Small Cap Commentary | Second Quarter 2022
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Introduction
The second quarter of 2022 was a lousy quarter for capital markets, with both stocks and bonds declining during the quarter. The S&P 500 Index fell 16.1%, and the Bloomberg Aggregate Bond Index dropped 4.7%. Small cap stocks were not spared from this decline either, as they fell 17.2% during the quarter with year-to-date returns standing at -23.4%. From the peak in November 2021, small cap stocks are down nearly 30%. Heightened inflation readings prompted a hawkish Federal Reserve to raise the Fed Funds rate by 0.75% in a single meeting for the first time since 1994. This action drove strong selling, as investors adjusted to higher prices for consumers and heightened borrowing costs across the economy. The Fed’s push to tamp down the highest levels of inflation in the past 40 years now has investors concerned that the economy may be pushed into recession in order to restore price stability to the economy.
The Punch Small Cap Strategy modestly outperformed the Russell 2000 Index for the quarter, returning -16.7% (net of fees) versus the index’s return of -17.2%. Over the last year, our strategy returned -21.2% versus -25.2% for the index. Since its inception, the Punch Small Cap Strategy has returned an annualized 9.77% versus 7.60% for the index.
Recession? No Recession? Does it Matter?
With each of our holdings, we regularly review our investment thesis and examine the potential upside compared to the downside risk at prevailing price levels. We are more confident in our ability to assess individual companies run by people with a business plan than predicting how the stock market will perform over the near term. That said, we are students of history and look for help in assessing the general investing environment. The Russell 2000 Index has lost nearly one-third of its value since early November. This is slightly worse than the median decline for a non-recessionary bear market and only a few percentage points away from the median decline for a recessionary bear market. While we acknowledge that stocks could decline further, our philosophy remains that opportunities are greatest where capital is most scarce. Based on the last eight months, we have good reason to believe that buyers are scarce, and investors willing to pick through the stock market rubble may be rewarded over the next few years.
So, What Usually Happens Next?
When there is widespread pain in the markets, especially the kind we’ve witnessed since November of last year, our investment team tends to get pretty excited. The work we do is thorough, and with recent market weakness, we are operating with an added sense of urgency to discover the future prospects for the companies in which we’re invested. While it’s difficult to pinpoint exactly when the pain might end, what usually follows is a much different experience for small cap investors. The table to the right shows the 14 bear markets since the inception of the Russell 2000 Index. Historically, when each of these markets has bottomed and collective fear has turned to optimism, returns have more than made up for the losses in just six to twelve months. It is also worth noting that performance for small cap indices is usually stronger than that of large cap indices coming out of a trough, generating an average return that is seven percent better per year over the ensuing two years.
Top and Bottom Contributors
During the quarter, the top contributor to our return was Digi International Inc. (DGII, $850 million market cap). This Minnesota business provides Internet of Things (IoT) connectivity products, solutions, and services. During the quarter, Digi reported strong numbers as they successfully navigated supply chain challenges while showing robust demand with record bookings and backlog. We believe the business is becoming increasingly predictable as 1) the recurring solutions business becomes a larger piece of the sales mix; and 2) customers’ transition to IoT has accelerated because of tight labor markets.
StoneX Group Inc. (SNEX, $1.6 billion market cap), a provider of execution, clearing, and payments services to commercial and retail clients, was a top contributor to performance during the quarter. StoneX reported strong results as market volatility drove high levels of activity across its various business lines. The company also benefitted from rising interest rates. In June, we caught up with the management team at their office in New York and walked away encouraged by the number of high-return investment opportunities for their business as they continue to gain scale in the coming years.
The third-largest contributor to performance was Par Pacific Holdings, Inc. (PARR, $937 million market cap), an owner of refineries, gas stations, and other energy infrastructure located predominately in Hawaii. Disruptions in Europe and Asia are helping to expand refinery spreads which should improve the economics of Par’s refineries. The resumption of travel to Hawaii is also driving increased demand. Finally, we believe the improved sentiment and valuations for energy assets could create an attractive opportunity for Par to divest some valuable, non-core assets.
