Commentaries

Small Cap Opportunity Fund Commentary

Small Cap Opportunity Fund Commentary

Market Overview

As of September 30, 2024

While the headline numbers suggest a blowout third quarter for smaller stocks, a look beneath the hood tells a more nuanced story of a July reversal rally that quickly petered out. While the Russell 2000 Value Index gained 10.2% during the third quarter and handily outpaced the S&P 500 Index’s 5.9%, its fade into late summer left investors like ourselves wanting more.1

The Rotation that Wasn’t

After struggling mightily year to date, especially relative to its large cap brethren, the Russell 2000 surged 10.2% during July, as mid-month data releases pointed to easing inflation and stable consumer spending, setting the table for a September federal funds rate cut and raising hopes that the Federal Reserve could achieve the soft landing it was seeking.2 In such a scenario, smaller companies, which tend to be more highly leveraged than larger ones and rely on more expensive floating-rate debt, would find their cost of capital reduced while the economic growth continued to support underlying demand. A meaningful rotation from large caps to small caps was not meant to be, however, and smaller stocks spent the rest of the summer in a funk.

Of course, performance relationships tend to ebb and flow over time; it’s been our experience that small cap/large cap leadership cycles tend to last around 10 years. The current string of small cap underperformance has been in place since 2010, however, and we think the elongation is at least partly due to the Covid-19 pandemic and the massive liquidity response to it. Easy capital tends to be ripe for misallocation, and the distortions that result can take time to normalize.

For example, the percentage of unprofitable companies in the Russell 2000 peaked at an all-time high of more than 45% in early 2021 as the world was just starting to reopen following the pandemic-related shutterings. Nearly three years later, this percentage has only declined by about 5% to a level more or less equal to its peak in the aftermath of the global financial crisis.3 Too many companies have been able to scuttle along on the back of cheap financing, and investors in general have demonstrated little interest in trying to identify quality small cap names.

We do see some signs that the factors contributing to this long cycle of underperformance may be reversing, however. As a result of the sharpest rate-hike cycle in Federal Reserve history, capital now has a cost—though not one so high that credit fundamentals have been broadly impacted. More recently, rates began to ease in anticipation of the Fed rate cuts, the first of which—at an oversized 50 basis points—came to pass in September.4 This should ease the burden of companies with floating-rate debts while lowering the cost of capital investment for all. As we’ve seen in the index’s underperformance over the past few years, it’s not enough for a company to simply remain solvent; successful names must demonstrate that they are positioned for future earnings growth and upside potential.

Economic resilience is another potential tailwind for the small cap space. While we can’t predict whether or not a recession is on the horizon, the economy has continued to expand in the face of much tighter financial conditions, with the labor market well supported and consumer metrics remaining solid. Anecdotally, there was little in the July/August batch of conference calls held by small cap companies to suggest managements were overly concerned about the potential for recession or planning mass layoffs of their own staff.

If Not Now, When?

Despite what seems to be a good base for a market rotation, small cap stocks continue to trade at recession-level valuations and in our view represent a particularly compelling risk-reward scenario.

As we were reminded in August and September, swift changes in the relative performance of small and large cap stocks can often be a head fake, reflecting nothing more than a mini-burst of excitement in a long slog of weakness. A true shift in sentiment requires consistent buying interest among market participants that perceive the same bargain pricing in the space like we do. Often, this takes the form of mergers and acquisitions activity. Strategic buyers, in particular, are often willing to pay attractive premiums for companies that have rationalized their cost structures, survived difficult times and now appear well positioned for the future, with sound business models and responsible balance sheets.

We have observed an uptick in takeout activity within the small cap universe during 2024, and we are hopeful that persistent interest from sophisticated buyers may call greater attention to the latent value we see in this market. In the meantime, we remain focused on what we as investors can control: namely, the stocks we invest in and the price we pay for them.

Portfolio Review

Small Cap Opportunity Fund A Shares (without sales charge*) posted a return of 5.25% in third quarter 2024 Financials, health care and industrials were the leading contributors among equity sectors; energy and communication services detracted and information technology also lagged. The Fund underperformed the Russell 2000 Value Index in the period.

Leading contributors in the First Eagle Small Cap Opportunity Fund this quarter included CareDx, Inc, Zeta Global Holdings Corp. Class A, FTAI Aviation Ltd., Carpenter Technology Corporation and Pennant Group Inc.

