ARISTOTLE CAPITAL BOSTON, LLC

Markets Review

SMID caps enjoyed strong gains in the third quarter with the Russell 2500 index delivering a total return of 8.75% but the performance belies the volatile path taken during the period. Equities rallied in July as a below consensus CPI print lent credence to the soft-landing narrative. However, the risk on environment was punctuated in early August as an interest rate hike by the Bank of Japan and the resulting unwind of the levered Yen carry trade rattled global markets. The second half of the quarter was influenced by softening economic data and the Federal Reserve (Fed). Following comments made at the August Jackson Hole economic symposium that the time had come for policy to adjust, the Federal Reserve voted to cut the Fed Funds by 50 basis points (bps). Markets embraced the decision, ending the inversion of the U.S. Treasury yield curve, and the front end is now pricing in roughly 100 bps of easing in 2024.

Stylistically, value stocks outperformed their growth counterparts during the quarter as evidenced by the Russell 2500 Value Index returning 9.63% compared to 6.99% for the Russell 2500 Growth Index. Energy was a negative sector in both indices with much of the relative outperformance of the value index coming from interest rate-sensitive sectors such as Financials and Real Estate. Looking under the hood, the knock-on effects of lower interest rates could be seen in the value index, as two of the top five performers during the quarter were housing related. While AI enthusiasm has subsided in the second half of 2024, pockets can still be seen in parts of the SMID cap market. Lumen Technologies, a languishing communications company, rallied in August and was the top third-quarter performer in the Russell 2500 index when the company announced $5 billion in new business to provide private networks for AI scalers along with the potential for increased customer demand.

At the sector level, ten of the eleven sectors in the Russell 2500 Index recorded positive returns during the third quarter, led by the Real Estate (+17.76%), Utilities (+14.23%), and Communication Services (+14.00%) sectors. Conversely, Energy (-7.61%), Consumer Staples (+2.62%), and Information Technology (+3.11%) all lagged.

Sources: CAPS Composite Hub, Russell Investments
Past performance is not indicative of future results. Returns are presented gross and net of investment advisory fees and include the reinvestment of all income. Gross returns will be reduced by fees and other expenses that may be incurred in the management of the account. Net returns are presented net of actual investment advisory fees and after the deduction of all trading expenses. Aristotle Small Cap Equity Composite returns are preliminary pending final account reconciliation. Please see important disclosures at the end of this document.

Performance Review

For the third quarter of 2024, the Aristotle Small/Mid Cap Equity Composite generated a total return of 9.48% net of fees (9.66% gross of fees), outperforming the 8.75% total return of the Russell 2500 Index. Outperformance was primarily driven by security selection while allocation effects detracted. Overall, security selection was strongest in the Information Technology, Financials, and Materials sectors and weakest in Industrials, Utilities, and Heath Care. From an allocation perspective, the portfolio benefited from an underweight in Consumer Staples and an overweight in Industrials, however, this was offset by an underweight in Real Estate and an overweight in Information Technology.

CONTRIBUTORS

Baldwin Insurance Group (BWIN), a Florida-based insurance company operating in the advisory, underwriting, and Mainstreet (consumer/small business) segments, built on second-quarter momentum with above consensus earnings on account of business line growth and margin improvement. We believe the company is starting to benefit from investments in talent made over the past year as well as the launch of new products. We maintain a position as we believe the company should continue to benefit from a positive inflection in free cash flow, improving margins, and deleveraging.

ACI Worldwide (ACIW), a provider of software solutions to facilitate payment transactions for financial institutions, retailers, and payment processors around the world, benefited from strong second-quarter results largely driven by growth in the bank segment along with the announcement of a $400 million stock buyback program. We maintain our investment as we believe the company is executing its strategy to maintain a strong market position in the payments software niche while upgrading its technology in select areas. With ongoing cost controls and high incremental margins on new revenue, we expect the company can drive additional growth with continued debt reduction and share repurchases.

DETRACTORS

Acadia Healthcare (ACHC), a behavioral healthcare and substance abuse treatment services company, declined in late September as a result of two negative news headlines related to patient care and questions about billing practices. While we take these developments seriously, we believe investors’ reaction to the news has been more severe than warranted. Industry peers have faced similar levels of scrutiny in the past with limited fundamental impact, and unless additional information is uncovered, we believe the current scrutiny will be resolved without much of an impact on their business. We continue to believe the company is well positioned to be an important part of the solution to an unfortunately growing need for behavioral health services.

Range Resources (RRC), a natural gas focused exploration and production company with operations in the Appalachian Basin, declined amid a weak commodity price backdrop for energy related companies. We maintain a position, as we believe the company’s low-cost acreage allows it to translate the healthy price environment into earnings and cash flow that is being used to reduce financial leverage, which can accrue additional value to equity shareholders in periods to come.

Recent Portfolio Activity

BUYS/ACQUISITIONS

Amentum Holdings (AMTM), a mission critical IT and engineering services company, was spun out of AECOM in 2020 and merged with the military contracting business of current holding, Jacobs Solutions, in September 2024. The portfolio received shares of Amentum Holdings as part of the corporate action.

