Q3 2022 - Investor Letter

Q3 2022 - Investor Letter.pdf

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October 4th, 2022

Dear Clients,

We hope you are all doing well and are looking forward to a nice holiday season. As we highlighted in our last letter these are uncertain and volatile times. Not much has changed since then. The market is continuing to discount high inflation, a steadfast Federal Reserve, a potential economic and earnings slowdown, and the possibility of war. While this macroeconomic backdrop remains complex, we continue to believe that the fundamentals of our companies are stable to improving, our longer-term theses are intact, and that the current environment provides an opportunity for stock selection.

The market, because of fear and greed can get overdone to the upside and to the downside (See chart above). But over the long term, stocks follow revenue and earnings growth, which we focus on. The chart below shows price to earnings ratios for mega-cap (Google, Amazon, Apple, Meta etc.), large-cap, mid-cap, and small-cap stocks. When comparing mega-cap to small-cap (the purple and green lines) you will see that the mega-caps are trading at 24x earnings and small-caps are trading at 11x. Simply put, we believe that while the large cap valuations can still contract, small-caps have already been discounted to a large extent which is being reflected in valuations.

Earlier this year we wrote an article highlighting small-cap outperformance cycles since 1926. The table below shows the cycles and the associated returns. We believe that when the dust settles, one of these outperformance periods will commence. While we can't predict the timing, our observations of growth and valuation plus our decades of experience operating through prior cycles gives us confidence that small-cap stocks will snap back in a big way. By continually screening for companies with new products and services, large market opportunities and high revenue growth with strong margins, we believe your portfolios are well positioned. While we are cautiously monitoring macroeconomic events, our time is best spent looking for new ideas and continually re-evaluating your portfolios despite the noise.

Outlook

We understand that these times are confusing due to investor fear and lack of liquidity, but our confidence in the ultimate outcomes makes us hesitant to abandon stocks in our portfolios. Historically, during times like these, we have identified some our best performing stocks. We saw this in July and August when the market rallied. While past performance is no guarantee of future results and the timelines are uncertain, we believe this time will be no different.

Portfolio

This quarter we would like to highlight CyberOptics (CYBE).

CYBE makes optical process control sensors and inspection systems to manufacture electronic circuit boards for electronic assembly and integrated circuit markets. During the quarter, CyberOptics announced an agreement to be purchased for $54/share or nearly a 50% premium to where the stock traded over the previous month. CYBE is the fourth stock to be acquired in our portfolios during the year, validating their underlying value. We believe that acquisitions are likely to continue in the marketplace and across our portfolios as valuations have become more attractive and the fundamentals of the businesses improve. During economic slowdowns, large companies tend to be more interested in acquisitions as they tend to stimulate revenue growth. In your portfolios, we feel we are positioned well to take advantage of this trend.

Another company we would like to highlight is ZETA Global (ZETA).

Zeta is a marketing technology software company which benefits from multiple market tailwinds in the advertising industry. Zeta’s software platform helps companies' market more efficiently by targeting ads based on specific demographics. The Zeta marketing platform helps customers deliver advertisements through all channels such as email, social media, web, chat, connected TV and video. Zeta is unique in that their platform doesn’t use cookies. This reduces risk from a regulatory and customer standpoint as they are not impacted by these issues. Consequently, they are able to take share from competitors like Adobe, Salesforce, and Oracle who have all made acquisitions to enter the space. The company was founded by former Apple CEO John Scully and the management team has a strong track record of performance. As marketing budgets tighten, Zeta is well positioned to take share and actually benefit from the weakening macro environment.

Conclusion

We thank you for your continued trust and support. While these times can be tumultuous, we would encourage any questions or comments you may have. As always, we are available for portfolio reviews anytime. Please contact us if you are interested in learning more about the stocks you own, we would be happy to facilitate that.

Sincerely,

The GROW Funds Team