The largest detractor from performance was Global Ship Lease, Inc. (GSL, $610 million market cap), an owner and lessor of mid-sized containerships. After two years of incredibly strong shipping demand, container freight rates started to decline during the quarter, creating negative headlines for the industry. While sentiment around the space has begun to sour, we believe the company is somewhat isolated from near-term swings in shipping rates as over 87% of the fleet is already contracted to liners through 2023. We remain comfortable holding shares as they trade at an undemanding valuation of less than 3x earnings while sporting over a 9% dividend yield.
Longtime holding B. Riley Financial, Inc. (RILY, $1.2 billion market cap) was a detractor as their capital markets businesses slowed during the quarter. After a remarkably strong 2020 and 2021, capital markets activity came to a halt during the first quarter, but B. Riley managed to stay profitable. Management has strategically built out less episodic businesses like wealth management and advisory along with counter-cyclical businesses including liquidation and restructuring to help offset the inherent cyclicality within capital markets. We believe the business has a strong balance sheet and is well positioned to weather this slowdown while still paying a healthy 9% dividend yield.
The E.W. Scripps Company (SSP, $1.0 billion market cap) operates a portfolio of local television stations and content networks in 41 markets across the U.S. The stock was a top detractor in the quarter despite reporting solid results as investors are likely concerned about advertising spending in a more uncertain economic environment. While demand for advertising might soften, we believe inflation will increasingly push consumers to watch free, over-the-air television, as cutting the cord and unsubscribing from streaming platforms becomes more appealing. Additionally, we anticipate that political ad spending this fall will be strong and will provide a significant windfall with several important U.S. Senate and gubernatorial races occurring in Scripps’s markets.
We initiated one new position during the quarter in Heritage-Crystal Clean, Inc. (HCCI, $655 million market cap). The company’s primary business is a route-based service that provides cleaning and waste collection for small- and medium-sized industrial businesses and vehicle maintenance providers. Heritage-Crystal Clean is the second largest full-service oil collector and re-refiner in North America and should benefit from rising oil prices. We believe the route-based business model is highly recurring and profitable, and industry fragmentation creates a long runway for the company to continue growing through acquisitions.
During the quarter we exited our investment in Faro Technologies Inc. (FARO), $563 million market cap). This Orlando based business designs lasers, software and related hardware used in factory automation and robotics. In June 2019, the company named a new CEO that entered with a strong reputation after the company experienced slowing growth and contracting profitability under previous management. Despite refreshing all major product categories, and reinvesting into sales and marketing, Faro has struggled to drive growth or margin improvement. We believe their core hardware business is becoming increasingly commoditized and the transition to software is still in the early stages. Compounding these challenges, supply chain outages and lockdowns in China have held back near-term performance and the company has struggled to pass along price increases for most hardware products in this inflationary environment. We anticipate these headwinds will persist for some time and elected to exit our position.
We finished the quarter with 43 holdings.
Conclusion
History suggests that now is a good time to be investing in small cap securities. As seen in the chart to the right, more than 30% declines, like we are currently experiencing, are rare in the small cap asset class. When a drawdown of that magnitude occurs, historically the market correction bottom was near, reaching it within four to 104 trading days. Even more encouraging is that when the market turns, small caps can experience an equally dramatic upswing.
We spent the second quarter re-underwriting investment theses and checking in with portfolio companies’ management teams. We can’t control whether a recession occurs or when the economy returns to more stable footing. We can continue to look for new and add to existing companies that can weather a variety of environments and generate attractive returns for shareholders over time. We are as excited as ever about the prospects for future returns.
We are grateful for our partnership with you and appreciative of your trust in our ability to create lasting value through your investment in the Punch Small Cap Strategy.
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