Small Cap Equity 4Q 2021
The small cap segment of the equity market, as measured by the Russell 2000 Index, appreciated 2.14% in the fourth quarter, capping a strong 2021 in which the asset class returned 14.82% for the full calendar year. Despite posting positive returns during the quarter, the period was not without volatility, as the emergence of the highly infectious Omicron variant captured headlines and led to a 13% intra-quarter decline in the Russell 2000 Index. Small caps quickly recovered into year-end however, as global data indicated the new variant may have a lower probability of hospitalization as compared to prior variants.
On the policy front, the U.S. Federal Reserve (Fed) took center stage, as the rapidly tightening labor market and persistent inflationary pressures pushed the Fed to adopt a more hawkish stance. The shift in Fed posturing appears to have been triggered by recent inflation and labor market data. In November, U.S. headline inflation posted a 39-year high, clocking in at 6.8% on a year-over-year basis, while the unemployment rate ticked down to just 4.2%. At the time of this writing, markets are currently pricing in three rate hikes in 2022; however, the situation remains fluid as a host of uncertainties could potentially alter the pace and direction of hikes throughout the year.
Stylistically, value outperformed growth in the fourth quarter, as measured by the Russell 2000 Value Index’s return of 4.36% compared to the 0.01% return of the Russell 2000 Growth Index. For the full year, the Russell 2000 Value turned in strong relative performance versus the Russell 2000 Growth, generating a total return of 28.27% compared to 2.83% and marking the first time in the last five calendar years where value has led the market. Fundamentally, companies with lower valuations, stronger profitability and higher return on equity generally outperformed, signaling a recent shift in sentiment towards more reasonably valued, higher quality companies within the small cap space.
At the sector level, eight of the eleven sectors within the Russell 2000 Index generated positive returns during the quarter, led by Utilities (+12.58%), Real Estate (+10.06%) and Industrials (+9.44%). Communication Services (-10.92%), Health Care (-9.98%) and Energy (-4.09%) exited the quarter as the only sectors to generate a negative return.
Sources: SS&C Advent; 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. Aristotle Boston Composite returns are preliminary pending final account reconciliation. Please see important disclosures at the end of this document. trailing twelve-month price-to-earnings data. Past performance is not indicative of future results. Please see important disclosures at the end of this document.
For the fourth quarter of 2021, the Aristotle Small Cap Equity Composite generated a total return of 5.22% gross of fees (5.08% net of fees), outperforming the 2.14% total return of the Russell 2000 Index and the 4.36% total return of the Russell 2000 Value Index. Both security selection and sector allocation contributed positively to relative performance. Security selection within the Information Technology, Health Care and Financials sectors added the most value on a relative basis, while selection within Energy, Consumer Discretionary and Industrials detracted. From an allocation perspective, the portfolio benefited from an overweight in Industrials and an underweight in Health Care; however, this was partially offset by underweights in Real Estate and Materials.
|Relative Contributors||Relative Detractors|
|Rogers||U.S. Xpress Enterprises|
|Bottomline Technologies||Merit Medical Systems|
|Cross Country Healthcare||HealthEquity|
Security selection added the most value within the Information Technology, Health Care and Financials sectors. From an allocation perspective, an overweight in Industrials and an underweight in Health Care contributed positively to relative performance. Additionally, the portfolio’s orientation toward companies with reasonable valuations and strong free cash flow profiles also contributed. At the company level, Customers Bancorp and Rogers were two of the largest contributors during the quarter.
- Customers Bancorp (CUBI), a Pennsylvania-based regional bank, benefited from strong fundamental performance driven by its role as a lender for the Paycheck Protection Program established as part of the CARES Act in response to the COVID pandemic. We believe investor sentiment has also been boosted in recent periods by the company’s blockchain payments deposit initiative.
- Rogers (ROG), a designer/manufacturer of highly engineered materials for a variety of end markets, appreciated following an announcement that the company was being acquired in an all-cash transaction by DuPont (DD).
Security selection detracted within the Energy, Consumer Discretionary and Industrials sectors. Additionally, the portfolio’s underweight in Real Estate and Materials modestly detracted from relative performance. At the company level, ModivCare and U.S. Xpress Enterprises were two of the largest detractors during the quarter.
- ModivCare (MODV), is a Colorado-based health care services company that provides non-emergency medical transportation (NEMT) and personal care services to Medicaid and Medicare populations. Shares of ModivCare took a breather during the quarter. We believe the catalyst for the pullback appears to be a function of the cost impact of a tightening labor market and higher transportation costs. Nevertheless, we believe the company’s investments in technology that were initiated pre-pandemic have been and will continue to offset some of the cost headwinds going forward. We continue to maintain a position, as we believe the long-term demand drivers of their businesses remain attractive and sustainable.
- U.S. Xpress Enterprises (USX), a Tennessee-based trucking company, declined following a disappointing earnings report and outlook. Heavy investments being made in a technology-enabled truckload service (more operationally efficient than traditional truckload solutions) are weighing on financial results while an industry-wide driver shortage is hampering their ability to leverage the investments being made. As of quarter-end, we continue to monitor and reevaluate the position to assess if our investment thesis remains intact.
