Small/Mid Cap Equity 2Q 2021

Small/Mid caps post modest quarterly return amidst improving economic backdrop

Economic data continued to improve across developed markets as vaccination rollouts gained traction in the second quarter. Coinciding with the positive vaccination trends, general easing of local COVID-19 restrictions has led to an uptick in economic activity. While investors have weighed these positive developments against inflationary concerns, especially the question of whether or not inflation will be mostly transitory, the general trend for equity prices has been positive. Small/mid cap equities generated a positive total return of 5.44% in the second quarter as measured by the Russell 2500 Index. Although this may seem modest compared to the last several quarters, it is more indicative of the asset class’ historical output over the long term. Considering the significant rise in equity prices since the pandemic-induced bear market in March 2020, it is not surprising that the small/mid cap rally would take a slight breather. Despite the Russell 2500 Index being down from its March 2021 highs, we believe the outlook for the market remains positive, not only for the asset class, but for active managers going forward.

Growth and Value continue to trade blows, meme stocks continue to make noise, and index concentration rises

Since the end of 2020, many have been calling for the value rally to finally take hold following the many years of significant outperformance by growth. While the Russell 2500 Value Index has outperformed the Russell 2500 Growth Index so far year-todate, the strong performance for the growth index since mid-May led to outperformance for the Russell 2500 Growth Index in the second quarter, with a total return of 6.04% compared to the 5.00% return for the Russell 2500 Value Index. We continue to believe that more reasonably valued securities are due for a multi-year relative recovery versus their growth counterparts; however, as we’ve noted in the past, these recoveries are not always linear. For example, following the early 2000’s dot-com bubble, the Russell 2500 Value Index also experienced short-term periods of underperformance versus the Russell 2500 Growth Index in the early stages of what would become a very strong multi-year period for the value style. While the past does not always repeat itself in investing, we would note that the valuations for both the Russell 2500 Index and Russell 2500 Value Index are historically attractive (on a forward P/E basis) relative to the Russell 2500 Growth Index. We believe investors with a focus on identifying attractively valued long-term investment opportunities can benefit going forward as the relative performance relationship between investment styles continues to normalize.

In our first quarter 2021 commentary, we highlighted the emergence of the January “meme stock” rally, where heavily shorted securities such as GameStop and AMC Entertainment rose exponentially on the strength of heightened retail trading activity. These meme stock gains significantly boosted benchmark returns in the first quarter and were a thorn in the side of many active managers that possess a quality discipline. Unfortunately for active managers, meme stocks experienced another strong run starting in May, which led to a pronounced low-quality rally in the second half of the second quarter. Similar to our previous comments on the value/growth dynamic, what we consider to be higher quality companies are historically attractive (on a forward P/E basis) relative to their lower quality counterparts. Following the unprecedented underperformance of quality factors in 2020 and the additional dislocation created by the two meme stock rallies in 2021, we believe higher quality companies will benefit on a relative basis going forward as earnings growth becomes a stronger driver of future returns and valuation multiples begin to contract following the significant gains in the market since March 2020.

Another interesting component of the market’s returns can be seen in the index’s concentration. Over the last several years, the Russell 2500 Index has become more concentrated by industry weighting as well as the combined weighting of the largest stocks in the benchmark. This has implications for returns as well – historically, the top 10 stocks in the benchmark have accounted for roughly 10% of the overall benchmark’s returns (in quarters where the Russell 2500 Index has returned more than 4%). In the second quarter, the top 10 stocks accounted for nearly 20% of the benchmarks’ return, nearly twice as much as their historical contribution. By these measures, the Russell 2500 Index has not seen this level of concentration since the dot-com bubble. As active managers are more likely to outperform when market breadth is higher, normalization of these measures should benefit active managers going forward.

Performance Review

For the second quarter of 2021, the Aristotle Small/Mid Cap Equity Composite generated a total return of 4.76% gross of fees (4.61% net of fees) compared to the 5.44% total return of the Russell 2500 Index. Security selection was neutral to relative performance, while sector allocation detracted. Security selection within the Health Care, Energy and Real Estate sectors added the most value on a relative basis, while selection within Industrials, Information Technology and Consumer Discretionary detracted. From an allocation perspective, the portfolio benefited from an underweight in Consumer Discretionary and an overweight in Information Technology; however, this was offset by underweights in Communication Services and Real Estate.

The Small/Mid Cap Equity Composite’s underperformance occurred in the second half of the quarter following the market’s shift toward what we consider to be lower quality leadership and a resumption of growth’s outperformance. While we are disappointed in this reversal, we believe the portfolio continues to be positioned well going forward and that our time-tested discipline of favoring what we believe to be higher quality business models at attractive valuations will be rewarded over the long term.

Relative Contributors	Relative Detractors
Charles River Laboratories	Dycom Industries
QTS Realty Trust	Team
Gartner	Bottomline Technologies
Range Resources	AerCap Holdings
Cohen & Steers	Wolverine World Wide

CONTRIBUTORS

Security selection added the most value within the Health Care, Energy and Real Estate sectors. Additionally, an underweight in Consumer Discretionary and overweight in Information Technology contributed positively to relative performance. At the company level, Charles River Laboratories and QTS Realty Trust were two of the largest contributors during the quarter.

