ARISTOTLE CAPITAL BOSTON, LLC
Markets Review
SMID caps enjoyed strong gains in the third quarter with the Russell 2500 index delivering a total return of 8.75% but the performance belies the volatile path taken during the period. Equities rallied in July as a below consensus CPI print lent credence to the soft-landing narrative. However, the risk on environment was punctuated in early August as an interest rate hike by the Bank of Japan and the resulting unwind of the levered Yen carry trade rattled global markets. The second half of the quarter was influenced by softening economic data and the Federal Reserve (Fed). Following comments made at the August Jackson Hole economic symposium that the time had come for policy to adjust, the Federal Reserve voted to cut the Fed Funds by 50 basis points (bps). Markets embraced the decision, ending the inversion of the U.S. Treasury yield curve, and the front end is now pricing in roughly 100 bps of easing in 2024.
Stylistically, value stocks outperformed their growth counterparts during the quarter as evidenced by the Russell 2500 Value Index returning 9.63% compared to 6.99% for the Russell 2500 Growth Index. Energy was a negative sector in both indices with much of the relative outperformance of the value index coming from interest rate-sensitive sectors such as Financials and Real Estate. Looking under the hood, the knock-on effects of lower interest rates could be seen in the value index, as two of the top five performers during the quarter were housing related. While AI enthusiasm has subsided in the second half of 2024, pockets can still be seen in parts of the SMID cap market. Lumen Technologies, a languishing communications company, rallied in August and was the top third-quarter performer in the Russell 2500 index when the company announced $5 billion in new business to provide private networks for AI scalers along with the potential for increased customer demand.
At the sector level, ten of the eleven sectors in the Russell 2500 Index recorded positive returns during the third quarter, led by the Real Estate (+17.76%), Utilities (+14.23%), and Communication Services (+14.00%) sectors. Conversely, Energy (-7.61%), Consumer Staples (+2.62%), and Information Technology (+3.11%) all lagged.
Sources: CAPS Composite Hub, Russell Investments
Past performance is not indicative of future results. Returns are presented gross and net of investment advisory fees and include the reinvestment of all income. Gross returns will be reduced by fees and other expenses that may be incurred in the management of the account. Net returns are presented net of actual investment advisory fees and after the deduction of all trading expenses. Aristotle Small Cap Equity Composite returns are preliminary pending final account reconciliation. Please see important disclosures at the end of this document.
Performance Review
For the third quarter of 2024, the Aristotle Small/Mid Cap Equity Composite generated a total return of 9.48% net of fees (9.66% gross of fees), outperforming the 8.75% total return of the Russell 2500 Index. Outperformance was primarily driven by security selection while allocation effects detracted. Overall, security selection was strongest in the Information Technology, Financials, and Materials sectors and weakest in Industrials, Utilities, and Heath Care. From an allocation perspective, the portfolio benefited from an underweight in Consumer Staples and an overweight in Industrials, however, this was offset by an underweight in Real Estate and an overweight in Information Technology.
| Relative Contributors | Relative Detractors |
|---|---|
| Baldwin Insurance Group | Acadia Healthcare |
| ACI Worldwide | Range Resources |
| Cohen & Steers | MACOM Technology Solutions |
| Alamos Gold | Advanced Energy Industries |
| Belden | Permian Resources |
CONTRIBUTORS
Baldwin Insurance Group (BWIN), a Florida-based insurance company operating in the advisory, underwriting, and Mainstreet (consumer/small business) segments, built on second-quarter momentum with above consensus earnings on account of business line growth and margin improvement. We believe the company is starting to benefit from investments in talent made over the past year as well as the launch of new products. We maintain a position as we believe the company should continue to benefit from a positive inflection in free cash flow, improving margins, and deleveraging.
ACI Worldwide (ACIW), a provider of software solutions to facilitate payment transactions for financial institutions, retailers, and payment processors around the world, benefited from strong second-quarter results largely driven by growth in the bank segment along with the announcement of a $400 million stock buyback program. We maintain our investment as we believe the company is executing its strategy to maintain a strong market position in the payments software niche while upgrading its technology in select areas. With ongoing cost controls and high incremental margins on new revenue, we expect the company can drive additional growth with continued debt reduction and share repurchases.
