continued to moderate, rising at the slowest rate in more than two years. We think investors should also keep in mind that rate hikes and inflation will likely be sunsetting over the next year or so, when the positive impacts of reshoring, the infrastructure bill, and the CHIPs Act will begin to take effect. This is all welcome news, even as we know that a recession remains a possibility.

As Lauren pointed out, small caps continue to be at their lowest relative valuation versus large caps in more than 20 years. Small cap’s weighting in the Russell 3000 is also near a 20-year low. That says “opportunity” to us. And for anyone waiting to invest until after a recession, I think it’s useful to know that small caps rebounded strongly before the end of previous recessions. I know bear markets and periods of economic uncertainty often discourage investors, so I think it’s critical to remind investors that difficult periods are often the most rewarding times to build a small-cap allocation at attractively low prices, particularly for long-term investors. I think history shows the benefits of staying invested during periods of sluggish or negative performance. For my portfolios, I certainly see the currently unsettled period as an opportune time to invest in select small caps for the long run.

Important Disclosure Information