First Interstate BancSystem (FIBK), a financial holding company, provides community banking solutions to individuals, businesses, and municipalities. The company is selling at attractive valuations as we believe company specific self-help initiatives such as repositioning their balance sheet to take advantage of the Fed’s forward curve are underappreciated by the market and not reflected in the current valuation.

Permian Resources (PR) is a Texas-based oil & gas exploration & production company with a large acreage position and deep inventory of high return potential drilling locations in the core of the Permian Basin. We expect management to continue to execute on its strategy of optimizing returns, diligently allocating capital to new opportunities, and returning excess capital to shareholders.

SELLS/LIQUIDATIONS

Diamondback Energy (FANG), an independent oil and natural gas company, was sold due to its market cap increasing materially above the market cap range of the Russell 2500 Index after its Endeavor Energy Resources acquisition.

Enviri (NVRI), an industrial services provider, was sold due to a change in our thesis arising from the company’s inability to de-lever its balance sheet leading to muted forward growth projections.

PetIQ (PETQ), a manufacturer and distributor of pet health and wellness products, was sold as the stock had appreciated, causing its reward-to-risk profile to compress as it reached our valuation target.

Outlook

We continue to remain optimistic about the long-term potential for the SMID-cap segment of the U.S. market as valuations and potential tailwinds bode well for the asset class. As we look out to the final months of 2024, we are cautiously constructive as encouraging signs of economic stability are balanced by now consensus expectations of a soft landing scenario and risk pricing. While rate-cutting cycles have historically been constructive for smaller companies, there remains a long list of items creating uncertainty that could lead to greater volatility in the final months of the year. This includes but is not limited to, the reignition of inflationary pressures, labor strikes in key industries and ports, geopolitical tensions, U.S. equity index concentration issues, ongoing commercial real estate and regional banking concerns, and the looming presidential election. We are aware that most of these issues are well known, but the timing and magnitude of the impact of any and all of these issues remains unpredictable. Therefore, as we always have, we will continue to avoid the temptation to forecast their outcome in favor of assessing the potential impact from a range of potential outcomes within our company‐specific, bottom-up analysis, and quality focus.

From an asset class perspective, valuations of SMID versus large continue to remain near multi-decade lows, which we believe suggests a more favorable setup for SMID caps relative to large caps in the periods to come (17.7x P/E for the Russell 2500 Index vs. 25.8x P/E for the Russell 1000 Index). Against a backdrop of disinflation, normalized interest rates, and a still growing U.S. economy, it looks to us that the SMID cap’s stretch of underperformance has the potential to end. If the economy continues to stabilize, our view is that valuations are likely to rise for those businesses that have largely sat out the mega-cap performance regime. Lastly, we believe SMID caps remain better positioned to benefit from the reshoring of U.S. manufacturing, a pickup in M&A activity,  fiscal policy bills passed in the last few years such as the IRA and Jobs Act, and several infrastructure projects on the horizon.

Positioning

Our current positioning is a function of our bottom-up security selection process and our ability to identify what we view as attractive investment candidates, regardless of economic sector definitions. Overweights in Industrials and Information Technology are mostly a function of our underlying company specific views rather than any top-down predictions for each sector. Conversely, we continue to be underweight in Consumer Discretionary, as we have been unable to identify what we consider to be compelling long-term opportunities that fit our discipline given the rising risk profiles of many retail businesses and a potential deceleration in goods spending following a period of strength. We also continue to be underweight in Real Estate as a result of structural challenges for various end markets within the sector. Given our focus on long-term business fundamentals, patient investment approach and low portfolio turnover, the strategy’s sector positioning generally does not change significantly from quarter to quarter. However, we may take advantage of periods of volatility by adding selectively to certain companies when appropriate.

ARISTOTLE CAPITAL BOSTON, LLC

Markets Review

Small caps enjoyed strong gains in the third quarter with the Russell 2000 index delivering a total return of 9.27% but the performance belies the volatile path taken during the period. Equities rallied in July as a below consensus CPI print lent credence to the soft-landing narrative. However, the risk on environment was punctuated in early August as an interest rate hike by the Bank of Japan and the resulting unwind of the levered Yen carry trade rattled global markets. The second half of the quarter was influenced by softening economic data and the Federal Reserve (Fed). Following comments made at the August Jackson Hole economic symposium that the time had come for policy to adjust, the Federal Reserve voted to cut the Fed Funds by 50 basis points (bps). Markets embraced the decision, ending the inversion of the U.S. Treasury yield curve, and the front end is now pricing in roughly 100 bps of easing in 2024.

Stylistically, value stocks outperformed their growth counterparts during the quarter as evidenced by the Russell 2000 Value Index returning 10.15% compared to 8.41% for the Russell 2000 Growth Index. Energy was the only negative sector in both indices with much of the relative outperformance of the value index coming from interest rate-sensitive sectors such as Financials, Utilities, and Real Estate. Looking under the hood, the knock-on effects of lower interest rates could be seen in the value index, as three of the top ten performers during the quarter were home builders. While AI enthusiasm has subsided in the second half of 2024, pockets can still be seen in parts of the small cap market. Lumen Technologies, a languishing communications company, rallied in August and was the top third-quarter performer in the Russell 2000 index when the company announced $5 billion in new business to provide private networks for AI scalers along with the potential for increased customer demand.