DETRACTORS
Acadia Healthcare (ACHC), a behavioral healthcare and substance abuse treatment services company, declined in late September as a result of two negative news headlines related to patient care and questions about billing practices. While we take these developments seriously, we believe investors’ reaction to the news has been more severe than warranted. Industry peers have faced similar levels of scrutiny in the past with limited fundamental impact, and unless additional information is uncovered, we believe the current scrutiny will be resolved without much of an impact on their business. We continue to believe the company is well positioned to be an important part of the solution to an unfortunately growing need for behavioral health services.
Range Resources (RRC), a natural gas focused exploration and production company with operations in the Appalachian Basin, declined amid a weak commodity price backdrop for energy related companies. We maintain a position, as we believe the company’s low-cost acreage allows it to translate the healthy price environment into earnings and cash flow that is being used to reduce financial leverage, which can accrue additional value to equity shareholders in periods to come.
Recent Portfolio Activity
| Buys/Acquisitions | Sells/Liquidations |
|---|---|
| Amentum Holdings | Diamondback Energy |
| First Interstate BancSystem | Enviri |
| Permian Resources | PetIQ |
BUYS/ACQUISITIONS
Amentum Holdings (AMTM), a mission critical IT and engineering services company, was spun out of AECOM in 2020 and merged with the military contracting business of current holding, Jacobs Solutions, in September 2024. The portfolio received shares of Amentum Holdings as part of the corporate action.
First Interstate BancSystem (FIBK), a financial holding company, provides community banking solutions to individuals, businesses, and municipalities. The company is selling at attractive valuations as we believe company specific self-help initiatives such as repositioning their balance sheet to take advantage of the Fed’s forward curve are underappreciated by the market and not reflected in the current valuation.
Permian Resources (PR) is a Texas-based oil & gas exploration & production company with a large acreage position and deep inventory of high return potential drilling locations in the core of the Permian Basin. We expect management to continue to execute on its strategy of optimizing returns, diligently allocating capital to new opportunities, and returning excess capital to shareholders.
SELLS/LIQUIDATIONS
Diamondback Energy (FANG), an independent oil and natural gas company, was sold due to its market cap increasing materially above the market cap range of the Russell 2500 Index after its Endeavor Energy Resources acquisition.
Enviri (NVRI), an industrial services provider, was sold due to a change in our thesis arising from the company’s inability to de-lever its balance sheet leading to muted forward growth projections.
PetIQ (PETQ), a manufacturer and distributor of pet health and wellness products, was sold as the stock had appreciated, causing its reward-to-risk profile to compress as it reached our valuation target.
Outlook
We continue to remain optimistic about the long-term potential for the SMID-cap segment of the U.S. market as valuations and potential tailwinds bode well for the asset class. As we look out to the final months of 2024, we are cautiously constructive as encouraging signs of economic stability are balanced by now consensus expectations of a soft landing scenario and risk pricing. While rate-cutting cycles have historically been constructive for smaller companies, there remains a long list of items creating uncertainty that could lead to greater volatility in the final months of the year. This includes but is not limited to, the reignition of inflationary pressures, labor strikes in key industries and ports, geopolitical tensions, U.S. equity index concentration issues, ongoing commercial real estate and regional banking concerns, and the looming presidential election. We are aware that most of these issues are well known, but the timing and magnitude of the impact of any and all of these issues remains unpredictable. Therefore, as we always have, we will continue to avoid the temptation to forecast their outcome in favor of assessing the potential impact from a range of potential outcomes within our company‐specific, bottom-up analysis, and quality focus.
From an asset class perspective, valuations of SMID versus large continue to remain near multi-decade lows, which we believe suggests a more favorable setup for SMID caps relative to large caps in the periods to come (17.7x P/E for the Russell 2500 Index vs. 25.8x P/E for the Russell 1000 Index). Against a backdrop of disinflation, normalized interest rates, and a still growing U.S. economy, it looks to us that the SMID cap’s stretch of underperformance has the potential to end. If the economy continues to stabilize, our view is that valuations are likely to rise for those businesses that have largely sat out the mega-cap performance regime. Lastly, we believe SMID caps remain better positioned to benefit from the reshoring of U.S. manufacturing, a pickup in M&A activity, fiscal policy bills passed in the last few years such as the IRA and Jobs Act, and several infrastructure projects on the horizon.
Positioning
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 Information Technology are mostly a function of our underlying company specific views rather than any top-down predictions for each sector. Conversely, we continue to be underweight in Consumer Discretionary, as we have been unable to identify what we consider to be compelling long-term opportunities that fit our discipline given the rising risk profiles of many retail businesses and a potential deceleration in goods spending following a period of strength. We also continue to be underweight in Real Estate as a result of 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.
