FY Income Equity – 2022 vs. R1000V

January 26, 2023

FY Income Equity – 2022 vs. R1000

Market Observations & Portfolio Commentary

2022 Market Update

U.S. equities traded lower during 2022 reflecting higher than desired inflation, a shift toward tighter monetary policy from the Federal Reserve, and geopolitical concerns. Persistently high inflation combined with a strong labor market led to the Fed increasing its funds rate seven times during the year for a total of 425bps. Separately, the Fed began reducing the size of its balance sheet via Quantitative Tightening (QT). Taken together, this resulted in a higher cost of capital, lower valuation multiples, and weak returns from most asset classes. The broader market, as measured by the Russell 3000 Index, was down 19.2% for the year. All of the major core indices posted double-digit declines with relatively small differences across the market cap ranges. Stylistically, this was the best year for Value vs Growth since the popping of the Tech Bubble. There was a huge spread in sector leadership as well. Despite oil and gasoline prices making a dramatic roundtrip, Energy was up ~66% for the year—its largest outperformance versus the market in the history of GICS sectors. Turning to factors driving performance during the year, Value (lower valuations) and Yield factors had the most positive influence on relative returns. Growth (with the exception of dividend growth) and Volatility factors had a negative impact. Momentum and Quality factors had a mixed impact.

Key Performance Takeaways for the Year

The London Company Income Equity portfolio declined -11.0% gross (-11.3% net) during the year vs. a -7.5% decrease in the Russell 1000 Value. Sector exposure was a headwind to performance, partially offset by positive stock selection.
The Income Equity portfolio split its benchmarks in 2022. It trailed its primary benchmark, the Russell 1000 Value and came up short of our longer-term expectations for 75% downside participation in falling markets. Meanwhile, it outperformed the S&P 500 and exceeded expectations. Amidst 2022’s valuation-driven selloff, investors sought safety in stocks with cheaper valuations, often overlooking fundamentals such as balance sheet flexibility & consistency of cash flow. Sector dispersion was extreme in 2022, and sector leadership was atypical. Limited exposure to Energy (the best performing sector, up +66%), an overweight position in Info. Technology, and a lack of deep value holdings were headwinds to relative performance vs. the Value index all year.
We believe the Income Equity portfolio remains built for long-term durability. If economic conditions deteriorate further and credit risks rise, we believe the benefits of high returns on capital and balance sheet strength could stand out in a meaningful way.

Top 3 Contributors to Relative Performance

Progressive (PGR) – PGR outperformed in 2022 as the company successfully navigated its plan to improve profitability and reignite policy growth. PGR’s best-in-class market segmentation gives lower rates for preferred drivers, which leaves competitors with worse drivers and more erratic pricing strategies. We remain attracted to its best-in-class operations and conservative underwriting philosophy.
Merck (MRK) – MRK benefitted all year from strong earnings growth and the flight to safety amidst broader equity market declines. The company continues to leverage its strength in oncology with its leading Keytruda franchise. MRK is also seeing strong demand globally for its human papillomavirus vaccine as well as continued support from its Animal health division. We remain attracted to the company’s strong bullpen of drugs and vaccines and believe MRK’s new leadership team can accelerate its drug pipeline and supplement growth with business development opportunities.
Chevron (CVX) – CVX was a beneficiary of strong oil and gas prices in 2022. CVX should continue to generate strong free cash flow at current prices and has demonstrated commitment to capital discipline. CVX has taken its leverage down to a low level, which should support capital flexibility on the downside of the cycle. While we do not take a position on the direction of commodity prices, we remain confident that management will manage CVX rationally and conservatively.

Top 3 Detractors from Relative Performance

Apple (AAPL) – AAPL underperformed the broader market in 2022 as the Fed raised rates, which caused a broad rotation out of technology stocks. Additionally, there has been concern about iPhone supply and demand as the global economy weakens and China grapples with a new round of Covid-19. We continue to believe that AAPL has a wide moat thanks to its nearly impenetrable ecosystem of hardware and services.
Crown Castle (CCI) – CCI underperformed reflecting its relatively high debt levels and timing issues related to network equipment deployment. Higher interest rates continued to cause much of the multiple compression. The tower business continues to be resilient and activity is growing as carriers are spending to enhance networks and deploy spectrum. We like CCI’s stable revenue stream, long-term tailwinds on growth in data consumption, and its ability to return cash to shareholders through its dividend policy.
Target (TGT) – 2022 was an exceptionally tough environment for retailers, like TGT, who made investments in inventory in 2021 amidst high consumer demand plus long lead times, and are now seeing the demand environment shift as supply chains finally catch up. Promotional behavior to reduce inventory combined with higher input costs (e.g. freight & wage inflation) squeezed TGT’s margins. We are confident this represents discrete pressures and is not representative of a long-term structural margin shift for the business. Additionally, we are encouraged that TGT has maintained positive traffic and held onto market share gains from the pandemic.

Sector Influence

We are bottom-up stock pickers, but sector exposures influenced relative performance as follows:

What Helped: Overweight Cons. Staples (a better performing sector) & underweight Financials (a weaker performing sector)
What Hurt: Overweight Info. Technology (the weakest performing sector) & underweight Energy (the best performing sector)

Portfolio Characteristics & Positioning

We believe the Income Equity portfolio is well positioned for an uncertain future and possesses the fundamental ingredients that stand the test of time: wide moats, durable profitability, strong free cash flow, healthy balance sheets, and an attractive shareholder yield (dividends + net buybacks). The portfolio trades at a premium to the Value index, but we believe this is justified as companies in the Value indices have lower returns on capital and higher leverage. As we face an economic slowdown and a higher cost of capital environment, we believe companies with strong balance sheets and the ability to self-fund their operations should have a structural advantage in 2023 and beyond.

