A Market Focused on Growth Fundamentals: Early Innings for Our Investment Style

Brandon Nelson, CFA

• We expect start-stop and rotational market conditions over the near term but believe we are in the early innings of an upcycle for our investment style.
• The Calamos Timpani funds are tilted toward stocks that we believe offer above-average growth prospects and very visible fundamental strength—and we are encouraged these characteristics are gaining traction in the market.
• Small caps are relatively inexpensive, have tended to do well in periods after bear market bottoms and are entering what historically has been a seasonally strong period running from October through April.

The third quarter saw overall weakness in equity markets, led lower by mid and small cap stocks. The smallest of the small were especially weak this quarter, as seen in the performance of the Russell Microcap Index, down -7.9%, and in the Russell Microcap Growth Index, down -12.0%

The market was in “risk-off” mode for most of the quarter, especially in August and September, two months that have tended to be seasonally difficult for equity markets. The underlying weakness in equity prices was at least partially caused by rising oil prices and rising 10-year US Treasury bond yields. Both rose each month of the quarter and caused investors to question the overall outlooks for earnings estimates and the valuation multiples paid on those estimates.

In addition to increasing oil prices and Treasury yields, another theme that gained traction during the quarter related to health care and a specific group of weight loss drugs known as GLP-1s (short for glucagon-like peptide 1 agonists). Clinical data continues to be released, but investors are encouraged by the potential for these drugs to improve not only patient aesthetics but also overall patient health. This excitement does have a downside for other industries, however, as some investors suspect a healthier society may result in lower demand for certain medical devices and medical procedures. We won’t know the true implications for some time, but stocks are moving in the meantime.

Although small caps have underperformed during the quarter and year to date, the outlook for them looks compelling. Small caps are relatively inexpensive and have tended to do well in periods after bear market bottoms (see our post “5 Reasons for Small Caps and Calamos Timpani Small Cap Growth Fund”). Small caps are also entering what historically has been a seasonally strong period running from October through April. Regarding valuation, small caps look extremely stretched to the downside relative to large caps. Looking back at more than 90 years of data, research by Jefferies shows that the most significant dislocations have historically tended to be a positive indicator for future small cap performance. The table below shows the historically strong relative performance for small caps versus large caps over the next one, three, and five years, with high probabilities of confidence (“Batting Average”).

When performance has been this bad, small caps have historically enjoyed long bounce backs

Past performance is no guarantee of future results.
Note: performance is annualized. Batting average is the % of time that small beats large. Source: Center for Research in Security Prices (CRSP®), the University of Chicago Booth School of Business, Jefferies. Large and small are defined by CRSP based on placing market caps into deciles. Deciles 1 and 2 are large and 6 through 8 are small.

We believe Calamos Timpani Small Cap Growth Fund (CTSIX) and Calamos Timpani SMID Growth Fund (CTIGX) are well positioned. Both funds are tilted toward stocks that we believe offer above-average growth prospects and very visible fundamental strength. Stocks with those characteristics were out of favor for most of 2022 as valuation multiples compressed, but since early February 2023, many of these stocks are back on track with the market.

In other words, we believe we are in the early stages of a new upcycle for our particular investment style. That, combined with the potential to see a recovery in the overall small cap asset class, has us feeling upbeat on an intermediate-to-long-term basis. Admittedly, the short-term is murky, with many macro sources of concern. This murkiness is causing performance to have many stops, starts, and rotations. We’re focused on finding stocks that have company-specific secular growth, and thus are theoretically less vulnerable to some of that macro murkiness. We believe this approach makes the most sense, especially in this environment.