It increasingly appears we are in a period of performance chasing and FOMO (fear of missing out) which has seen trillions of dollars flow into these handful of growth stocks. In the second quarter alone, NVIDIA Corp.⁽¹⁾, still riding the wave of artificial intelligence exuberance, added over $800 billion of market cap – ending the quarter with a market valuation exceeding $3 trillion. Conversations at recent family cookouts of how much NVIDIA partygoers owned are reminiscent of similar discussions surrounding Janus funds during the summer of 1999. We view this as a dangerous set up for many investors, including those who have the bulk of their wealth in index funds. Should we see a rotation out of loved mega-cap stocks, much as we did following the “dotcom bubble,” the impact on the market could be dramatic…perhaps even more so than the turn of the century move, given the top-heavy concentration existing today. A recent Wall Street Journal article reminded readers that following the bursting of that tech bubble, small-cap stocks, as represented by the Russell 2000, beat the S&P 500 by 114% through 2014.

 

 

It is possible a Fed easing cycle could turn the tide, given the “higher for longer” interest rate environment has been extra burdensome on smaller companies. These companies often have less readily available access to capital markets to fund operations, and must resort to higher-cost, often floating-rate debt. Should the market begin to discount lower interest rates, smaller-cap companies could see significant relative outperformance. Indeed, a recent reaction to a softer CPI (Consumer Price Index) reading could be foreshadowing. On July 11, the June CPI reading came in at <0.1%> versus forecasts of 0.1% increase versus May’s level. Despite year over year inflation coming in at 3%, still above the Fed’s 2% target, the lower month over month number raised expectations of a Fed rate cut in the coming months, and a powerful rotation ensued. This one day move saw the “Magnificent 7” mega-cap stocks lose over $500 billion in market value alone, while the small-cap Russell 2000 gained 3.6% on the day. Was this a proverbial “canary in the coal mine”? Only time will tell, but we feel your portfolio is set up well should market leadership continue to broaden.

 

Election 2024 – Potential Implications

We are currently in the midst of a U.S. presidential election year. And, while every election cycle brings with it the potential for unknown outcomes and volatility, this cycle has already had more than its share - from a debate performance by President Biden that was widely viewed as so disastrous that many called for him to step aside as a candidate, ultimately resulting in his doing just that on July 21, to the recent despicable attempt on former President Trump’s life. Our thoughts go out to the former president, his family, and to the families of the bystanders who were horrifically killed and injured in the senseless shooting.

The results in November could have myriad impacts on the U.S. consumer, various industries, and the overall stock market in general. With the House of Representatives and the U.S. Senate up for grabs with slim majorities, and recent presidential elections resulting in narrow margins of victory, making investment decisions based on an outcome are difficult at this point and, arguably, even imprudent. Further complicating matters, certain proposals offered by each candidate would require a majority vote in both houses of Congress, while other actions are dependent only on who wins the presidency. While we at Prospector are not making portfolio tilts based on expectations for who will win in November, we, like many, are following events closely. Below are some of the potentially material issues worth watching – each of which could have implications for current, or potential portfolio holdings.

 

Where the parties seem to agree:

 

In recent years, both the Republicans and Democrats have been, at times, anti-big tech. For example, both President Biden and former President Trump have attacked section 230, which provides limited federal immunity for content on social media platforms. Any elimination of section 230 could greatly change social media platforms' ability to exist as currently designed. Additionally, both parties have raised antitrust concerns related to these mega-cap companies. While Trump's concerns were more verbal in nature, the Biden FTC's 21-month delay of Microsoft’s⁽¹⁾ acquisition of Activision Blizzard, was a more substantive example of anti-trust concerns. We expect to hear continued "Break up big tech!" proclamations from both parties in coming years. Any resulting actions could have material consequences.

Both parties have also consistently pledged to lower drug prices. Often, PBM's (pharmacy benefit managers) have been the focus of attacks and of congressional hearings. The current administration's "Inflation Reduction Act" (IRA) contains several provisions attempting to lower drug prices, including giving the federal government the authority to negotiate Medicare prices for a number of drugs, starting in 2026. We expect continued proposals to lower drug prices, and potentially modify the PBM model from both parties.