At the sector level, ten of the eleven sectors in the Russell 2000 Index recorded positive returns during the third quarter, led by the Real Estate (+18.16%), Communication Services (+17.79%), and Financials (15.14%) sectors. Conversely, Energy (-8.31%), Information Technology (+4.30%), and Materials (+8.14%) all lagged. Looking at market factors, profitable companies outperformed loss makers by nearly 125 bps during the quarter.

Sources: CAPS Composite Hub, Russell Investments
Past performance is not indicative of future results. Returns are presented gross and net of investment advisory fees and include the reinvestment of all income. Gross returns will be reduced by fees and other expenses that may be incurred in the management of the account. Net returns are presented net of actual investment advisory fees and after the deduction of all trading expenses. Aristotle Small Cap Equity Composite returns are preliminary pending final account reconciliation. Please see important disclosures at the end of this document.

Performance Review

For the third quarter of 2024, the Aristotle Small Cap Equity Composite posted a total return of 7.40% net of fees (7.57% gross of fees), trailing the 9.27% total return of the Russell 2000 Index. Underperformance was driven by both security selection and allocation effects. Overall, security selection was weakest in the Industrials and Health Care sectors and strongest in Information Technology and Materials. From an allocation perspective, an underweight in Real Estate and an overweight in Information Technology detracted from relative performance but this was partially offset by underweights in Materials and Health Care.

CONTRIBUTORS

Baldwin Insurance Group (BWIN), a Florida-based insurance company operating in the advisory, underwriting, and Mainstreet (consumer/small business) segments, built on second-quarter momentum with above consensus earnings on account of business line growth and margin improvement. We believe the company is starting to benefit from investments in talent made over the past year as well as the launch of new products. We maintain a position as we believe the company should continue to benefit from a positive inflection in free cash flow, improving margins, and deleveraging.

ACI Worldwide (ACIW), a provider of software solutions to facilitate payment transactions for financial institutions, retailers, and payment processors around the world, benefited from strong second-quarter results largely driven by growth in the bank segment along with the announcement of a $400 million stock buyback program. We maintain our investment as we believe the company is executing its strategy to maintain a strong market position in the payments software niche while upgrading its technology in select areas. With ongoing cost controls and high incremental margins on new revenue, we expect the company can drive additional growth with continued debt reduction and share repurchases.

DETRACTORS

Ardmore Shipping (ASC), a product and chemical transportation company focused on modern mid-sized vessels, drifted lower during the quarter as concerns over oil production and potentially weak Chinese growth weighed on the broader energy sector. We maintain a position, as we believe the company continues to operate from a position of strength, driven by recent shareholder-friendly capital allocation decisions, strong operating performance, and a favorable industry supply-demand backdrop.

Acadia Healthcare (ACHC), a behavioral healthcare and substance abuse treatment services company, declined in late September as a result of two negative news headlines related to patient care and questions about billing practices. While we take these developments seriously, we believe investors’ reaction to the news has been more severe than warranted. Industry peers have faced similar levels of scrutiny in the past with limited fundamental impact, and unless additional information is uncovered, we believe the current scrutiny will be resolved without much of an impact on their business. We continue to believe the company is well positioned to be an important part of the solution to an unfortunately growing need for behavioral health services.

Recent Portfolio Activity

BUYS/ACQUISITIONS

First Interstate BancSystem (FIBK), a financial holding company, provides community banking solutions to individuals, businesses, and municipalities. The company is selling at attractive valuations as we believe company specific self-help initiatives such as repositioning their balance sheet to take advantage of the Fed’s forward curve are underappreciated by the market and not reflected in the current valuation.

SELLS/LIQUIDATIONS

Enviri (NVRI), an industrial services provider, was sold due to a change in our thesis arising from the company’s inability to de-lever its balance sheet leading to muted forward growth projections.

PetIQ (PETQ), a manufacturer and distributor of pet health and wellness products, was sold as the stock had appreciated, causing its reward-to-risk profile to compress as it reached our valuation target.

Outlook

We continue to remain optimistic about the long-term potential for the small-cap segment of the U.S. market as valuations and potential tailwinds bode well for the asset class. As we look out to the final months of 2024, we are cautiously constructive as encouraging signs of economic stability are balanced by now consensus expectations of a soft landing scenario and risk pricing. While rate-cutting cycles have historically been constructive for small caps, there remains a long list of items creating uncertainty that could lead to greater volatility in the final months of the year. This includes but is not limited to, the reignition of inflationary pressures, labor strikes in key industries and ports, geopolitical tensions, U.S. equity index concentration issues, ongoing commercial real estate and regional banking concerns, and the looming presidential election. We are aware that most of these issues are well known, but the timing and magnitude of the impact of any and all of these issues remains unpredictable. Therefore, as we always have, we will continue to avoid the temptation to forecast their outcome in favor of assessing the potential impact from a range of potential outcomes within our company‐specific, bottom-up analysis, and quality focus.

