Portfolio Manager and Senior Research Analyst
Kayne Anderson Rudnick
KAR Portfolio Manager Julie Kutasov discusses small- and mid-cap equity performance in the second quarter, the KAR Small-Mid Cap Core strategy’s largest contributors and detractors for the quarter, and key considerations she will be focusing on in the second half of the year.
STEVE RIGALI: Hello, this is Steve Rigali, executive managing director with Kayne Anderson Rudnick, and with me today I have Julie Kutasov, the portfolio manager on the Kayne Anderson Rudnick Small And Midcap portfolio.
JULIE KUTASOV: Hello, Steve, happy to be here.
STEVE RIGALI: Julie, 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 of performance for small- and mid-cap equities?
JULIE KUTASOV: U.S. equities continued to advance in the second quarter. The S&P 500® Index rose 8.7% and the Nasdaq Composite Index climbed 13.1%. Larger-cap stocks outperformed smaller caps and tech-heavy growth indices outperformed bank-heavy value counterparts. As you mentioned, markets gains were relatively narrow, led by large technology companies that investors believed to be at the forefront of artificial intelligence, seen by many as the dawn of the new era for computing.
Most importantly, a widely anticipated recession – some would say the most anticipated recession ever – did not materialize. Quick action from bankers and regulators in March helped prevent the collapse of Silicon Valley Bank from sparking a broader financial crisis. And lawmakers managed to strike an agreement on government spending in late May, preventing a potentially devastating default.
The labor market remains solid despite recent layoffs in the tech sector, and inflation, albeit elevated, continued to ease. With their worst fears behind them, investors continued buying risky assets. The second quarter’s performance of the Russell 2500TM index, this strategy’s benchmark, was driven by companies with low earnings quality, weaker balance sheets, and higher share price volatility.
STEVE RIGALI: Julie what portfolio holdings contributed to the portfolio performance during the second quarter, and which portfolio holdings contributed the least?
JULIE KUTASOV: Our strongest performing stock was Bentley Systems, ticker BSY. Other top contributors included Thor Industries, ticker THO, Lennox International, ticker LII, Watsco, ticker WSO, and SiteOne Landscape Supply, ticker SITE.*
A leading developer of software for infrastructure markets, Bentley has created a brand synonymous with infrastructure. Engineering software is highly specialized nature. Once engineers adopt a particular technology and integrate into their work processes, they are reluctant to try something new, resulting in the company's robust customer retention rates. Shares performed strongly, driven by solid operating results with growth broad-based both in terms of geographic regions and markets.
We believe that Bentley's multi-decade commitment to the infrastructure segment has led to the company’s superior domain expertise and meaningful intellectual property that is hard to replicate. We also believe that Bentley is well positioned to benefit from increased infrastructure spending, both in the U.S. and abroad, as well to capitalize on further advancements in computer simulation and artificial intelligence technologies.
Aspen Technology, ticker AZPN, was our weakest performer of the quarter. Other detractors were Zebra Technologies, ticker ZBR, Teledyne Technologies, ticker TDY, Scotts Miracle-Gro, ticker SMG, and Exponent, ticker EXPO.
Aspen is a leader in process optimization software used to run multi-million dollar capital-intensive processes and solving highly complex problems. The software is mission critical by nature, so customers are more willing to pay a premium and less likely to switch to a less expensive upstart solution. Importantly, once implemented, Aspen software is extremely costly and disruptive to replace, resulting in the company's solid recurring revenue base.
Shares declined sharply in late April, however, following the company’s announcement of worse-than-expected operating results and annual guidance reduction. Management attributed the weakness to slow activity by large chemicals customers that had been struggling with supply chain disruptions and inventory destocking issues following the post-pandemic reopening surge.
We view these developments as temporary and believe that Aspen's solid market positioning remains intact and has been further enhanced by the company’s recently acquired software assets. We believe the transaction should allow new Aspen to achieve faster revenue growth and profitability improvement, accelerate expansion into new verticals, and capitalize on long-term sustainability trends in the engineering and construction space.
STEVE RIGALI: Julie as we turn our focus and attention to the second half of 2023, what are the key considerations you are evaluating from a portfolio perspective?
JULIE KUTASOV: Slowing economic growth remains most concerning, particularly as it is taking place against the backdrop of inflationary pressures exacerbated by continued uncertainty on the geopolitical front. While improved, inflation remains elevated, impacting consumer spending – the key driver of the U.S. economy and businesses struggling to offset input cost increases with high prices. An unintended consequence of the Fed's interest rate hikes, the recent banking crisis has constrained bank lending, the lifeblood of the economy, thus, increasing the risk of a more severe downturn.
While economic data have largely been better than expected, some worrisome signals have emerged. In the first five months of the year, nearly 300 U.S. companies filed for bankruptcy protection, including Silicon Valley Bank and Bed Bath and Beyond – the highest number since 2010. Manufacturing data has also been deteriorating for several months, and the yield curve continues to be averted, leading investors to fear recession.
On the positive side, the inflation data continues to trend lower, and the Fed's aggressive monetary policy with a time lag as expected, appears to have started cooling the economy, thus, reducing the likelihood of further interest rate increases. The labor market albeit still tight, also appears to be moving in the right direction.
In our experience, slowing economic growth usually leads to investors’ flight to quality. While the outlook remains uncertain, we believe that our focus on the highest quality companies is particularly relevant today, and you will always find us looking for new investment opportunities. With artificial intelligence expected to eventually impact most industries, we’ll be searching for companies that, like Bentley Systems, are best positioned to benefit as the technology is being developed and deployed over time.
STEVE RIGALI: Julie, thank you for taking the time to provide your insights to our KayneCast listeners.
JULIE KUTASOV: Thanks, Steve.
*The #4 and #5 contributors for the KAR Small-Mid Cap Core SMA portfolio (Watsco and SiteOne Landscaping Supply) were the #5 and #4 contributors, respectively, for the Virtus KAR Small-Mid Cap Core Fund.
This information is being provided by Kayne Anderson Rudnick Investment Management, LLC (“KAR”) for illustrative purposes only. Information contained in this material is not intended by KAR to be interpreted as investment advice, a recommendation or solicitation to purchase securities, or a recommendation for a particular course of action and has not been updated since the date of the material, and KAR does not undertake to update the information presented should it change. This information is based on KAR’s opinions at the time of the recording of this material and are subject to change based on market activity. There is no guarantee that any forecasts made will come to pass. KAR makes no warranty as to the accuracy or reliability of the information contained herein.
Past performance is no guarantee of future results.