Shaker Investments - 4Q 23 Update

US Equity Markets had broadly positive returns in the quarter and specifically a widening rally in the last two months of the year.  As we discussed in prior letters this year, positive equity market returns for the first ten months of the year were almost entirely due to the performance of the ten largest stocks by market capitalization – as of October 31, 2023, these companies were 25.5% of the US Total Market Index and accounted for 97.8% of the 9.4% gain in the market year to date. In contrast, the small cap index was down 4.5% for the first ten months of the year. By October 31, profitable small and mid-capitalization stocks were selling at the lowest level relative to large capitalization stocks since early 2000. However, in November this trend began to change, and small cap stocks rose 22.4% in the last two months versus 14.1% for the S&P 500.

Time will tell if this was a major trend change or just a temporary pause in the domination of the market by large cap technology stocks. In the last fifteen years, large cap stocks, especially large cap tech stocks, have benefited from a significant decrease in tax rates versus small cap stocks. This has been one key factor supporting their earnings growth during this period, though we believe it is likely to be less of a tailwind going forward. Recently, they have also benefited from the increase in interest rates as many hold large amounts of cash or short term investments. Historically, small capitalization stocks have often begun periods of outperformance versus large capitalization stocks when relative valuation spreads reach the current extreme levels as well as when the Federal Reserve begins to cut interest rates. The Fed has yet to start cutting rates, but Federal Open Market Committee (FOMC) members have indicated that they expect to start cutting rates at some point in 2024.  Investor hopes and expectations for rate cuts in the range of 1.5 – 2.0% in 2024 helped trigger a rally in the last two months of 2023. While investor euphoria has moderated some over the last month as to the magnitude of cuts in 2024, there is still a general expectation that the process of cutting rates will begin in 2024, and we expect this to be supportive of positive equity returns this year.

Discussion of Fourth Quarter Performance and Positions

In the Shaker Fundamental Growth strategy, the largest positive contributors to returns during the quarter were Axos Financial (AX), Broadcom (AVGO), Micron (MU), Dexcom (DXCM), and Monolithic Power Systems (MPWR). Our largest detractors during Q4 were Fox Factory (FOXF), United Airlines (UAL), Paylocity (PCTY), Paycom (PAYC), and Kirby Corp. (KEX).

In the Shaker Small Cap Growth strategy, the largest positive contributors to returns during the quarter were Axos Financial (AX), Installed Building Products (IBP), Medpace Holdings (MEDP), and Euronet Worldwide (EEFT). Our largest detractors during the quarter were Fox Factory (FOXF), Paylocity (PCTY), Henry Schein (HSIC), and Lantheus Holdings (LNTH).

Despite a mixed macroeconomic environment, we are finding opportunities to upgrade the portfolio across a range of industries, and we continue to work to identify companies with a robust growth outlook over the next 3-5 years trading at attractive valuations.

Investment Outlook

The economic outlook at the beginning of 2024 is looking more favorable as a soft landing appears increasingly likely. The broader economy clearly developed some excesses due to the significant stimulus provided by the government and Federal Reserve in response to the detrimental effects of the Covid pandemic. However, it appears that these excesses are being worked through at different times by different industries making it more likely that we will be able to avoid a broad-based recession. For example, in 2020 and 2021 consumers spent large amounts on goods due to the difficulty of travel and dining out, and as a result, product shortages increased. In response to this surge in demand, retailers increased orders and inventories grew to what became excessive levels when customers shifted spending to travel and dining out as pandemic limitations eased.  Retailers and consumer product companies then experienced recessions as both reduced excess inventories, but from a broader economic perspective, this was essentially offset by strong growth in travel and services spending. At this point, retail and consumer product inventories appear to be at healthier levels and these industries look poised to return to normalized growth. While this is just one, there are numerous examples of growth in one area of our economy offsetting a decline in another over the last several years which leaves us optimistic that we will in fact see the much hoped for soft landing.

We expect the economy to grow in 2024, though at a slower pace than in 2023. As stated earlier in the letter, we expect the Fed to start cutting rates this year, and if the market responds as it has in the past, small cap stocks should be a significant beneficiary of these interest rate reductions.

We look forward to updating you in April and we are always available to assist in any way we can.

Sincerely,

The Shaker Investment Team