From an asset class perspective, valuations of small versus large continue to remain near multi-decade lows, which we believe suggests a more favorable setup for small caps relative to large caps in the periods to come (16.7x P/E for the Russell 2000 Index vs. 25.8x P/E for the Russell 1000 Index). Against a backdrop of disinflation, normalized interest rates, and a still growing U.S. economy, it looks to us that small-cap’s stretch of underperformance has the potential to end. If the economy continues to stabilize, our view is that valuations are likely to rise for those businesses that have largely sat out the mega-cap performance regime. Lastly, we believe small caps remain better positioned to benefit from the reshoring of U.S. manufacturing, a pickup in M&A activity,  fiscal policy bills passed in the last few years such as the IRA and Jobs Act, and several infrastructure projects on the horizon.

Positioning

Our current positioning is a function of our bottom-up security selection process and our ability to identify what we view as attractive investment candidates, regardless of economic sector definitions. Overweights in Industrials and Information Technology are mostly a function of our underlying company specific views rather than any top-down predictions for each sector. Conversely, we continue to be underweight in Consumer Discretionary, as we have been unable to identify what we consider to be compelling long-term opportunities that fit our discipline given the rising risk profiles of many retail businesses and a potential deceleration in goods spending following a period of strength. While the portfolio’s allocation to Health Care is modestly below that of the benchmark, we continue to remain underweight the Biotechnology industry as many companies within that group do not fit our discipline due to their elevated levels of binary risk. Given our focus on long-term business fundamentals, patient investment approach and low portfolio turnover, the strategy’s sector positioning generally does not change significantly from quarter to quarter. However, we may take advantage of periods of volatility by adding selectively to certain companies when appropriate.

(All MSCI index returns are shown net and in U.S. dollars unless otherwise noted.)

Markets Review

Sources: CAPS CompositeHub^TM, Bloomberg
Past performance is not indicative of future results. Aristotle Global Equity Composite returns are presented gross and net of investment advisory fees and include the reinvestment of all income. Gross returns will be reduced by fees and other expenses that may be incurred in the management of the account. Net returns are presented net of actual investment advisory fees and after the deduction of all trading expenses. Aristotle Capital Composite returns are preliminary pending final account reconciliation. Please see important disclosures at the end of this document.

Global equity markets reached record highs during the quarter. The MSCI ACWI Index rose 6.61%, while the Bloomberg Global Aggregate Bond Index rallied 6.98%. Value outperformed growth, with the MSCI ACWI Value Index outperforming the MSCI ACWI Growth Index by 5.35% during the quarter.

Latin America and Asia/Pacific ex-Japan were the strongest regions, while Japan and North America gained the least. On a sector basis, ten out of the eleven sectors within the MSCI ACWI Index finished in the green, with Real Estate, Utilities and Financials increasing the most. Meanwhile, Energy (the only sector to post a negative return), Information Technology and Communication Services were the weakest performers.

The global economy continued to improve, with the IMF projecting global GDP to rise to 3.3% in 2025 as economic indicators trended positively. Both the U.K. and eurozone reported annualized inflation at 2.2% in August, while U.S. inflation fell below the 3.0% mark for the first time in over three years. To maintain economic growth and employment, the Bank of England cut its bank rate 25 basis points, the European Central Bank reduced its deposit facility rate 25 basis points and the U.S. Federal Reserve slashed its federal funds rate 50 basis points.

In Asia, the Bank of Japan announced its second rate hike of the year to a short-term policy rate of 0.25%, marking its highest level since 2008. With rising inflation, a weak yen and a push for policy normalization, Bank of Japan Governor Kazuo Ueda has not ruled out an additional rate hike by the end of the year. Meanwhile, China is grappling with deflationary pressures, as consumer prices rose just 0.6% year-over-year in August. In response, the People’s Bank of China unveiled a monetary stimulus package worth 1 trillion to 2 trillion yuan, which included reducing a key short-term interest rate and lowering banks’ reserve requirements.

On the geopolitical front, the ongoing wars in Ukraine-Russia and the Middle East continued with escalations of various magnitudes. At the time of this writing, oil markets responded with Brent Crude rising over 12% in the first five trading days of October to more than $80 per barrel.

Performance and Attribution Summary

For the third quarter of 2024, Aristotle Capital’s Global Equity Composite posted a total return of 6.64% gross of fees (6.54% net of fees), underperforming the MSCI ACWI Index, which returned 6.61%, and outperforming the MSCI World Index, which returned 6.36%. Please refer to the table below for detailed performance.

Source: FactSet
Past performance is not indicative of future results. Attribution results are based on sector returns which are gross of investment advisory fees. Attribution is based on performance that is gross of investment advisory fees and includes the reinvestment of income.

