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2024 Outlook: Small Cap Value

Year In Review

2023 will go down as a unique year where broad equity returns, and the health of the underlying economy, were not perfectly correlated.  Equity market performance was dominated by the “Magnificent Seven”*. These seven stocks account for approximately 30% of the S&P 500 and 40% of the Nasdaq 100 and have driven well over half of the total return for both indexes.  The Wall Street Journal noted that the combined weighting of the Magnificent Seven is larger than that of all stocks from Japan, France, China and the U.K., within the MSCI All Country Index – a benchmark that claims to cover 85% of the global investable equity market.  This startling lack of breadth stands in stark contrast to historically healthy bull markets where a thriving economy benefits many companies to a similar degree.  For example, in the S&P 500, the “Magnificent Seven” accounted for just under 16% of the total performance while the other 493 stocks accounted for approximately 10%.  Many investors who allocate to index funds may even be unaware of the nature of the concentration, which stands in contrast to indexing edicts.

Commentary from companies, industry regulators and a wide array of economic data supports the concept that all is not well in the economy.  Consumers are struggling in the face of continued high inflation, and while slowing on a rate-of-change basis, it remains positive and structurally higher relative to pre-pandemic levels.  This has taken some time to show as savings had been elevated post-pandemic (peaking at about $2.3T), but have pulled back to about $0.7T. With consumer spending representing approximately 70% of US GDP, the cumulative pressure of persistent inflation is slowing the economy.  Student loan payments have resumed and access to credit has become both more difficult and burdensome as rates remain high relative to the zero-interest-rate policy of the preceding decade.  Certain asset classes such as bonds, oil and the US dollar have been pricing in a recession throughout much of the year, while others such as large-cap equity indexes and cryptocurrencies were pricing in a risk-on environment.

To combat inflation, the Federal Reserve raised interest rates by 525bps over 18-months, while also shrinking their balance sheet by up to $95B per month.  While the Federal Reserve opened the door in mid-December to potential rate cuts in 2024, the market is reacting as if we are returning to near-zero interest rates, quantitative easing, helicopter money and a stimulus payment environment, perhaps all at once!  All of which are entirely unrealistic given the inflation backdrop and federal deficits.  While the Fed’s comments resulted in a “dove-ish” risk-on rally, the rate cuts that are being extrapolated by the market are taking place over a shorter time period than we envision.  The timing of rate cuts is highly uncertain, seemingly changing with every piece of economic data.  What is certain, is that generationally tighter monetary policy conditions will have lagged effects across the economy.  These effects have started to show their signs, yet are not reflected in broad equity valuations.

We view the economy as much weaker than what the market is pricing in, with valuations on the indexes increasing given the lack of breadth, driven by rising multiples for the Magnificent Seven. We question whether investors will be willing to continue to pay 20x earnings for the S&P 500 going forward.  This is considering a softening environment where the implied equity risk premium is at-or-near zero when compared to available bond yields.  Fortunately for us, as active managers, the lack of breadth leads to a wide valuation dispersion, meaning that there are areas of opportunity where stocks are priced attractively.  We continue to find stocks with idiosyncratic catalysts and asymmetric payouts, with great balance sheets, and ample free-cash-flow with which to populate our portfolio.

We are pleased with the Easterly Snow Small Cap Value strategy’s performance for 2023. The strategy continues to perform well as we stick to our core philosophy of identifying structurally sound companies going through short-term, often self-inflicted difficulties, where an earnings recovery leads to a P/E re-rating.

A dislocated macro backdrop, such as the one we see today, suits our style well, where our fundamental research process is able to identify what we view as the best opportunities, where current valuations do not reflect underlying fundamentals. This can include the aftermath of periods where correlations are elevated and equities trade down in tandem with their peer groups, or following broad market sell-offs. The strategy’s 97% active share highlights that we are able to construct a portfolio based on idiosyncratic stock theses and not be beholden to lower quality subsections of the index.