Charles River Laboratories

Charles River Laboratories (CRL), a contract research organization that provides outsourced clinical trial services to pharmaceutical and biotechnology companies, benefited from strong operating results and an announced acquisition to bolster its cell and gene therapy capabilities. We maintain a position, as we believe the company is well-positioned to benefit from the continued trend of large pharmaceutical companies outsourcing an increasing amount of their discovery, research and testing functions.

QTS Realty Trust

QTS Realty Trust (QTS), a real estate investment trust that owns and operates data centers, appreciated following the announcement that the company will be acquired by Blackstone Group. We maintain our investment, as we assess the risk-reward associated with the pending acquisition.

DETRACTORS

Security selection detracted within the Industrials, Information Technology and Consumer Discretionary sectors. Additionally, the portfolio’s underweights in Communication Services and Real Estate detracted from relative performance. At the company level, Dycom Industries and Team were two of the largest detractors during the quarter.

Dycom Industries

Dycom Industries (DY), a provider of engineering and construction services to the telecommunications and cable television industries, declined due to mixed spending trends associated with its customer base. We maintain a position, as we remain confident that demand for broadband should continue to expand and the upcoming spending cycle associated with 5G infrastructure will drive demand for the company’s services.

Team

Team (TISI), a provider of specialty industrial services for the refining, petrochemical, power and pipeline industries, continued to be negatively impacted by the pandemic with additional disruption coming from February winter storms, which led to lower activity levels. We maintain a position, as we believe an upswing in demand from pandemic-related disruptions and company-specific cost-efficiency initiatives will allow the company to create value for shareholders.

Recent Portfolio Activity

Buys	Sells
Huntington Bancshares	FLIR Systems
KB Home	HMS Holdings
Mercury Systems	John Wiley & Sons
PetIQ	TCF Financial
Teledyne Technologies

BUYS/ACQUISITIONS

Huntington Bancshares

Huntington Bancshares (HBAN), a bank holding company based in Columbus, Ohio, was added to the portfolio by virtue of its merger with existing portfolio holding TCF Financial.

KB Home

KB Home (KBH), one of the largest homebuilders in the U.S., was added to the portfolio. We believe the company’s unique build-to-order model, which provides strong pricing power and margin potential, combined with the stock’s attractive valuation offer a compelling risk-reward opportunity over the next several years.

Mercury Systems

Mercury Systems (MRCY), a provider of secure sensor and safety-critical processing subsystems, was added to the portfolio. We believe the company is well-positioned to capitalize on the continued trend of prime contractors outsourcing subsystem development to third parties, and its peer-leading growth and margin potential, along with its attractive valuation makes it a compelling long-term investment.

PetIQ

PetIQ (PETQ), a holding company which engages in the manufacturing, procurement, packaging and distribution of pet health and wellness, was added to the portfolio. We believe the company is well-positioned to benefit from secular demand tailwinds for pet health products. Additionally, management’s focus on increased penetration for its wellness clinics has the potential to drive further upside and create value for shareholders.

Teledyne Technologies

Teledyne Technologies (TDY ), a provider of electronic, communication, instrumentation and digital imaging products for wireless and satellite systems, was added to the portfolio by virtue of its acquisition of existing portfolio holding FLIR Systems.

SELLS/LIQUIDATIONS

FLIR Systems

FLIR Systems (FLIR), a manufacturer of thermal imaging cameras for commercial and government applications, was removed from the portfolio after being acquired by Teledyne Technologies.

HMS Holdings

HMS Holdings (HMSY), a healthcare technology company that provides cost-containment services to government and private healthcare payers and sponsors, was removed from the portfolio after being acquired by a private equity firm.

John Wiley & Sons

John Wiley & Sons ( JW.A), a multinational publishing company focused on academic publishing and instructional materials, was removed from the portfolio as the company’s valuation had approached a level where we felt the risk-reward opportunity no longer justified maintaining the position.

TCF Financial

TCF Financial (TCF), a Michigan-based bank holding company, was removed from the portfolio after being acquired by Huntington Bancshares.

Outlook and Positioning

Our long-term outlook for the small/mid cap equity market remains positive, and we believe the current environment should provide a favorable backdrop for companies with strong fundamentals and attractive valuations over the next multi-year period. The pandemic environment that drove the markets last year created a headwind for many cyclical areas of the market, leading to a favorable environment for longer-duration growth companies and significant outperformance of money-losing companies relative to profitable businesses. Thus far in 2021, we have seen short-term periods where more reasonably valued companies have recovered on a relative basis, but this has not been a linear shift in the market. Additionally, short-term dislocations driven by the meme stock rallies have allowed the low-quality rally to continue, but we believe higher quality businesses have the potential to recover meaningfully going forward. Overall, we believe our focus on businesses with strong fundamentals and attractive valuations will be rewarded as these relative performance relationships continue to return to more normalized levels. Additionally, earnings growth is expected to continue to improve from last year and outpace that of large cap, which we believe provides further upside for the asset class. We believe active managers with a focus on quality should benefit as earnings growth becomes a more dominant driver of equity returns going forward.

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 Financials 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 Real Estate as a result of valuations and 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. 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.