CareDx provides diagnostic surveillance solutions for organ-transplant recipients, including testing products and services to match donors with recipients and monitor post-transplant care. The company reported better-than-expected results for its most recent quarter, driven by sales volume and margin improvement, and achieved positive free cash flow sooner than expected. In addition, the Centers for Medicare and Medicaid Services (CMS) during the quarter announced plans to restore coverage for blood-based surveillance testing for detecting early signs of transplanted organ rejection. We believe that CMS coverage will encourage broader use of the company’s products and services, which are less invasive relative to biopsy, and support long-term growth and profitability.

Zeta Global operates a multichannel data-driven cloud platform that utilizes artificial intelligence to provide consumer data to enterprise clients and provides marketing automation software worldwide. The company reported better-than-expected results for its most recent quarter, driven by growth from large agency customers targeting users across different mobile applications. In our view, Zeta is well positioned to continue gaining market share among large advertising holding companies in this high-growth segment.

FTAI Aviation leases and provides maintenance services for commercial jet engines to Tier 2 and Tier 3 airlines with a focus on CFM56 and V2500 engines. The company has been executing well with notable growth in its after-market replacement parts, repair and maintenance segment, which offers compelling cost savings as well as faster turnaround times. FTAI has also been investing in capacity expansion to support future growth.

Carpenter Technology produces stainless steel, titanium and specialty metal alloys primarily for the aerospace and defense industry as well as for medical, transportation, energy and industrial, and consumer applications. The company reported better-than-expected results for its most recent quarter, driven by improved productivity, product mix and pricing. Carpenter also indicated that it expects to achieve its fiscal 2027 goals earlier than expected, likely in fiscal 2025.

Pennant Group operates senior living facilities and provides home health and hospice care services and hospice agencies in rural areas in 13 states. Following significant disruptions to its business during the Covid-19 pandemic, Pennant has experienced a strong recovery and reported better-than-expected results for its most recent quarter. The company has also been growing by acquiring underperforming senior living facilities and improving operations, which we believe is a significant long-term growth opportunity.

The leading detractors in the quarter were PBF Energy, Inc. Class A, Veeco Instruments Inc., Amkor Technology, Inc., Vital Energy, Inc. and Matador Resources Company.

PBF Energy is one of the largest independent petroleum refiners in North America. Amplifying the impact of weak commodity prices during the quarter, margins were further pressured by extended maintenance downtime at certain of its refineries. With maintenance upgrades now largely complete in this difficult-to-replicate asset, the company may be well positioned for margin expansion as the cycle recovers.

VEECO Instruments is a US-domiciled global capital equipment supplier that designs and builds processing systems for semiconductor manufacturing, data storage and scientific markets for applications including advanced packaging, photonics, power electronics and display technologies. Semiconductor capital equipment companies were under pressure during the quarter on inventory overstocking in anticipation of quick and widespread approval of first-generation test kits. We remain constructive on the shares, prospectively driven by cyclical recovery in advanced packaging of DRAMs. Reduced dependence on China for growth could provide stability to the shares.

Amkor is the world’s largest provider of outsourced semiconductor packaging and test services and has strategic manufacturing partnerships with leading semiconductor companies, foundries and electronics manufacturers around the world. Recent volatility in the stock may reflect short-term industry dynamics, as the supply of high bandwidth memory essential to artificial intelligence applications was constrained during the quarter. Weakness in the auto-related portion of Amkor’s business additionally may have pressured the shares. Amkor maintains a solid balance sheet and we remain constructive on its revenue growth prospects.

Vital Energy (known as Laredo Petroleum until 2023) is a hydrocarbon exploration company with principal operations in the Permian Basin. Even faced with volatile commodity prices and a weak market for natural gas, the company increased production and productivity and reduced leverage during the quarter. That said, the company’s limited reserve life on its core assets may serve as a headwind in the long term.

Matador Resources is an independent energy company engaged in the exploration, development, product and acquisition of oil and natural gas resources. It has assets in the Delaware Basin in New Mexico and Texas, as well as the Eagle Ford Shale in Texas and the Haynesville Shale and the Cotton Valley in Louisiana. Shares were buffeted by volatile commodity prices during the quarter. Production remains strong, and the company continues to develop its base of upstream assets, including additional acreage in the Delaware Basin.

We appreciate your confidence and thank you for your support.

Sincerely,
First Eagle Investments

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