Source: FactSet

Looking Ahead

As we enter 2023, conditions remain fragile, and the lagged effect of 2022’s rate hikes and Quantitative Tightening (QT) may lead to further economic weakness. Inflation remains higher than desired, but inflation readings have improved from peak levels. Meanwhile, the labor market remains tight and the service side of our economy remains strong. As the Fed continues to balance its goals of stable pricing and full employment, additional rate hikes are likely early in the year. It is hard to predict what could happen longer term, but the message from the Fed is that rates will stay higher for longer. Much will depend on the level of inflation and the performance of the broader economy. In terms of the equity market, we recognize the difficulty in determining what is already factored into stock prices at this point in the economic cycle. With higher interest rates likely, equity valuations may experience multiple compression, while a slowing economy may lead to weaker earnings from many companies. The next phase of this slowdown will likely hinge on the path of earnings, credit spreads, and employment. In this more challenging environment, we continue to expect greater volatility in share prices and lower expected returns relative to the strong returns generated from 2009-2021. Longer term, we continue to believe that quality attributes and solid company fundamentals will lead to strong risk-adjusted returns.

As we face an economic slowdown and a higher cost of capital environment, we believe companies with strong balance sheets and the ability to self-fund their operations should have a structural advantage in 2023 and beyond.

Performance

As of 12/31/2022

Inception date: 12/31/1999. Past performance should not be taken as a guarantee of future results.

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The London Company’s performances are size weighted and annualized based on calculations for the period ending December 31, 2022. The characteristics discussed herein relate to a representative account, and not every client’s account will have these exact characteristics. As London manages its client portfolios according to each client’s specific investment needs and circumstances, London cannot affirm that the characteristics of the account shown are similar to all accounts participating in the strategy. This is due in part to the timing of trades by the Adviser, market conditions, cash availability, and the timing of client deposits and withdrawals. Therefore, prospective clients should not assume that similar performance results to those shown would have been achieved for their accounts had they been invested in the strategy during the period. None of the information contained herein should be construed as an offer to buy or sell securities, or as investment recommendations. An investment in a London Company strategy is subject to risks, including the loss of principal.

Definition of Firm: The London Company of Virginia is a registered investment advisor. Registration does not imply a certain level of skill or training. More information about the advisor, including full descriptions of its investment strategies, fees and objectives, can be found in the firm’s Form ADV Part 2, which is available upon request by calling 804.775.0317 or visiting www.TLCadvisory.com. The London Company claims compliance with the Global Investment Performance Standards (GIPS®). GIPS® is a registered trademark of CFA Institute. CFA Institute does not endorse or promote this organization, nor does it warrant the accuracy or quality of the content contained herein. Please visit www.TLCadvisory.com or contact us at 804.775.0317 to request a complete list and description of The London Company’s composites and/or a presentation that adheres to the (GIPS®) standards.

Composite Creation/Inception Date: December 31, 1999

Composite Definition: The Income Equity strategy invests mainly in common equities with a focus on higher overall dividend yield orientation, which may be supplemented with primarily investment grade, preferred equities. This strategy has a more conservative orientation, with a focus on capital preservation, income and growth, in order to provide greater yield and downside protection relative to our Large and Mid Cap strategies. Our Income Equity strategy is designed to generate above-average, absolute returns over full market cycles. Accounts in this product composite are fully discretionary taxable and tax-exempt portfolios with no minimum dollar amount of assets. The product is measured against the Russell 1000 Value Index and has a creation and inception date of December 31, 1999. There is no use of leverage, derivatives or short positions. All actual fee-paying discretionary portfolios are included in one or more composites that have been managed for a full calendar quarter with limited restrictions and similar objectives. As of July 1, 2022 The London Company redefined the composites to exclude all dual contract relationships and any potentially bundled fee scenarios. This policy is not retroactive, but will continue to apply going forward.

Benchmark Description: The Russell 1000 Value Index measures the performance of the large-cap value segment of the U.S. equity universe. It includes those Russell 1000 Index companies with lower price-to-book ratios and lower expected growth values. Benchmark returns are not covered by the report of independent verifiers.

Performance and Fees: Gross of fee returns are calculated gross of management and custodian fees and net of transaction costs. Net of fee returns are calculated net of actual management fees and transaction costs and gross of custodian and other fees. Returns may be net of miscellaneous fund expenses. The gross figures do not reflect the deduction of investment advisory fees. Returns are calculated and stated in US dollars. Returns are calculated gross of withholding taxes on foreign dividends and interest. Dividends are reinvested. Policies for valuing investments, calculating performance, and preparing GIPS Reports are available upon request.

Past performance should not be taken as a guarantee of future results. The report is for informational purposes only. Data, while obtained from sources we believe to be reliable, cannot be guaranteed and all statistics are subject to change. The statements contained herein are solely based upon the opinions of The London Company and the data available at the time of publication of this report, and there is no assurance that any predicted results will actually occur. Information was obtained from third party sources which we believe to be reliable but are not guaranteed as to their accuracy or completeness. This report contains no recommendations to buy or sell any specific securities and should not be considered investment advice of any kind. In making an investment decision individuals should utilize other information sources and the advice of their investment advisor.

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