Actively managed small cap growth strategy driven by bottom-up fundamental research seeking high-quality companies with strong balance sheets and cash flow characteristics that are beneficiaries of sustainable growth trends.
- First quarter returns for small cap growth stocks, as measured by the Russell 2000 Growth Index (the Index), on net asset value basis (NAV), were positive. The year started with a significant rally across many asset classes and small cap was no exception. On the heels of a flattish February, March closed the quarter with positive performance despite headline news surrounding the collapse of Silicon Valley Bank (SVB) in mid-March that sent shockwaves across the banking industry.
- Markets continued to be macro focused with all eyes on the Fed and their balancing act between the timing and magnitude of current and future rate hikes versus the inflationary environment and the potential lagging effects of previous hikes.
- Investors continue to debate whether the Fed can navigate the shallow valley of a “soft landing” or if the economy is on the verge of entering a much deeper valley and a meaningful recession.
For the quarter ended March 31, 2023, the strategy outperformed the index, on NAV basis, due to individual stock selection. The industrials, information technology, healthcare and financials sectors added the most to performance. Sector allocation was a slight detractor along with stock selection in the energy and materials sectors.
Key contributors to performance included Indie Semiconductor, Inc., Axcelis Technologies, Inc. and Focus Financial Partners, Inc.
Indie Semiconductor, Inc. (INDI), a fabless semiconductor company that serves the automotive technology market, was the largest individual contributor to performance for the quarter. Semiconductors were one of the best performing market segments in 1Q23, with the Philadelphia Semi Index (SOXX) rallying above 20%. After a poorly executed convertible debt offering in November 2022, INDI rallied along with semis and posted solid 4Q22 results and 2023 outlook in February. We continue to hold the stock but have recently trimmed the position.
Axcelis Technologies, Inc. (ACLS), a supplier of semiconductor manufacturing equipment and a leader in ion implant equipment, outperformed for the quarter. The company continues to grow through the cycle given their exposure (25% of revenue) to the Silicon Carbide (SiC) power device market, which is growing at a more than 30% compound annual growth rate (CAGR). These high-powered SiC devices are in high demand for the electric vehicle market and investors have realized their SiC exposure would allow them to grow earnings in 2023, while the stock had been priced as if earnings would decline.
Focus Financial Partners, Inc. (FOCS) was a top three contributor for the quarter. FOCS is a holding company and active acquirer of registered investment advisors (RIA’s). FOCS underperformed broadly in 2022 on the combined earnings challenges of down equity and bond markets and rising interest rates. FOCS rallied in 1Q23 on the equity market rebound and slowing forward rate increase expectations. It was then announced on February 27th that FOCS would be acquired by private equity firm Clayton, Dubilier & Rice for $53 in cash. We have liquidated the majority of the position.
Key detractors from performance included Western Alliance Bancorp, Patterson-UTI Energy, Inc. and Matador Resources Co.
Western Alliance Bancorp (WAL) a regional bank, was the largest detractor of performance for the quarter, as many regional banks came under pressure after the collapse of SVB in mid-March. Despite a much lower exposure to the venture capital market (around 11% of loans compared to 50% at Silicon Valley) and significantly smaller HTM (hold to maturity) book of assets, WAL was under the microscope as other regional banks failed over the weekend following the SVB announcement. We initially trimmed WAL by 40% on the day the SVB news broke and then made the decision to exit WAL completely to mitigate risk, as the future regulatory environment is opaque, and the current fundamentals are less predictable.
Patterson-UTI Energy (PTEN), a provider of contract drilling services to oil and natural gas operators, underperformed for the quarter. The company guided to 26% higher 2023 capital expenditure budget driven by eight incremental rig reactivations and one incremental frac fleet reactivation. This was not well received due to a weaker economic outlook and lower energy prices. Investors are concerned that PTEN is not exercising good capital discipline and may unintentionally oversupply the market for drilling and fracking. We are actively monitoring our position.
Matador Resources Co. (MTDR), an independent energy company engaging in exploration and production of oil and natural gas resources in the United States, underperformed due to the swift drop in the price of crude and natural gas during the quarter. Concerns surrounding the company’s higher capital expenditure expectations related to the build out of their midstream assets and a minimally hedged book has led to near term volatility. We continue to hold the position and like the company’s exposure to the Delaware shale basin, lower cost structure and the recent accretive acquisition of Advance Resources.
Current Strategy and Outlook
Valuations of small cap stocks relative to large cap stocks remain near 20-year lows and stocks that were previously outside our valuation overlay bandwidth are plentiful. Most investors are expecting a slowing economy over the next several months and it is our view that the importance of companies that can continue to grow revenue and earnings will be paramount. The small cap growth team continues to be prudent in adding new names to the portfolio, preferring companies that have provided 2023 growth perspectives, in order to avoid negative earnings revisions. The recent regional banking issues will clearly have an impact on small cap companies in need of accessing capital. It is difficult to know the ultimate outcome, but we believe that added regulatory oversight and a vastly different funding environment is inevitable. For these reasons, in the near term, the small cap growth team will avoid any investments in regional banks and take a “wait-and-see” approach.
Small cap growth portfolios have taken profits in companies where we expect decelerating fundamentals and those with stretched valuations. Conversely, the team is considering investments in companies where sentiment is low and fundamentals are holding up. The Voya Small Cap Growth strategy remains overweight the industrial sector, neutral to technology and slightly overweight healthcare. As stated in prior quarters, our investment philosophy of identifying companies with double digit revenue and earnings growth that are trading at sustainable valuations continues to perform well in this environment on a relative basis.
Companies mentioned in this report – percentage of portfolio investments, as of 03/31/23: Indie Semiconductor, Inc. 0.48%, Axcelis Technologies, Inc. 0.78%, Focus Financial Partners, Inc. 0.73%, Western Alliance Bancorp 0%, Patterson-UTI Energy, Inc. 0.73% and Matador Resources Co. 1.42%; 0% indicates that the security is no longer in the portfolio. Portfolio holdings are subject to daily change.