Under both the Trump and Biden administrations, tariffs have been used as a way of battling anti-competitive trade tactics by other countries. The Trump administration imposed new tariffs on many Chinese goods, as well as on steel and aluminum from various countries. The Biden administration kept in place, and expanded the Chinese tariffs in particular, while easing certain tariffs on other countries. While the inflationary and overall economic impacts of these tariffs are the topics of much debate, both parties’ recent predilection for tariffs as a trade policy could have material impact on various industries.

 

Major Bones of Contention:

 

One of the most contentious topics which must be addressed no matter who wins the presidency is the impending expiration of the Trump tax cuts at the end of 2025. The 2017 TCJA (Tax Cuts and Jobs Act) included a number of items which expire and will most likely lead to much debate as expiration nears. Some of these items include: the higher standard deduction, lower marginal tax rates, the SALT (state and local taxes) deduction limitation, the higher estate tax exemption, etc. Absent a GOP sweep and thus a likely extension, we could see material changes to some or all of the aforementioned items from the TCJA. Additionally, while the corporate tax rate of 21% enacted under the Trump administration does not expire, each party has dramatically different views of where that rate should go. Changes to these policies could have significant effects on both consumers and corporations.

Both the American Rescue Plan Act in 2021 and the IRA in 2022 included subsidies which boosted Affordable Care Act (ACA) enrollment by millions of insureds. These also expire at the end of 2025. The elimination of the subsidies would not only impact insureds, but also healthcare organizations benefiting from increased enrollment. However, despite these being enacted during a Democrat administration, many of the beneficiaries reside in red states and the subsidies are reportedly popular among Republicans surveyed.

The IRA also included clean energy subsidies which have spurred billions of dollars of investments in projects around the country. Many of these projects are still in the planning stages, and any reversal of the IRA could have meaningful implications on regions of the country and certain companies. However, much as with the ACA subsidies described above, the majority of these projects are slated to benefit Republican majority states. According to a February, 2024 Wall Street Journal article, "more than three-quarters of these factory and mining investments will go to congressional districts held by Republicans."

 

Regulation and Banks:

 

One of the starkest contrasts between the GOP and Democrats is their stance on regulations – with Republicans believing in a more laissez-faire approach, as opposed to a tighter regulatory environment which has existed under President Biden, and generally favored by the left. For example, over the past several years, many management teams have discussed a more difficult merger & acquisition (M&A) environment given longer reviews by the FTC and other regulatory bodies.

While many of the impacts from increased regulations are hard to measure, and have impacted many different industries, we believe the banking industry is disproportionately exposed to what happens in November. Under the Biden Administration, regulators have increased the magnitude and severity of their oversight. This has ranged from tougher capital rules under a strict interpretation of Basel III, rhetoric against bank M&A, to limiting fees that banks can charge. During our meetings with bank management teams, a universal complaint is that regulators today are never satisfied with compliance and systems spending, always demanding more – this applies to the largest and smallest of banking institutions.

In a GOP administration, it is likely the “muzzle” will once again be placed on the regulators, resulting in a stagnation of new regulation. Over time, key regulatory positions will be replaced with “business friendly” appointees, and we could even see a reversal of some regulation enacted under the current administration. Additionally, we expect a dramatic rebound in bank M&A under the GOP as antitrust rhetoric is rolled back. Per the chart below, the M&A environment was more robust under the Trump administration. We believe there is pent-up demand for deal making per conversations with managements, which could result in a wave of industry consolidation in future years. Consolidation would enhance the return profile of acquirers, while providing takeout premiums to shareholders of target banks. Your portfolio has multiple bank stocks that stand to benefit from a recovery in M&A, both as attractive targets and astute acquirers. A more business-friendly administration should also aid loan demand and ensure a favorable tax environment, which disproportionately benefits domestic banks.

