August has historically been a volatile month for the equity markets, and this past period did not disappoint. It was a month of high anxiety and increased volatility as the ongoing effects of the pandemic and its more recent Delta variant continued to affect businesses across the globe while geopolitical risks re-emerged in the wake of the U.S. withdrawal from Afghanistan. At the same time—and somewhat paradoxically—the global economy continued to recover, stoking the sizable appetite for risk among investors, one that’s already led to record valuations for the U.S. large cap indexes.

Amid this more uncertain climate, we have also seen more modest returns for the small-cap market of late. Since its previous high in mid-March 2021 into mid-August, the Russell 2000 Index endured a stealth correction, down 8.2% from 3/15/21 through 8/18/21, before a rally saw out the last two weeks of the month. As of the end of August, however, the small-cap index remained 3.2% below its mid-March high. During this correction in time, corporate earnings have continued to expand while multiples have contracted. Among our numerous small-cap holdings, we have seen few disappointments in earnings or downward revisions. In this positive context for small-cap company results, we think that small caps can reassert their prior leadership—but the more relevant issue may be determining which small cap companies are best positioned to lead.

It still seems more probable than not to us that slowly rising rates should gradually pressure historically high absolute valuations that will be potentially offset by continued strong earnings and healthy prospects for ongoing growth through at least the end of next year. However, these countervailing forces will not affect all small-cap stocks in the same way, especially as the profit cycle continues to mature. Differentiation will be critical—which is why within all of our strategies, we have focused on identifying businesses that first proved capable of capitalizing on the difficulties wrought by the pandemic and ensuing recession to improve their operations, execution, and/or prospects.

To be sure, we are just beginning to see the fruits of their labors. For example, many of our portfolio businesses from the retail, restaurant, and even title insurance industries are just starting to see the benefits of enhanced technology investments that are leading to higher operating margins and increased profitability, which should continue well beyond the pandemic period. At the same time, we hold several industrial businesses that made effective use of the down time mandated by the COVID outbreak to push forward with production enhancements that are in turn giving them a leg up on their competitors. Moreover, we own companies in industries as diverse as trucking, semiconductors, homebuilding, and retail that are managing the ongoing interruptions in global supply chains in constructive ways. As the profit cycle matures, we expect these well-run small caps to further distinguish and distance themselves. We reserve a particular confidence for what we see as high-quality businesses—those with strong balance sheets, high returns on invested capital, and the ability to generate free cash flow—which have lagged through much of the small-cap market’s rebound from the March 2020 trough.

We anticipate that volatility will likely increase or remain elevated over the next several months as macro uncertainty lingers and earnings comparisons become more challenging in 2022. These factors should encourage investors to be more discerning, rewarding those companies that show sustainable growth in what in all likelihood will be a still expanding global economy. We have already seen that those small-cap businesses which managed adversity best have also experienced notable earnings and revenue growth. This is precisely the sort of differentiation that we expect to be key as we move forward into what looks like a very promising period for active small-cap management.

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