We had a strong second quarter, bringing year-to-date gains to near double-digit levels, far ahead of the Russell 2000® Value Index gain of 2.5%. While this pales in comparison to the NASDAQ’s 31.7% gain YTD, we would point out that in 2022, the NASDAQ dropped 33.1%, leaving investors still down over 10% after this year’s huge recovery. A 33% decline requires a 50% recovery to become whole again. On the other hand, Kestrel’s net performance would be very close to breakeven over this eighteen-month period, but without the excitement or cocktail party conversation material.

History can be interesting and informative, but not necessarily predictive of future performance. So, let’s take a look at a few statistics that may be more useful. The stock market in the first half of 2023 was dominated by the newly dubbed Magnificent Seven – Alphabet, Amazon, Apple, Meta, Microsoft, Nvidia, and Tesla. This group now trades at an average multiple of 32x 2024 earnings estimates. The market valuation of Apple alone exceeds the market capitalization of the entire Russell 2000 Index. Turning to Kestrel’s “Forgotten Forty” (actually 38 names at quarter-end), they are trading at a 12-month forward earnings multiple of 11x. It is pretty clear which portfolio we would choose.

Our big winner for the quarter was Open Lending (+49%). When we purchased this stock in the first quarter of 2023, we would have been hard-pressed to come up with a category more out-of-favor than sub-prime automotive lending. We are now seeing some improvement in company fundamentals, and the market is apparently taking a less negative view of future prospects. Southside Bancshares (-21%) led our loser’s list. This is a Texas regional bank with a clean loan portfolio that has been dragged down by broader industry concerns. While rising deposit rates will put some pressure on margins, we believe these prospects are reflected in a stock trading at 9x expected 2023 earnings of $2.80.

We had one takeover announced during the quarter; Triton International. This lessor of shipping containers is being bought at about a 35% premium to its previous trading price despite a collapse in short-term voyage rates. Triton management had the wisdom to lock up a large portion of its fleet at high rates while supply chain disruptions dominated the headlines. When the stock market did not recognize Triton’s solid outlook, management was able to find an outside investor to validate their view. It will take the collective action of many investors to validate our view of small cap value’s relative attractiveness, but extreme valuation differentials have a way of correcting over time.

                                                                                                                                                Abbott J. Keller, CFA

                                                                                                                                            Chief Investment Officer