Q2 KAR Mid-Cap Core Portfolio Review Podcast

Transcript

STEVE RIGALI: Hello, this is Steve Rigali, executive managing director with Kayne Anderson Rudnick, and with me today is Jon Christensen, portfolio manager on the Kayne Anderson Rudnick Mid-Cap Core strategy.

Jon, equities generally had positive returns during the second quarter, but it was dominated by the returns of a few mega-cap stocks. Can you provide our listeners with your perspective on the second quarter performance for mid-cap equities?

JON CHRISTENSEN: Of course. You know, it feels like once again, the quarter was kind of a tale of two cities and markets. In a quick summary of the year so far, the Russell Midcap® Index started off January with gusto after a weak 2022, increasing over 8% in that month. After the Russell saw four straight months of negative returns until June came along, the negative period was really characterized by ongoing fears of a recession that were exacerbated by the banking crisis in early 2023.

June seemed to bring some optimism that the Fed was closer to ending its hawkish policy, and inflation was also seeing some signs of abating. The surge in June was led by sectors that usually are associated with more cyclical characteristics, such as industrials, consumer discretionary, and materials. Many mega-cap tech companies that have been riding the artificial intelligence wave has made large-cap growth stocks have a fantastic year to date, with the Russell 1000® Growth Index up 29% so far in 2023. But again, the inverted yield curve has been a driver of the underperformance of smaller caps, as fears of a recession make new investors uneasy. However, as time goes on and the economy continues to absorb these shocks, we believe the likelihood of a recession goes down or the magnitude is dampened.

For the quarter, the Mid-Cap Core portfolio outperformed the Russell 2000® Index by 150 basis points. The Index skewed towards lower quality in the quarter as the industrial sector was the best performer. In other metrics we use to assess low versus high quality, almost all were in favor of low. This creates a nominal headwind for our portfolios that could sometimes be overcome with stock selection. That was the case here this quarter as our picks in healthcare were favorable. Asset allocation can sometimes influence the performance more, and that's what we also saw in the portfolio. Our overweight in industrials and the underweight in utilities help us achieve our outperformance in the quarter.

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 is heightened due to current conditions.

STEVE RIGALI: Jon, what portfolio holdings contributed to your portfolio performance during the second quarter, and what portfolio holdings contributed the least?

JON CHRISTENSEN: In terms of contributors for the portfolio in the quarter, they were Bentley Systems, Lennox International, AMETEC, Verisk, and West Pharmaceutical.

Let's take a moment for Lennox. Lennox manufactures and sells residential and commercial HVAC and refrigeration equipment. As the second largest residential HVAC manufacturer, the company has established a strong brand reputation and benefits from a scale distribution network. Lennox reported a good quarter of growth with marginal recovery ahead of target as it executes the turnaround of its commercial business and implements better operational practices. Management also actively engages with shareholders on forthcoming improvements to help build confidence in the long-term outlook.
Discussing the detractors to Mid Cap Core in Q2, they were Aspen Technology, Zebra Technologies, Exponent, First Financial Bankshares, and W.R. Berkeley.*

Regarding Exponent, Exponent provides science and engineering consulting services in the U.S. and internationally. Through its history of expert testimony on multidisciplinary engineering-related failure situations in litigation, Exponent has developed a leading reputation as a technical expert that translates into premium pricing for its services.

During the quarter, the company delivered solid revenue growth but reported lower utilization and margins due to headcount growth and expense normalization. Additionally, scrutiny by some clients amidst macro uncertainty, particularly in proactive work, has led to some short-term pauses in demand.

STEVE RIGALI: Jon, as we turn our focus to the second half of 2023, what are the key considerations you are evaluating from a portfolio perspective?

JON CHRISTENSEN: We entered 2023 with a general consensus view that the U.S. economy will have a mild recession, and the debate has endured through Q2 2023. As we move along here in 2023, the markets seem to be absorbing the ups and downs of inflation and the Fed maintaining its hawkish bias. We still have many balls in the air…Russia-Ukraine conflict, inflation still higher than normal, banking crisis fallout, Fed seemingly focused on getting inflation back to 2%. This creates uncertainty in terms of entry points for the equity markets.

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

STEVE RIGALI: Jon, thank you for taking the time to provide your insights to our KayneCast listeners.