The small cap growth market fared well in the third quarter, but the biggest gainers were speculative companies with weak fundamentals. We expect the rally will broaden going forward. Please see below for a discussion of the Osterweis Opportunity Fund’s recent performance and our near- to medium-term market outlook.
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### Market Recap
The third quarter was another favorable stretch in the markets, as corporate earnings were strong and economic fundamentals remained robust. In addition, the Federal Reserve cut rates by 25 basis points, which served as a tailwind for both stocks and bonds.
The Russell 2000 Growth Index had a particularly bullish quarter, returning 12.2%, marking its second consecutive quarter of 12% returns. It again outpaced the S&P 500, which returned 8.1%. However, the majority of the gains over the past two quarters have been driven by speculative companies with weak fundamentals. Specifically, companies with no profits and the highest price-to-earnings (P/E) ratios delivered the strongest performance.
Some of these companies benefited from a short squeeze, driving prices higher as short sellers were forced to buy back shares. Others rose based on thematic momentum and market hype.
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### Osterweis Opportunity Fund Performance
The Osterweis Opportunity Fund had a solid quarter, gaining 5.14%, but it lagged the index because we avoided speculative winners, including most biotechs and companies focused on quantum computing. We have always believed that valuation discipline is fundamental to successful investing, and we generally avoid businesses that are not profitable.
As a result, we missed some of the upside of the past two quarters. However, our long-term track record validates our approach, as we have substantially outperformed the index since the strategy’s inception and over the past ten years.
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### Portfolio Attribution
#### Security Selection
Our underperformance during the quarter was primarily driven by security selection, particularly in Health Care, Consumer Discretionary, and Information Technology. Our holdings in Consumer Staples, Industrials, and Real Estate outperformed the index but not enough to offset the sectors that lagged.
Our Health Care stocks performed worst both on an absolute and relative basis. The biggest negative contributor was PROCEPT BioRobotics (PRCT), a provider of robotic systems to treat benign prostatic hyperplasia (BPH). The company underwent a management shakeup with the longtime CEO retiring and the COO departing. PROCEPT appointed Larry Wood, an industry veteran with a strong track record from Edwards Lifesciences (EW), as the new CEO. Despite initial disappointment and negative optics surrounding the leadership change, we are confident in Wood’s leadership and anticipate strong Q3 results next month, which should help restore investor confidence.
On the positive side, Artivion (AORT), a medical device company specializing in cardiovascular disease treatments, was our largest contributor in Health Care. The company reported strong Q2 results, led by accelerating sales of their Onyx heart valve, which grew sales by 26% compared to 12% in the first quarter. This device offers significant benefits over traditional mechanical heart valves by combining longevity with reduced need for blood thinners. The product enjoys high gross margins and is supported by an existing sales force, leading to attractive incremental profits. We believe the company is entering a discovery phase as investors begin to recognize its emerging growth potential.
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#### Consumer Discretionary
Our biggest detractor was Duolingo (DUOL), the online language learning platform. User growth stalled in Q2 and remained stagnant in Q3. What began as an anticipated quick AI backlash turned into a prolonged headwind, causing us to lose confidence in management’s goal to triple the paying subscriber base. As a result, we exited the stock.
Conversely, Boot Barn (BOOT), a retailer specializing in Western wear and cowboy boots, was the largest contributor in Consumer Discretionary. The company reported solid Q2 results and raised its full-year guidance. The new CEO has demonstrated strong capability in driving consistent same-store sales growth and effectively navigating the current tariff environment. However, we exited the position as the company’s market cap has grown significantly in recent months, and we believe much of the anticipated upside has been realized.
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#### Information Technology
Information Technology mildly detracted from our relative performance, with semiconductor stocks performing strongly while software stocks lagged. This reflects broader macro trends: companies providing foundational infrastructure for AI fared well, while sentiment turned negative for traditional software companies.
The ongoing demand to train and deploy increasingly complex AI models has driven strong tailwinds for semiconductor and high-speed connectivity sectors. We have focused on profitable companies in this space while avoiding AI-related firms that show top-line growth but remain unprofitable.
Monday.com (MNDY), a cloud-based platform for custom project management and workflows, was our largest detractor in Technology. Despite strong reported results, the stock fell sharply following a weaker growth outlook and declining customer acquisition, partly attributed to recent Google algorithm changes prioritizing AI-generated natural language summaries over traditional paid search links. We gradually reduced our holdings before earnings and fully exited the position post-earnings due to the risk of disruption from AI.
Our biggest Technology contributor was Rambus (RMBS), a provider of high-performance semiconductor products crucial for data center memory and connectivity. Rambus reported an impressive 43% year-over-year increase in Q2 product revenue, driven by market share gains and strong demand for its DDR5 memory interface chips used in servers. The company is launching three new companion chips, and management expects continued growth. The memory market benefits from rising AI inference workloads, highlighted by recent collaborations such as OpenAI working with Samsung and SK Hynix to expand advanced memory chip production.
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#### Consumer Staples
Our Consumer Staples holdings were among the best performers relative to the index. Vital Farms (VITL), an ethical egg and dairy producer, was a significant contributor. The company reported a strong Q2 with beats on both top and bottom lines and raised full-year guidance. We see meaningful untapped demand for Vital’s pasture-raised egg products and expect market share gains. Having overcome prior supply constraints, we anticipate accelerating revenue and profit growth in Q3, with hopes for updated long-term guidance by Q4 earnings.
No laggards were noted in this sector.
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#### Industrials
Industrials also showed relative strength. CECO Environmental (CECO), which provides equipment to treat wastewater and pollutants at manufacturing and power plants, was our biggest contributor. The company delivered strong Q2 results, with sales growth of 35% and order growth of 95%, boosted by a large power infrastructure project. Additional projects in the Middle East and Asia contribute to optimism. CECO benefits from trends such as near-shoring, data center expansion, and increasing power infrastructure needs. We consider it an undiscovered gem.
Our biggest detractor in Industrials was Trex Company (TREX), a leader in composite decking. The stock declined late in the quarter amid rumors that its competitor, James Hardie Industries, was offering more aggressive discounts to customers. After discussions with the companies and distributors, we believe these rumors are unfounded and stem from misinterpreted investor comments. The housing sector remains out of favor, leading to a “shoot first, ask questions later” mentality among investors. We expect solid Q3 results based on dealer surveys and remain invested in Trex.
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### Sector Allocation
Sector allocation was a minor drag on our relative performance during Q3. Our underweight positions in Financials and zero weighting in Communication Services were positive contributors, while our underweight in Industrials, overweight in Consumer Staples, and zero weighting in Materials detracted compared to the index.
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### Portfolio Positioning & Outlook
In the near term, we expect the speculative fervor driving small cap growth stocks to subside. The rally will likely expand to companies demonstrating solid sales and earnings growth.
Furthermore, we anticipate increased opportunities as large structural technology shifts—such as mobile phones, eCommerce, and now AI—historically benefit large-cap markets first before filtering down to small caps. This trend is already unfolding, and we expect smaller, innovative companies to leverage AI to create targeted, business-specific applications.
We also believe a more accommodative Federal Reserve policy will support continued gains in small cap stocks.
Meanwhile, we will continue to seek high-quality, reasonably valued small cap companies with strong, long-term growth potential.
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We thank you for your continued confidence in our management.
**James Callinan, CFA**
Chief Investment Officer
Small Cap Growth