From a sector perspective, the portfolio’s performance relative to the MSCI ACWI Index can be primarily attributed to allocation effects. Security selection in Financials, Health Care and Consumer Discretionary contributed the most to the portfolio’s relative performance. Conversely, security selection in Information Technology and Industrials and a lack of exposure to Utilities detracted from relative return.

Regionally, security selection was primarily responsible for the portfolio’s performance relative to the MSCI ACWI Index. Security selection in Japan and Asia/Pacific ex-Japan contributed the most to relative performance, while security selection in North America and Emerging Markets detracted.

Contributors and Detractors for 3Q 2024

Relative Contributors	Relative Detractors
Lennar	Qualcomm
MonotaRO	Microchip Technology
Otsuka Holdings	Samsung Electronics
Brookfield	Rentokil Initial
AIA Group	Adobe

MonotaRO, the Japanese online business-to-business (B2B) e-commerce platform, was a main contributor during quarter. The company, which serves as a one-stop solution, allowing customers to shop for millions of products via a centralized location, reported an increase in order value and sales per shipment. It also continues to gain traction on orders coming from large corporations—a catalyst we previously identified—which now represent more than 30% of total sales, up from 25% at the end of last year. Large “enterprise” customers have a higher lifetime value and can afford to pay for value-added services that MonotaRO offers (e.g., purchase management systems), which in turn has the potential to increase the stickiness of clients. Moreover, we believe that the market underappreciates the importance that convenience (rather than price) plays in the B2B segment, where MonotaRO’s curation skills and execution capabilities are difficult to replicate.

Microchip Technology, the microcontroller (MCU) and analog semiconductor producer, was a primary detractor for the period. The company reported results in line with guidance, but its short-term outlook remains challenged. Between 2021-2023, amid a global chip shortage, Microchip implemented a preferred supply program to meet the large demands of its clients, who overestimated their needs and are now working through their inventory levels. While management has started to see some positive signs pointing toward a recovery (e.g., higher expedited orders and fewer order cancelations), it is taking longer than anticipated. Longer term, Microchip has been able to generate 15+ years of robust FREE cash flow and margins, while lowering its debt and consistently returning money to shareholders. This, we believe, speaks to the company’s proven ability to manage the business through economic cycles, while taking advantage of its broad portfolio to continue gaining share in areas including IoT, 5G infrastructure, autonomous driving and data centers.

Rentokil Initial, the U.K.-based pest control and hygiene services company, was one of the largest detractors for the quarter. In an unscheduled update, management provided a revised outlook for the North American pest control business, with 2024 revenue growth from the region now expected to be just 1%, a significant reduction from the prior guidance of 2%-4%. The company is experiencing temporary disruption due to the ongoing integration of Terminix into Rentokil’s existing branch network, with recent investments in sales and marketing requiring additional time to deliver results. However, while these integration efforts are weighing on short-term results, we believe they are precisely the foundation of Rentokil’s long-term value proposition. Once integration challenges are resolved, the combination should provide operational synergies through scale efficiencies and improved density in key markets, paving the way for a faster consolidation of the U.S. pest control industry and positioning the company to capture even more market share in the coming years. This “Right Way 2” operational plan underscores management’s focus on increasing customer retention and driving productivity gains via technology and data utilization. The ongoing branch integration and market densification initiatives represent key catalysts already in motion. Given its scale, operational excellence and strategic acquisitions, we believe Rentokil is well positioned to deliver both revenue growth and margin expansion over time.

Recent Portfolio Activity

During the quarter we invested in Tokyo Century.

Tokyo Century Corporation

Tokyo Century is a leading Japanese financial services company that specializes in leasing and financing. Formed in 2009 through the merger of Century Leasing System and Tokyo Leasing, the company offers a broad spectrum of services that consist of specialty financing for areas such as aviation, shipping and real estate (~50% of FY 2024 revenues), equipment leasing (~22% percent), auto leasing and rental car services (~8%), and various other services from IT leasing to financing for environmental infrastructure (~20%).

Tokyo Century’s services allow its customers the necessary funding to grow, as well as operate and manage, fleets of vehicles and necessary equipment without the need for large capital expenditures. The company has also been expanding its global presence outside of Japan, predominately through partnerships and joint ventures, with operations today in more than 30 countries and regions.

High-Quality Business

Some of the quality characteristics we have identified for Tokyo Century include:

• Economies of scale allow for operational efficiencies and greater bargaining power with equipment manufacturers;
• Global partnerships with industry leaders allow the company to not only expand its offerings but also enhance its reach across geographies and adapt to local customer needs; and
• Strong balance sheet enables the company to secure favorable financing terms, which is crucial for its capital-intensive business model.

Attractive Valuation

Based on our estimates of normalized earnings, we believe Tokyo Century’s stock price is offered at a discount to the company’s intrinsic value. In our view, the market has underappreciated both company and industry-specific dynamics which provides an attractive valuation.