Stock selection was key for the Easterly Snow Small Cap Value strategy in 2023, as we were able to identify companies who were earning structurally higher EPS relative to past periods or cycles, and the market began to reward those companies with higher P/E multiples.  Within Information Technology, Super Micro Computer (SMCI) gained 246% given its unique exposure to artificial intelligence growth, specifically the increasing demand for datacenter infrastructure that will only get more complex and capital intensive over time.  Our total return for SMCI over our entire holding period is nearly 20x.  Photronics (PLAB) has gained more than 86%, as a niche player on the semiconductor supply chain with a great balance sheet that stands to gain both in share and pricing power as their end-markets grow.  Our Financial exposure added to outperformance for the year as we were able to take advantage of the volatility brought on by the failures of Silicon Valley Bank, First Republic and Signature Bank by identifying companies that were indiscriminately sold, yet had the balance sheet strength and depositor base to emerge with earnings in-tact.  Our Financials drove 294bps in total outperformance relative to the benchmark.  Stock selection in Consumer Discretionary (Modine +200%, Urban Outfitters +49%) and Communication Services (Cinemark +62%) also added to outperformance.

The market adapting to higher-for-longer interest rates relative to the mid-2010s has led to stronger support on the P/E multiple for companies that fit our investment profile: real, substantial free-cash-flows anchored by strong balance sheets.  We continue to believe that we remain in the early innings of the current value cycle given higher-for-longer inflation and a more normalized interest rate environment relative to the prior decade.

Set-Up for Small Caps Remains Constructive Amidst Challenging Equity Market Backdrop

Over the past eleven recessions, small cap equities have outperformed mid-and-large caps by mid-double-digits when emerging from those recessionary periods.  As profits begin to recover from whatever the next recession may look like, we expect small caps to lead given the breadth and outsized cyclicality of small cap stocks relative to their larger peers.  That being said, we are not adding to cyclical names at current market valuation levels, but are instead finding stocks with lower correlations to GDP and more “self-help” type catalysts.  Our cyclical holdings have performed very well, especially following the recent Fed announcement that rate cuts should be expected in 2024.  We expect the strategy to outperform broader value indices during times where the market is pricing in forward normalization, given the conviction weighted nature of the portfolio and bias towards strong balance sheets and substantial free-cash-flow, which outperform when fundamentals are rewarded.

We continue to question the reverberation of higher interest rates throughout the economy.  We do not believe the market has priced in some items, such as the $1T in corporate debt that will expire each year from 2025 – 2028, where businesses will have to either roll the debt at higher rates, shrink to the point where their cash flows are aligned with higher borrowing costs or declare bankruptcy and wipe out equity holders.  The Fed Funds rate going down to 4% does not save all of these companies, as recent market behavior is implying.  We also question the impact of higher rates on federal deficits.  With an annual deficit of more than $2T, as a percentage of GDP (about 8%) the deficit is larger than any fiscal year in history where the country did not face a war, recession, or other major emergency. With US Debt/GDP having risen from 35% in 2007 to greater than 90% now, higher spending on structurally higher debt levels will come with a higher cost to service.  Yields will also likely need to move higher to attract buyers, given the Fed’s attempt to reduce their own balance sheet (let alone being an active purchaser) and less purchasing activity from foreign entities.  We view this as a long-term structural headwind that will continue to suppress the equity market risk premium, specifically for indexes where valuations are near historical highs.

Our investment team are no strangers to navigating volatility.  Our core philosophy and process has been in place for over 30 years while the Small Cap Value strategy is now in its 18th year, with an annualized gross return 3.21% ahead of the Russell 2000 Value index since inception (2.45% net), as of 12/31/2023.  The Easterly Snow Small Cap Value strategy has an 10% free-cash-flow yield, 97% active share, a 9x forward P/E (with the index at 17%), as of 12/31/2023.

Over market cycles, equity prices often oscillate in ways that are hard to predict.  This may result in periods that can be difficult to endure; however, our investment approach is designed to outpace its benchmark over full market cycles. On a rolling five and ten-year basis, the strategy has outpaced the benchmark during the majority of periods under observation and lends credence to our view that our investment approach will outpace the broad market over the long-term, during a full cycle.  Given the strategy’s consistent 96% – 98% active share profile, deviations relative to the benchmark can be due to either stock selection or allocation effects, but the core of our competency lies in our lack of style-drift over full market cycles.  No matter how “unique” 2024 looks relative to prior years, we remain committed to our philosophy and process that has delivered consistent excess returns over the last three decades.