The opinions expressed herein are those of Aristotle Capital Boston, LLC (Aristotle Boston) and are subject to change without notice.
Past performance is not indicative of future results. The information provided in this report should not be considered financial advice or a recommendation to purchase or sell any particular security. There is no assurance that any securities discussed herein will remain in an account’s portfolio at the time you receive this report or that securities sold have not been repurchased. The securities discussed may not represent an account’s entire portfolio and, in the aggregate, may represent only a small percentage of an account’s portfolio holdings. The performance attribution presented is of a representative account from Aristotle Boston’s Small/Mid Cap Equity Composite. The representative account is a discretionary client account which was chosen to most closely reflect the investment style of the strategy. The criteria used for representative account selection is based on the account’s period of time under management and its similarity of holdings in relation to the strategy. It should not be assumed that any of the securities transactions, holdings or sectors discussed were or will be profitable, or that the investment recommendations or decisions Aristotle Boston makes in the future will be profitable or equal the performance of the securities discussed herein. Aristotle Boston reserves the right to modify its current investment strategies and techniques based on changing market dynamics or client needs. Recommendations made in the last 12 months are available upon request.
Returns are presented gross and net of investment advisory fees and include the reinvestment of all income. Gross returns will be reduced by fees and other expenses that may be incurred in the management of the account. Net returns are presented net of actual investment advisory fees and after the deduction of all trading expenses.
As of December 31, 2014, there were no non-fee-paying accounts in the Composite.
All investments carry a certain degree of risk, including the possible loss of principal. Investments are also subject to political, market, currency and regulatory risks or economic developments. International investments involve special risks that may in particular cause a loss in principal, including currency fluctuation, lower liquidity, different accounting methods and economic and political systems, and higher transaction costs.
These risks typically are greater in emerging markets. Securities of small‐ and medium‐sized companies tend to have a shorter history of operations, be more volatile and less liquid. Value stocks can perform differently from the market as a whole and other types of stocks.
The material is provided for informational and/or educational purposes only and is not intended to be and should not be construed as investment, legal or tax advice and/or a legal opinion. Investors should consult their financial and tax adviser before making investments.
The opinions referenced are as of the date of publication, may be modified due to changes in the market or economic conditions, and may not necessarily come to pass.
Aristotle Capital Boston, LLC is an independent investment adviser registered under the Investment Advisers Act of 1940, as amended. Registration does not imply a certain level of skill or training. More information about Aristotle Boston, including our investment strategies, fees and objectives, can be found in our Form ADV Part 2, which is available upon request. ACB-2410-20
Sources: CAPS Composite Hub, Russell Investments
Composite returns for periods ended September 30, 2024, are preliminary pending final account reconciliation.
*The Aristotle Small/Mid Cap Equity Composite has an inception date of January 1, 2008, at a predecessor firm. During this time, Jack McPherson and Dave Adams had primary responsibility for managing the strategy. Performance starting January 1, 2015, was achieved at Aristotle Boston.
As of December 31, 2014, there were no non-fee-paying accounts in the Composite. Past performance is not indicative of future results. Performance results for periods greater than one year have been annualized.
Returns are presented gross and net of investment advisory fees and include the reinvestment of all income. Gross returns will be reduced by fees and other expenses that may be incurred in the management of the account. Net returns are presented net of actual investment advisory fees and after the deduction of all trading expenses. Please see important disclosures enclosed within this document.
The Russell 2500 Index is a subset of the Russell 3000® Index representing approximately 10% of the total market capitalization of that index. It includes approximately 2000 of the smallest securities based on a combination of their market cap and current index membership. The Russell 2500 Growth® Index measures the performance of the small/mid cap companies located in the United States that also exhibit a growth probability. The Russell 2500 Value® Index measures the performance of the small/mid cap companies located in the United States that also exhibit a value probability. The Russell 1000 Index is a subset of the Russell 3000® Index, representing approximately 90% of the total market capitalization of that index. It includes approximately 1,000 of the largest securities based on a combination of their market capitalization and current index membership. The Consumer Price Index (CPI) is a measure of the average change over time in the prices paid by urban consumers for a market basket of consumer goods and services. The volatility (beta) of the composite may be greater or less than the benchmarks. It is not possible to invest directly in these indices.
