FY Income Equity – 2022 vs. R1000V
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.
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.
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.
As of 12/31/2022
Inception date: 12/31/1999. Past performance should not be taken as a guarantee of future results.