Recent Portfolio Activity
|United Community Banks||CAI International|
- United Community Banks (UCBI), is a bank holding company that provides business and consumer banking services in the southeast region of the U.S. In addition to shares being attractively valued, we believe the company’s exposure to markets growing faster than the national average, strong credit performance of their loan portfolio and balance sheet capacity to grow their loan portfolio should create value for shareholders going forward.
- CAI International (CAI), a freight container leasing and management company, was removed from the portfolio after being acquired by Mitsubishi HC Capital.
- Team (TISI), a provider of specialty industrial services for the refining, petrochemical, power and pipeline industries, was removed from the portfolio as a result of ongoing disappointing fundamental performance, along with a surprising negative legal development that called into question the ongoing viability of the business.
Outlook and Positioning
Global equity markets, including U.S. small caps, posted healthy returns in 2021, although the year was not without its challenges. Inflationary pressures continue to linger, central banks are becoming more aggressive, supply chain issues remain and pandemic-related uncertainties persist. While each of these factors, along with a plethora of others, may contribute to uncertainty and affect investors’ risk appetites over the near term, we believe equity markets will continue to be driven by business fundamentals over the long term.
From a fundamental standpoint, we believe the economic backdrop in the U.S. remains supportive of small cap equities over the next multi-year horizon. While we are, by no means, market prognosticators, the company-specific insights that we have obtained through our bottom-up research lead us to believe that there is the opportunity for further appreciation, especially for companies with what we consider solid fundamentals and compelling valuations. Additionally, as the Fed continues its path towards interest rate normalization, and as company fundamentals and valuations become increasingly more important, we believe this development should be beneficial for fundamentally-oriented, active managers like ourselves.
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 broad-based with recent purchases across a variety of industries and end markets. Conversely, we continue to be underweight in Consumer Discretionary, as we have been unable to identify what we consider to be compelling opportunities that fit our discipline given the rising risk profiles as a result of structural headwinds for various brick and mortar businesses. We also continue to be underweight in Health Care due to our lack of exposure to early-stage biotechnology companies, which generally 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. As always, our focus remains on identifying what we view as attractive, long-term investment opportunities that can create value for shareholders over the next three to five years, which we believe gives us the best opportunity to generate alpha for our clients.
The opinions expressed herein are those of Aristotle Capital Boston, LLC (Aristotle Boston) and are subject to change without notice.
Past performance is not indicative of future results. The information provided in this report should not be considered financial advice or a recommendation to purchase or sell any particular security. There is no assurance that any securities discussed herein will remain in an account’s portfolio at the time you receive this report or that securities sold have not been repurchased. The securities discussed may not represent an account’s entire portfolio and, in the aggregate, may represent only a small percentage of an account’s portfolio holdings. The performance attribution presented is of a representative account from Aristotle Boston’s Small Cap Equity Composite. The representative account is a discretionary client account which was chosen to most closely reflect the investment style of the strategy. The criteria used for representative account selection is based on the account’s period of time under management and its similarity of holdings in relation to the strategy. It should not be assumed that any of the securities transactions, holdings or sectors discussed were or will be profitable, or that the investment recommendations or decisions Aristotle Boston makes in the future will be profitable or equal the performance of the securities discussed herein. Aristotle Boston reserves the right to modify its current investment strategies and techniques based on changing market dynamics or client needs. Recommendations made in the last 12 months are available upon request.
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. For example, a 0.5% annual fee deducted quarterly (0.125%) from an account with a ten-year annualized growth rate of 5.0% will produce a net result of 4.4%. Actual performance results will vary from this example.
The Russell 2000® Index measures the performance of the small cap segment of the U.S. equity universe. The Russell 2000 Index is a subset of the Russell 3000® Index representing approximately 10% of the total market capitalization of that index. It includes approximately 2000 of the smallest securities based on a combination of their market cap and current index membership. The Russell 2000 Growth® Index measures the performance of the small cap companies located in the United States that also exhibit a growth probability. The Russell 2000 Value® Index measures the performance of the small cap companies located in the United States that also exhibit a value probability. The Russell 1000® Index measures the performance of the large cap value segment of the U.S. equity universe. The volatility (beta) of the composite may be greater or less than the benchmarks. It is not possible to invest directly in these indices.
Aristotle Capital Boston, LLC is an independent investment adviser registered under the Investment Advisers Act of 1940, as amended. Registration does not imply a certain level of skill or training. More information about Aristotle Boston, including our investment strategies, fees and objectives, can be found in our Form ADV Part 2, which is available upon request. ACB-2201-17
Sources: SS&C Advent, Russell Investments
Composite returns for periods ended December 31, 2021 are preliminary pending final account reconciliation.
1The Aristotle Small Cap Equity Composite has an inception date of November 1, 2006 at a predecessor firm. During this time, Jack McPherson and Dave Adams had primary responsibility for managing the strategy. Performance starting January 1, 2015 was achieved at Aristotle Boston.
2For the period November 2006 through December 2006.
Past performance is not indicative of future results. Performance results for periods greater than one year have been annualized.
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. Please see important disclosures enclosed within this document.