 

 

While a GOP victory is a major tailwind for the banking industry, green shoots for the sector still exist if the Dems retain control. At recent conferences, bankers state that their commercial client base has growing pent-up loan demand, but remain on the sidelines pending clarity on the direction of Federal Reserve policy and the outcome of the election (with Fed Policy cited as the primary driver). Getting past election uncertainty, in conjunction with a Fed that communicates easing inflation and lower rates should lead to a rebound in loan demand. This environment would also lead to a welcomed easing of funding costs. The combination would aid net interest income under either administration. That said, a GOP presidency would be a “supercharger” for the engine of the banking sector.

 

Outlook

Since early 2022, the Federal Reserve has aggressively raised interest rates in an effort to lower inflation, causing significant uncertainty within stock and bond markets. While the rate of inflation has subsided, and the consensus appears to be we have reached an end to the Fed hiking cycle, declaring victory could be premature. The U.S. and rest of the world continue to manage the impacts of inflation, higher interest rates, and geopolitical events. In our assessment, there remains a possibility of Federal Reserve policy error and / or recession, though barring extraneous events, we still lean towards slowdown and not recession per se.

The biggest risk right now would seem to be from a “shock to the system” while we continue transitioning from the pandemic economy to a more normalized economy. Certainly, the risk of potential systemic shock that might spread from the Middle East, Eastern Europe, or the South China Sea keep us up at night. As always, with our bias towards quality, we strive to mitigate any downside, while also participating in the upside.

Meanwhile, heavy fiscal stimulus from already passed U.S. legislation for defense, infrastructure, semiconductors, and energy investment are only in the early stages of being awarded. This fiscal spending will not peak until later in the decade. Relatively high energy costs in Europe, and Germany in particular, makes manufacturing here relatively more attractive. Political risk in China makes that country less attractive to do business in. All told, U.S. manufacturing is being called upon to step up. While unemployment has risen from the lows, the overall jobs market remains healthy. We expect continued housing market pressures as a result of higher interest rates and affordability concerns. However, the shortage of housing after over a decade of underinvestment following the Great Financial Crisis should prevent a disastrous decline in home prices. Lower-income consumers have been most impacted by the current inflationary environment, but consumer balance sheets remain generally healthy for the majority of Americans, and consumer credit quality remains strong at the moment.

While what we see argues for a more inflationary and higher interest rate environment than seen in the past ten years, it also does not argue for a recession. Nonetheless, the unexpected can occur. Should a recession happen in the near term, the factors highlighted above suggest it could be less significant than the previous two recessionary periods. We are also mindful that this is an election year, the result of which could have implications on companies, sectors and the overall economy.

Following years of lower interest rates helping to drive ever-higher growth-stock valuations, we feel value investing is ripe for a period of outperformance. We continue to find opportunities to invest in quality businesses with solid balance sheets and cash flows, whose share prices have detached from our assessment of the fundamentals. The bargains inherent in your portfolio should attract acquirers and other investors over time.

 

(1) As of June 30, 2024, Microsoft (MSFT) represented 1.7%, and Nvidia (NVDA) 0.0%, of the total fair market value of the Fund’s investment holdings (including cash).

 

Disclosures:

 

You should carefully consider the investment objectives, potential risks, management fees, and charges and expenses of the Fund before investing. The Fund’s prospectus contains this and other information about the Fund, and should be read carefully before investing. You may obtain a current copy of the Fund’s prospectus by calling 1.877.336.6763.

Past performance is not a guarantee of future results.

Important Risk Information
Investment in shares of a long/short equity fund have the potential for significant risk and volatility. A short equity strategy can diminish returns in a rising market as well as having the potential for unlimited losses. These types of funds typically have a high portfolio turnover that could increase transaction costs and cause short-term capital gains to be realized. The stocks in the Fund’s portfolio may decline in value or not increase in value when the stock market in general is increasing or decreasing in value and you could lose money. The Fund may lose money due to fluctuations within the stock market which may be unrelated to individual issuers and could not have been predicted. The price of the securities which the Fund holds may change unpredictably and due to local, regional, international, or global events. In the case of a general market downturn, multiple asset classes, or the entire market, may be negatively affected for an extended and unknown amount of time.