Easterly Investment Partners LLC Snow Small Cap Value Composite GIPS® Report

Composite Inception Date: October 31, 2006

Year EndComposite PerformanceAnnualized 3-Year Standard DeviationTotal Assets (millions)
GrossNetRussell 3000® ValueCompositeRussell 3000® ValueComposite DispersionTotal Firm AssetsFirm (AUM)Firm (AUA)*CompositeNumber of Accounts
2022-6.68%-7.33%-14.48%33.38%27.66%N/A1,8341,34149355Five or fewer
202128.44%27.56%28.27%32.10%25.35%N/A27181540117877Five or fewer
202024.16%23.31%4.63%32.68%26.12%0.10%--78Five or fewer
201919.39%18.57%22.39%20.50%15.70%0.20%--82Five or fewer
2018-18.81%-19.39%-12.86%20.10%15.80%N/A--103Five or fewer
201344.53%43.55%34.52%20.30%15.80%N/A--141Five or fewer

*Firm-wide advisory- only assets.  Assets under Advisement (AUA) includes the assets where Easterly Investment Partners (“Easterly”) provides its advisory services in similar strategies and does not have discretionary trading authority.

Firm Definition
For purposes of complying with the GIPS® standards, the firm is defined as Easterly Investment Partners LLC (“EIP”) which is an SEC registered investment adviser under the U.S. Investment Advisers Act of 1940, as amended, effective January 2019. The firm was redefined on 1/1/2023 to reflect that EIP is comprised of two distinct firms: the institutional asset management operations, investment strategies, performance track records, certain employees and client accounts of Levin Capital Strategies, which were acquired by EIP in March 2019, and Snow Capital Management LLC’s (“SCM”) asset management business, investment strategies, performance track records, client accounts, and certain employees, acquired by EIP in July 2021.

Firm Verification Statement
Easterly claims compliance with the Global Investment Performance Standards (GIPS®) and has prepared and presented this report in compliance with the GIPS standards. Easterly has been independently verified for the period April 1, 2019 through December 31, 2022. A firm that claims compliance with the GIPS standards must establish policies and procedures for complying with all the applicable requirements of the GIPS standards.  Verification provides assurance on whether the firm’s policies and procedures related to composite and pooled fund maintenance, as well as the calculation, presentation, and distribution of performance, have been designed in compliance with the GIPS standards and have been implemented on a firm-wide basis.

Composite Verification Statement
The Small Cap Value Composite has had a performance examination from composite inception date through December 31, 2022. The verification and performance examination reports are available upon request.

Composite Description
The Small Cap composite provides exposure to long-only US publicly-listed securities and ADRs, and may occasionally invest in convertible and corporate bonds, taking into account various factors.  The strategy is biased toward Small capitalization value stocks, and position sizes range between 0.5% to 5%, with liquidity as a consideration.

Benchmark Description
The Russell 2000 Value Index measures the performance of small-cap value segment of the U.S. equity universe. It includes those Russell 2000 companies with lower price-to-book ratios and lower forecasted growth values. Indexes are unmanaged. It is not possible to invest directly in an index.

Performance Calculation
All returns are calculated and presented in US dollars based on fully discretionary AUM, including those investors no longer with the firm. All gross composite returns are net of transaction costs and gross of foreign withholding taxes, if any, and reflect the reinvestment of interest income and other earnings.  Net performance results reflect the application of a model investment management fee which is higher than the actual average weighted management fee charged to accounts in the composite applied to gross performance results. Actual fees may vary depending on, among other things, the applicable fee schedule and portfolio size.  Actual investment advisory fees incurred by clients will vary. Policies for valuing investments, calculating performance, and preparing GIPS reports are available upon request. A list of composite descriptions is available upon request. Past performance is not indicative of future performance. Results may be higher or lower based on IPO eligibility, and actual investor’s returns may differ, depending upon date(s) of investment(s). Additional information is available upon request.

Investment Management Fee Schedule
The current standard management fee schedule for a segregated account managed to the composite strategy is as follows: 0.70% on the first $25 million; 0.55% on the next $75 million; 0.50% on the next $100 million; 0.45% on the next $100 million; 0.35% on the balance.

Composite Dispersion
The annual composite dispersion, if shown, is an asset-weighted standard deviation calculated using gross returns for the accounts in the composite the entire year. The internal dispersion measure is not applicable if there are five or fewer portfolios in the composite for the entire year if that is the reason this is N/A.