Compelling Catalysts

Catalysts we have identified for Tokyo Century, which we believe will cause its stock price to appreciate over our three- to five-year investment horizon, include:

• Enhanced revenue and profitability from aviation leasing as manufacturing constraints, and the resulting supply and demand imbalance, allow for increasing lease rates and higher values of aircrafts;
• Continued benefits from prior acquisitions, joint ventures and partnerships (e.g., Tokyo Century’s investment in NTT Data’s North American build-out of data centers); and
• Improvements in IT leasing through its subsidiary CSI Leasing as companies increasingly rely on technology assets and seek to optimize IT infrastructure spending.

Conclusion

With the evolving global macroeconomic landscape, increasing geopolitical tensions and the approaching U.S. elections, there are plenty of headlines to follow. At Aristotle Capital, our priority is determining whether these events provide valuable insights for long-term investors. Instead of repositioning our portfolios based on predictions of how the market may or may not respond to such events, we focus on identifying and owning companies that, we believe, can succeed in the face of global uncertainty. It is our belief and experience that well-managed, high-quality companies will take appropriate actions to respond to the ever-changing world.

(All MSCI index returns are shown net and in U.S. dollars unless otherwise noted.)

Markets Review

Sources: CAPS CompositeHub^TM, Bloomberg
Past performance is not indicative of future results. Aristotle International Equity Composite returns are presented gross and net of investment advisory fees and include the reinvestment of all income. Gross returns will be reduced by fees and other expenses that may be incurred in the management of the account. Net returns are presented net of actual investment advisory fees and after the deduction of all trading expenses. Aristotle Capital Composite returns are preliminary pending final account reconciliation. Please see important disclosures at the end of this document.

Global equity markets reached record highs during the quarter. The MSCI ACWI Index rose 6.61%, while the Bloomberg Global Aggregate Bond Index rallied 6.98%. Value outperformed growth, with the MSCI ACWI Value Index outperforming the MSCI ACWI Growth Index by 5.35% during the quarter.

The MSCI EAFE Index climbed 7.26% during the third quarter, while the MSCI ACWI ex USA Index went up 8.06%. Within the MSCI EAFE Index, Asia/Pacific ex-Japan gained the most, while Japan gained the least. On a sector basis, nine of the eleven sectors within the MSCI EAFE Index posted  positive returns, with Real Estate, Utilities and Communication Services recording the largest gains. Conversely, Energy, Information Technology and Health Care performed the worst.

The global economy continued to improve, with the IMF projecting global GDP to rise to 3.3% in 2025 as economic indicators trended positively. Both the U.K. and eurozone reported annualized inflation at 2.2% in August, while U.S. inflation fell below the 3.0% mark for the first time in over three years. To maintain economic growth and employment, the Bank of England cut its bank rate 25 basis points, the European Central Bank reduced its deposit facility rate 25 basis points and the U.S. Federal Reserve slashed its federal funds rate 50 basis points.

In Asia, the Bank of Japan announced its second rate hike of the year to a short-term policy rate of 0.25%, marking its highest level since 2008. With rising inflation, a weak yen and a push for policy normalization, Bank of Japan Governor Kazuo Ueda has not ruled out an additional rate hike by the end of the year. Meanwhile, China is grappling with deflationary pressures, as consumer prices rose just 0.6% year-over-year in August. In response, the People’s Bank of China unveiled a monetary stimulus package worth 1 trillion to 2 trillion yuan, which included reducing a key short-term interest rate and lowering banks’ reserve requirements.

On the geopolitical front, the ongoing wars in Ukraine-Russia and the Middle East continued with escalations of various magnitudes. At the time of this writing, oil markets responded with Brent Crude rising over 12% in the first five trading days of October to more than $80 per barrel.

Performance and Attribution Summary

For the third quarter of 2024, Aristotle Capital’s International Equity Composite posted a total return of 10.97% gross of fees (10.82% net of fees), outperforming the MSCI EAFE Index, which returned 7.26%, and the MSCI ACWI ex USA Index, which returned 8.06%. Please refer to the table below for detailed performance.

Source: FactSet
Past performance is not indicative of future results. Attribution results are based on sector returns which are gross of investment advisory fees. Attribution is based on performance that is gross of investment advisory fees and includes the reinvestment of income.

From a sector perspective, the portfolio’s outperformance relative to the MSCI EAFE Index can be attributed to security selection, while allocation effects had a negative impact. Security selection in Financials, Health Care and Information Technology contributed the most to the portfolio’s relative performance. Conversely, an overweight in Energy and a lack of exposure to Utilities and Real Estate detracted from relative returns.

Regionally, security selection was responsible for the portfolio’s outperformance, while allocation effects had a negative impact. Security selection in Europe & Middle East and Asia contributed the most to relative performance, while exposure to Emerging Markets and an underweight in Asia detracted.

