Q1 KAR Mid-Cap Core Portfolio Review Podcast

Transcript

JORDAN GREENHOUSE: Hello, this is Jordan Greenhouse, managing director with Kayne Anderson Rudnick, and with me today I have Jon Christensen, senior portfolio manager and senior research analyst with the Kayne Anderson Rudnick Mid-Cap Core portfolio. Jon, thank you for your time today.

Jon, the first quarter of 2023 began with a carryover of the recovery that we saw at the tail end of 2022 in which there’s been a greater focus on quality. As we moved into the tail end of the first quarter, we saw markets reverse course a bit due to concerns related to the banking sector. Can you provide our listeners with your perspective on the first quarter from where we began the year to the tail end of the quarter in 2023?

JON CHRISTENSEN: Of course. It feels like the rollercoaster we saw in 2022 was somewhat carried over into Q1 2023, albeit on a shorter time scale. January appeared to put the market in good spirits with the Russell Midcap Index increasing over 8% in the month. Alas, that didn’t last long as the banking issues associated with Silicon Valley Bank and its peers promptly took some of the wind out of the sail as February and March were both negative for the Index.

While these issues can have ripple effects through the markets as concern over banking weakness contagion could spread beyond financial institutions and the greater economy, we believe for the most part the Fed acted swiftly and decisively in containing any possible imminent issues.

This does not mean we’re out of the woods, but it does provide some confidence in the markets going forward. We here at Kayne don’t own an inordinate amount of banks, but the ones we do own we consider to be high quality and believe they should be able to withstand these current conditions.

Now, local as well as global financial entities could continue to see some volatility as we move through the year, and yes, this could cause some further disruption in equities, even in our names. But our goal is to monitor our portfolio companies for any structural cracks for now and on an ongoing basis. This, of course, is more heightened due to current conditions.

It was interesting to see the sector performance in Q1 for the Russell Midcap as energy and financials led the way lower – no surprise there – but also real estate and utilities were very weak. Communication services and technology were the stronger sectors. Month by month, the Russell Midcap was up 8.3% in January, then the banking crisis hit with February down 2.4%, and March added another 1.5%.

So, despite the issues we have seen in the Russell Midcap, it still finished up the quarter about 4%. March is the month that really made the difference for us as there was a clear flight to quality as the banking crisis gained momentum, which contributed to our relative outperformance.

JORDAN GREENHOUSE: Jon, would you be able to provide our listeners with some names in the portfolio that contributed most during the quarter, and in addition to that, would you provide some insight into some of the names that detracted the most in the quarter?

JON CHRISTENSEN: In terms of top contributors for the portfolio in the quarter, they were West Pharmaceutical, Monolithic Power Systems, Lamb Weston, Dolby Laboratories, and Zebra Technologies.

Let’s take a few moments just for West. West Pharmaceutical manufactures and markets pharmaceuticals, biologics, vaccines, and consumer healthcare products. It operates through the following business segments: proprietary products and contract-manufactured products.

After some operating hiccups in the third quarter, West reported a solid quarter for year-end. The company had been hurt by declining sales from its Covid-related business and had to retool equipment for new products. That transition is largely behind it, and we believe new design wins on its high-margin, high-value products should sustain earnings growth in the medium term.

Discussing the detractors to Mid-Cap Core in Q1, they were Azenta, Globus Medical, Pool Corp., W.R. Berkley, and Ross Stores.

Regarding Ross Stores, Ross Stores engages in the operation of off-price retail apparel and home accessory stores. The company is a large and consistent purchaser of excess inventory from apparel and consumer goods manufacturers. In our view, this has positioned the company as an important, reliable buyer of last resort for vendors, allowing the company to offer compelling value to its customers.

The company reported in its latest quarter continued improved comparable store trends and better inventory levels than its prior sequential quarter. Management provided conservative guidance for the upcoming year, which, when combined with strong prior quarter stock performance, caused shares to underperform.

JORDAN GREENHOUSE: Jon, lastly, as we move into the second quarter, what are some of the key considerations you and the team are evaluating from a portfolio perspective?

JON CHRISTENSEN: We entered 2023 with a general consensus view that the U.S. economy would have a mild recession, though the degree has been hotly debated. The first part of the quarter was where more optimism occurred as many investors began looking beyond any recession ideas; however, we were then met with the banking crisis that was led by Silicon Valley Bank and Signature Bank. This then put more uncertainty into the markets, which already had the Fed being aggressive in rate increases. This put some fear into investors that any pending recession would be more severe than thought.

However, the decisive actions to shore up deposits at these institutions, combined with other banks not seeing any contagion symptoms, led to a more muted downturn in the markets, especially as many viewed this as a sign that the Fed maybe would become more dovish in its tone or at least less hawkish. With all of this, we are still dealing with the issues, such as inflation, supply chain issues, as well as the ongoing Russia-Ukraine conflict, which has only added to the uncertainties and enhanced volatility.

So, given these uncertainties and volatility, what does one do? Our goal is to seek out solid companies with business models that can react and persevere in reaction to this volatility. High-quality companies that have the ability to pass through pricing while maintaining high customer retention through the value-add of its products to its customers.

But our mandate is clear and consistent, as we focus on high-quality businesses that we believe should outgrow their markets over the long term and take advantage of this market volatility.

JORDAN GREENHOUSE: As always, thank you very much for your time and your insights, and we look forward to future conversations.