The second quarter was a shining example of how, even though investors have a lot to worry about, markets can rally unexpectedly. In short, consistent, and successful timing of the stock market should be reserved for fairy tales.
After a fearful start to the year, when the banking crisis dominated the headlines in March, investors seemed to shift back to a risk-on mode over the past three months. Sparked by inflation data that was cooler than expected and newfound hope that the Federal Reserve might be able to engineer a “soft landing,” the Russell 3000® Value Index jumped more than 8% in the three months ending June 30.
Yet the lion’s share of the market’s gains was driven by just seven mega-cap stocks: Apple, Alphabet, Tesla, Amazon, Microsoft, Meta and Nvidia. The Strategy owns one of these stocks, Alphabet. We own Alphabet because this equity offers a unique combination of attractive valuation and a business that seems to possess a deep economic moat with strong fundamentals. Others may possess one of these characteristics, but we will only own those that offer both.
While the Federal Reserve kept rates steady at its June Federal Open Market Committee (FOMC) meeting, the Central Bank is still leaning toward cooling the economy, according to the Federal Reserve’s most recent “dot plot.” That array reflects the expectations of each FOMC member, and the median dot (or forecast) for the Federal Reserve Funds rate climbed to 5.6% in June, up from 5.1%. This suggests the possibility of further monetary policy tightening later this year, which isn’t good news for richly priced and speculative investments that have led so far in 2023.
Another potential headwind for these stocks: the likelihood for further credit stress. Even if rates don’t rise further, many of the effects of higher borrowing costs are taking their toll. Consumer loan delinquencies are climbing, led by late payments on credit card and automobile loans, which have hit multi-year highs. While commercial real estate loans haven’t experienced broad-based credit stress yet, that could change as loans underwritten in a lower interest-rate environment come due and as the cost to hedge floating-rate debt increases. These warning signs, in addition to bank funding stress, have led to stricter lending standards at banks, which amounts to a form of tightening indirectly caused by Federal Reserve policy. This is why we believe balance sheet strength, while always important, will be rewarded in this tighter credit environment.
Though the market seems to be driven by a handful of mega caps, we remain confident that small- and mid-cap stocks will outperform over a multi-year time horizon. Why are we so confident? Part of it is rooted in history. Today’s market is narrower than it’s been in recent history, with fewer stocks on pace to beat the S&P 500® than even during the dotcom bubble (see chart below).

Source: Ned Davis Research, yearly data from 12/31/1973 to 12/31/2022 and partial year data from 1/1/2023 to 6/22/2023. This chart represents the percentage of S&P 500® Stocks that outperformed the S&P 500® over the calendar year. All indices are unmanaged. It is not possible to invest directly in an index. Past performance does not guarantee future results.
Narrow breadth has been an indicator of structural weakness in the market. However, one area that stands to benefit from the fallout of sparse leadership is smaller stocks. Ned Davis Research examined past periods in which the market’s breadth narrowed — specifically, when fewer than 30% of the names in the S&P 500® were beating the benchmark. It found that in the 12 months following those instances, small-cap equities outperformed large every time.

Source: Ned Davis Research, daily data from 3/27/1980 to 5/31/2023. This chart represents the Russell 2000® to 1000® ratio performance after the percent of S&P 500® stocks outperforming index in last three months falls below 30%. All indices are unmanaged. It is not possible to invest directly in an index. Past performance does not guarantee future results.
Beyond history, there’s also a fundamental reason why we believe the era of large-stock leadership, which began well before the start of the global pandemic, appears extended. Large-cap earnings have grown around 20% faster than small-company profits over the past five years, yet the former have outpaced the latter by around 45% over the same period. This means large caps have become more expensive and future return prospects are less attractive, all else equal.
As an all-cap Strategy that can go wherever we find the best risk/reward opportunities, we believe the Strategy is uniquely positioned to take advantage of this market once it returns to normalcy. And as patient and disciplined investors who lean on our 10 Principles of Value Investing,™ we are mindful not to overpay or overextend for those opportunities.
Attribution Analysis & Portfolio Activity
For the quarter, the Strategy was virtually on par with the Russell 3000® Value Index, posting gains of 3.86% versus 4.0% for the benchmark.
Stock selection was the primary driver of the Strategy’s performance led by outperformance in the Health Care, Utilities, Materials, and Real Estate sectors, partially offset by underperformance in Financials. We took advantage of the selloff in regional banks to add incremental exposure to the group, however, one of the Strategy’s bank holdings lagged peers in the second quarter. We remain confident in this bank’s financial strength and the margin of safety provided by its discounted valuation.
While the Q2 rally was disproportionately driven by a few large, mostly tech-related, names within the S&P 500®, the situation was more nuanced within the Value universe. Large caps outperformed small but underperformed mid in the Russell 3000® Value Index. Though we are convinced that small- and mid-cap equities stand to benefit once the market broadens, we don’t target any specific cap size. We are bottom-up stock pickers who focus on financial, strategic, and leadership strength coupled with attractive valuations.
Here are three examples of such companies:
Healthcare. Centene Corporation (CNC) is one of the largest managed health care insurance providers in the U.S. and the largest player in Medicaid. The stock has underperformed this year, as CNC faces reimbursement headwinds including a reduction in its 2024 Medicare Advantage premiums and higher healthcare utilization from the return of elective procedures. Investors also fear a potential loss of insured lives when Medicaid eligibility, which was expanded during the pandemic, gets redetermined in 2023-2024.
CNC’s historical results have lacked the consistency demonstrated by premier large managed care companies. However, since 2021, the company has steadily upgraded its leadership ranks from the CEO on down through the executive ranks and line-of-business leaders. CNC’s executive leadership is comprised of industry veterans with a demonstrated record of success. Their executive compensation is clearly aligned with shareholder value creation, and they recently bought large amounts of CNC stock personally in the open market, demonstrating confidence in their prospects. Self-help initiatives are well underway and include noncore divestitures, material expense streamlining, improved digital capabilities, improved provider contracting, and meaningful share repurchases.
In our estimation, the market is too focused on near-term overhangs that will prove temporary and disregards the substantial value creation opportunities that lie ahead. CNC trades at just 10X 2023 earnings compared to peers valued at mid/upper teens P/E ratios. After a brief pause caused by the reimbursement headwinds in 2024, we expect CNC to resume its 12-15% EPS growth rate, comparable to leading industry operators. This should help close the valuation gap.