Contributors and Detractors for 3Q 2024

Relative Contributors	Relative Detractors
Brookfield	Samsung Electronics
Haleon	Rentokil Initial
MonotaRO	Cameco
Otsuka Holdings	Heineken
Accenture	TotalEnergies

Brookfield, one of the world’s largest and most diversified private market investors, was the top contributor for the period. Several key factors contributed to this success, which are linked to both catalysts currently underway and the company’s long-term strategic positioning. In the near term, the company reported significant fundraising strength, with over $68 billion in inflows during the second quarter of 2024. This capital influx was bolstered by an expanded credit platform, positioning Brookfield to return substantial cash to shareholders through more than $800 million in share buybacks so far this year. Additionally, Brookfield advanced its energy transition strategy, particularly through its renewable power and infrastructure businesses. A notable development was the company’s agreement to acquire a majority stake in Neoen, a leading global renewables platform operating in Australia, France and the Nordics. Neoen specializes in solar, wind and energy storage projects, sectors that are critical to the global shift toward clean energy. Looking at Brookfield from a long-term perspective, the company is uniquely positioned to capitalize on its scale, expertise and diverse business model. Its ability to attract large amounts of capital, combined with its experience in managing high-quality assets, gives Brookfield a competitive edge in both the traditional and renewable energy markets. Brookfield’s long-standing reputation as a successful owner-operator and its ability to quickly act on opportunities further strengthen our outlook for the company.

Rentokil Initial, the U.K.-based pest control and hygiene services company, was one of the largest detractors for the quarter. In an unscheduled update, management provided a revised outlook for the North American pest control business, with 2024 revenue growth from the region now expected to be just 1%, a significant reduction from the prior guidance of 2%-4%. The company is experiencing temporary disruption due to the ongoing integration of Terminix into Rentokil’s existing branch network, with recent investments in sales and marketing requiring additional time to deliver results. However, while these integration efforts are weighing on short-term results, we believe they are precisely the foundation of Rentokil’s long-term value proposition. Once integration challenges are resolved, the combination should provide operational synergies through scale efficiencies and improved density in key markets, paving the way for a faster consolidation of the U.S. pest control industry and positioning the company to capture even more market share in the coming years. This “Right Way 2” operational plan underscores management’s focus on increasing customer retention and driving productivity gains via technology and data utilization. The ongoing branch integration and market densification initiatives represent key catalysts already in motion. Given its scale, operational excellence and strategic acquisitions, we believe Rentokil is well positioned to deliver both revenue growth and margin expansion over time.

Recent Portfolio Activity

During the quarter, we sold our position in KDDI and invested in two new positions: Diageo and MonotaRO.

We first invested in KDDI during the third quarter of 2013. When we originally invested, smartphone penetration in Japan was only about 40%, which is low for a developed economy. In contrast, the U.S. was at approximately 70% at the time. Our estimate of normalized penetration in Japan was closer to 70%, and today it is over 85%. (The U.S. is over 90%.) We view the Japanese telecom industry as unique because the spectrum is “owned by the people.” As a result, telecommunications providers like KDDI are not required to participate in expensive spectrum auctions as are their U.S. peers. This results in lower capital intensity and higher normalized FREE cash flow for the Japanese companies. Additionally, KDDI has benefited from a competitive environment best described as a rational oligopoly. Over the years, government-controlled NTT has been ceding market share to KDDI and Softbank. Softbank has seemingly been continuously distracted and required to divert FREE cash flow to fund its venture investments. These circumstances created a favorable decade for KDDI, as the company executed well, increasing average revenue per user (“ARPU”) and ancillary services. However, KDDI now has ambitions to enter “new areas,” as its core wireless business has become saturated and increasingly competitive with the entrance of a fourth player, Rakuten. While many of our catalysts played out as expected, we view the company’s recent multibillion-dollar acquisition (in conjunction with Mitsubishi Corp.) of Japanese retailer Lawson as a suboptimal allocation of capital. Lawson operates approximately 14,600 stores in Japan, which KDDI intends to utilize to promote banking and insurance products. Although we continue to believe KDDI shares are inexpensive, we exited the investment, as we see few catalysts remaining and have questions on strategy that we prefer to monitor from the sidelines.

Diageo plc

Headquartered in London, England, Diageo is a global leader in the alcoholic beverages industry. The company has a vast portfolio of over 200 well-recognized premium spirits (~80% of FY 2024 sales), beers (~15% and mostly Guinness) and other beverages (~5%) that are sold in nearly 180 countries. Led by its Johnnie Walker brand, Diageo is the world’s largest exporter of Scotch whiskey—its largest category at ~25% of sales—followed by other spirits such as tequila and vodka (~10% each). Diageo also owns a ~34% stake in the premium champagne and cognac maker Moët Hennessy (a subsidiary of LVMH Moët Hennessy Louis Vuitton).

The company is the product of the 1997 merger between Grand Metropolitan and Guinness and the subsequent divestiture of its food-related businesses. M&A continues to be a part of Diageo’s strategy, as regional brands often dominate local markets (which provides further opportunities for mergers and industry consolidation). Over the last decade, Diageo has also meaningfully increased its presence in the rapidly growing tequila market with the acquisitions of Don Julio and Casamigos.

High-Quality Business

Some of the quality characteristics we have identified for Diageo include:

• Strong portfolio of some of the world’s most iconic alcohol brands (e.g., Johnnie Walker, Crown Royal, Guinness, Smirnoff, Captain Morgan, Baileys and Tanqueray, among others), which supports pricing power and promotes customer loyalty;
• Global reach and distribution networks provide Diageo with operational flexibility and economies of scale; and
• Well diversified across product categories and geographies, with a history of fairly consistent results even in difficult economic environments.