Standard Deviation
The annualized 3-year standard deviation represents the annualized standard deviation of actual gross  composite and benchmark returns, using the rolling 36 months ended each year end.  Standard deviation is a measurement of historical volatility of investment returns.

GIPS® is a registered trademark of CFA Institute. CFA Institute does not endorse or promote this organization, nor does it warrant the accuracy or quality of the content contained herein.

Important Disclosures

© 2024. Easterly Asset Management. All rights reserved.

Easterly Asset Management’s advisory affiliates (collectively, “EAM” or “the Firm”), including Easterly Investment Partners LLC, Easterly Funds LLC, and Easterly EAB Risk Solutions LLC (“Easterly EAB”) are registered with the SEC as investment advisers under the Investment Advisers Act of 1940, as amended. Registration does not imply a certain level of skill or training. More information about the firm, including its investment strategies and objectives, can be found in each affiliate’s Form ADV Part 2 which is available on the website. This information has been prepared solely for the use of the intended recipients; it may not be reproduced or disseminated, in whole or in part, without the prior written consent of EAM.

No funds or investment services described herein are offered or will be sold in any jurisdiction in which such an offer or sale would be unlawful under the laws of such jurisdiction. No such fund or service is offered or will be sold in any jurisdiction in which registration, licensing, qualification, filing or notification would be required unless such registration, license, qualification, filing, or notification has been effected.

The material contains information regarding the investment approach described herein and is not a complete description of the investment objectives, risks, policies, guidelines or portfolio management and research that supports this investment approach. Any decision to engage the Firm should be based upon a review of the terms of the prospectus, offering documents or investment management agreement, as applicable, and the specific investment objectives, policies and guidelines that apply under the terms of such agreement. There is no guarantee investment objectives will be met. The investment process may change over time. The characteristics set forth are intended as a general illustration of some of the criteria the strategy team considers in selecting securities for client portfolios. Client portfolios are managed according to mutually agreed upon investment guidelines. No investment strategy or risk management techniques can guarantee returns or eliminate risk in any market environment. All information in this communication has been obtained from sources believed to be reliable but cannot be guaranteed. Investment products are not FDIC insured and may lose value.

Investments are subject to market risk, including the loss of principal. Nothing in this material constitutes investment, legal, accounting or tax advice, or a representation that any investment or strategy is suitable or appropriate. The information contained herein does not consider any investor’s investment objectives, particular needs, or financial situation and the investment strategies described may not be suitable for all investors. Individual investment decisions should be discussed with a personal financial advisor.

Any opinions, projections and estimates constitute the judgment of the portfolio managers as of the date of this material, may not align with the Firm’s opinion or trading strategies, and may differ from other research analysts’ opinions and investment outlook. The information herein is subject to change without notice and may be superseded by subsequent market events or for other reasons. EAM assumes no obligation to update the information herein.

References to securities, transactions or holdings should not be considered a recommendation to purchase or sell a particular security and there is no assurance that, as of the date of publication, the securities remain in the portfolio. Additionally, it is noted that the securities or transactions referenced do not represent all of the securities purchased, sold or recommended during the period referenced and there is no guarantee as to the future profitability of the securities identified and discussed herein. As a reminder, investment return and principal value will fluctuate.

The indices cited are, generally, widely accepted benchmarks for investment performance within their relevant regions, sectors or asset classes, and represent non managed investment portfolio.  It is not possible to invest directly in an index.

This communication may contain forward-looking statements, which reflect the views of EAM and/or its affiliates. These forward-looking statements can be identified by reference to words such as “believe”, “expect”, “potential”, “continue”, “may”, “will”, “should”, “seek”, “approximately”, “predict”, “intend”, “plan”, “estimate”, “anticipate” or other comparable words. These forward-looking statements or other predications or assumptions are subject to various risks, uncertainties, and assumptions. Accordingly, there are or will be important factors that could cause actual outcomes or results to differ materially from those indicated in these statements. Should any assumptions underlying the forward-looking statements contained herein prove to be incorrect, the actual outcome or results may differ materially from outcomes or results projected in these statements. EAM does not undertake any obligation to update or review any forward-looking statement, whether as a result of new information, future developments or otherwise, except as required by applicable law or regulation.

Past performance is no guarantee of future results.


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