Risk Statistic Definitions:
The S&P 500 Index is a widely recognized, unmanaged index of equity prices and is representative of a broader market and range of securities than is found in the Fund’s portfolio. The Russell 2000 Index is a stock market index that measures the performance of the 2,000 smaller companies included in the Russell 3000 Index.  Standard Deviation measures the volatility of the Fund’s returns. Beta measures the Fund’s sensitivity to market movements. Sharpe Ratio uses the Fund’s standard deviation and average excess return over the risk-free rate to determine reward per unit of risk. R-squared represents the percentage of the portfolio’s movements that can be explained by general market movements. Upside/Downside Capture Ratio measures a manager’s ability to generate an excess return above the benchmark return in up markets and retain more of the excess return in down markets. Risk statistics are relative to the S&P 500. Batting Average is a statistical measure used to evaluate an investment manager’s ability to meet or beat their index. Omega is a relative measure of the likelihood of achieving a given return. Max Drawdown is the peak-to-trough decline during a specific recorded period of an investment. Gross Exposure is the sum of the absolute values of the fund’s long and short exposures. Net Exposure is the fund’s total long exposure less the fund’s total short exposure. HFRI - Equity Hedge (Total) Index is a fund weighted index of investment managers that maintain positions both long and short in primarily equity and equity derivative securities. All index returns include the effect of reinvested dividends. The Expense Ratio, Gross of Any Fee Waivers or Expense Reimbursements, is 3.05%. The Expense Ratio, Net of Fee Waivers and Expense Reimbursements (contractual through 9/30/2023), is 3.00%. The Expense Cap is 1.95. The Adviser has contractually agreed to waive or limit its fees to 1.95% and to assume other expenses of the Fund until September 30, 2024, so that the ratio of total annual operating expenses (not including interest, taxes, brokerage commissions, other expenditures which are capitalized in accordance with generally accepted accounting principles, other extraordinary expenses not incurred in the ordinary course of business, dividend expenses on short sales, expenses incurred under a Rule 12b-1 plan, acquired fund fees and expenses and expenses that the Fund incurred but did not actually pay because of an expense offset arrangement) does not exceed 1.95%.

 

Prospector Partners, LLC assumed investment management duties on 05-28-2015 and was formally approved by shareholders on 09-17-2015.

Morningstar US Long Short Fund Category – Long-short portfolios hold sizable stakes in both long and short positions. Some funds that fall into this category are market neutral – dividing their exposure equally between long and short positions in an attempt to earn a modest return that is not tied to the market’s fortunes. Other positions that are not market neutral will shift their exposure to long and short positions depending upon their macro outlook or the opportunities they uncover through bottom-up research.

†† The Morningstar Rating for funds, or "star rating", is calculated for managed products (including mutual funds, variable annuity and variable life subaccounts, exchange-traded funds, closed-end funds, and separate accounts) with at least a three-year history Exchange-traded funds and open-ended mutual funds are considered a single population for comparative purposes It is calculated based on a Morningstar Risk-Adjusted Return measure that accounts for variation in a managed product's monthly excess performance, placing more emphasis on downward variations and rewarding consistent performance The top 10% of products in each product category received 5 stars, the next 22 5% receive 4 stars, the next 35% receive 3 stars, the next 22 5% receive 2 stars, and the bottom 10% receive 1 star. The Overall Morningstar Rating for a managed product is derived from a weighted average of the performance figures associated with its three-, five-, and 10-year (if applicable) Morningstar Rating metrics The weights are: 100% three-year rating for 36-59 months of total returns, 60% five-year rating/40% three-year rating for 60-119 months of total returns, and 50% 10-year rating/30% five-year rating/20% three-year rating for 120 or more months of total returns While the 10-year overall star rating formula seems to give the most weight to the 10-year period, the most recent three-year period actually has the greatest impact because it is included in all three rating periods. Across the US Long Short Equity category, as of 06/30/2024, LSOFX received the following Morningstar Rating for the 3-year, 5-year, 10-year periods, respectively: 3 stars out of 145 funds, 3 stars out of 129 funds, and 4 stars out of 69 funds.

The Fund is distributed by Ultimus Fund Distributors, LLC. (Member FINRA).