Attractive Valuation

Given our estimates of higher future earnings through market share gains in alcoholic beverages, we believe shares of the company are undervalued. At our purchase price, we believe shares were valued at a price to normalized earnings of ~13x, an attractive price for this high-quality business, and a discount to our estimate of intrinsic value.

Compelling Catalysts

Catalysts we have identified for Diageo, which we believe will cause its stock price to appreciate over our three- to five-year investment horizon, include:

• Well positioned to benefit from the global consumer mix shift toward premium alcoholic beverages;

• Continued market share gains in Scotch whiskey and tequila given the company’s scale advantage;
• Further penetration in emerging markets (e.g., India, China, Brazil, Mexico and African countries); and
• Enhanced FREE cash flow should result in dividend increases and benefits of further consolidation through selective acquisitions.

MonotaRO Co., Ltd. plc

Established in Japan in 2000, MonotaRO operates a business-to-business (B2B) e-commerce platform, selling approximately 20 million items (over 650,000 SKUs) to more than 8 million customers (mostly in Japan). The company is an MRO (maintenance, repair and operations) distributor focused on small- and mid-sized companies (~two-thirds of customers), with manufacturing, construction and auto repair industries accounting for the majority of sales. MonotaRO’s business may seem simple; however, the company’s unique profile (>95% of sales are online) and innovative solutions, we believe, provide its customers a distinct value proposition and its shareholders a compelling opportunity to own a leader in a fragmented industry.

MonotaRO serves as a one-stop solution, allowing customers to shop for millions of products via a centralized location. Its transparent pricing saves clients time and reduces costs by removing the need to rely on independent catalogs, individual quotes or separate orders. The company sources its merchandise from thousands of suppliers (i.e., manufacturers and wholesalers) in ten countries and carries over 500,000 products in stock, ready for same-day shipment from its own distribution centers. In addition, its ONE SOURCE Lite service allows large clients to link their purchasing management systems to MonotaRO’s, providing company-wide visibility of items and purchases and an integrated experience.

MonotaRO operates as a consolidated subsidiary of U.S.-based Grainger (an industrials supplier) and provides consulting services to the parent’s e-commerce businesses in the U.S., Germany and the U.K.

High-Quality Business

Some of the quality characteristics we have identified for MonotaRO include:

• High barriers to entry given that scale is essential to most products in the MRO market, which requires high variety yet small lot ordering, making it imperative to offer a high number of SKUs while investing in technology to provide easier curation and shorter delivery times;
• The company’s vast product breadth, combined with its advanced data analytics, allows it to analyze procurement behaviors and better predict which items to keep in inventory. The client is able to spend less time ordering and can count on reliable delivery;
• Attractive business fundamentals, as ordering can be cumbersome, and clients value reliability, convenience and variety more so than price. The MRO market is also highly fragmented and inefficient. As MonotaRO expands, the more difficult it becomes for others to compete; and
• Expertise in database marketing leads to high repeat order rates, while its integrated purchasing management system (primarily for large corporate customers) increases retention.

Attractive Valuation

Using our estimates of normalized sales attained through continued market share gains, we believe MonotaRO’s current stock price is offered at a discount to our estimate of the company’s intrinsic value.

Compelling Catalysts

Catalysts we have identified for MonotaRO, which we believe will cause its stock price to appreciate over our three- to five-year investment horizon, include:

• Ability to continue gaining share from inefficient small players (e.g., door-to-door dealers relying on people, catalogs and even fax machines);
• Increasing existing customers’ sales through technological improvements (e.g., website personalization and recommendation displays) aimed at reducing the time it takes to (1) find, (2) purchase and (3) receive products;
• Further penetration into enterprise customers should provide a larger source for sales growth, as this segment represents a higher customer lifetime value as well as stickiness; and
• Growth in sales of MonotaRO’s private label offering of approximately 300,000 products that are higher margin yet provide savings to clients.

Conclusion

With the evolving global macroeconomic landscape, increasing geopolitical tensions and the approaching U.S. elections, there are plenty of headlines to follow. At Aristotle Capital, our priority is determining whether these events provide valuable insights for long-term investors. Instead of repositioning our portfolios based on predictions of how the market may or may not respond to such events, we focus on identifying and owning companies that, we believe, can succeed in the face of global uncertainty. It is our belief and experience that well-managed, high-quality companies will take appropriate actions to respond to the ever-changing world.

Similar to a bar of steel, a small cap equity portfolio should be a balance of strength and malleability. While less tangible than minerals, it can be said that an impurity is slowly weakening the Russell 2000 Index —an increasing presence of unprofitable companies. At 39% of the Russell 2000 Index as of June 30, 2024, investments in these unprofitable companies can have detrimental effects on the long-term returns of those investors who passively buy exposure. By reviewing the current state of the index, we believe investors should take a look at how an active focus on quality and valuation can positively impact future performance.

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