FY Income Equity – 2023 vs R1000V
Market Observations & Portfolio Commentary
Income Equity – 2023 vs R1000V
Full Year Market Update
For the year, the broader market posted solid gains, with the Russell 3000 up 26.0%. At the start of 2023, interest rates were rising, inflation was stubbornly high, and investors were bracing for a recession. Instead, inflation continued falling, consumers kept spending, and the unemployment rate fell to its lowest level since 1969. With slowing inflation, signs of better balance in the labor market, and normalized GDP growth expectations, the Federal Reserve indicated that it would pivot to rate cuts later in 2024. Huge rallies by the mega-cap Magnificent 7 (Apple, Microsoft, Amazon, NVIDIA, Alphabet, Tesla, & Meta Platforms) were a big driver of overall index performance, and narrow market leadership remained a nagging concern for much of the year.
It was a year of bifurcated performance, led by the mega-cap stocks. Enthusiasm over artificial intelligence and robust gains by the Magnificent 7 led to significant outperformance of the Growth Indices and helped mask weakness in other corners of the market. Non-dividend paying companies significantly outperformed companies that pay a regular dividend, especially in the large cap space. Turning to market factors for the year, Volatility and Growth factors posted the strongest results. Value, Yield, and Momentum factors presented headwinds; while Quality and Momentum factors delivered mixed results.
Key Performance Takeaways for the Year
The London Company Income Equity portfolio gained 5.9% (5.5% net) for the year vs. an 11.5% increase in the Russell 1000 Value Index. Sector allocation aided relative performance, offset by stock selection.
The Income Equity portfolio lagged the Russell 1000 Value in 2023 and came up short of our 85-90% upside capture expectations. Headwinds from exposure to higher yielding, lower beta, higher quality holdings relative to the Russell 1000 Value Index led to challenging relative performance. Higher yielding stocks had a historically bad year versus non-dividend payers, as nearly 50% of the Russell 1000 Value’s return came from non-dividend payers.
Historically, a reliance on high Quality factors and dividend investing has proven to be a strategy that can lose battles along the way but tends to win the war over time. As the past few years have demonstrated, market trends and leadership can turn on a dime. We don’t chase the ups and downs of the risk trade; instead, we commit long-term capital to Quality companies that have greater control over their own destiny. While the full benefits of quality & dividend investing have been delayed at the large cap level, we don’t think they’ll be denied in the long term. In our view, the characteristics of the Income Equity portfolio remain attractive, and we believe we’re well positioned for an uncertain future.
Top 3 Contributors to Relative Performance
Apple (AAPL) – AAPL was strong all year reflecting growth in iPhone sales as well as gains from the mix toward services. AAPL returned significant cash to shareholders via share repurchase and dividends, and the balance sheet remains strong. Valuation based on near term profits is relatively high.
Microsoft (MSFT) – MSFT was strong all year reflecting growth in Azure as well as the addition of AI to various products. The balance sheet remains strong and MSFT continues to repurchase shares.
Fastenal (FAST) – FAST outperformed in 2023 as management continued to execute on expanding onsite locations and increasing sales through its digital footprint. With low leverage, strong cash generation, and ongoing business investments, we believe FAST is well-positioned to strengthen its already robust set of competitive advantages.
Top 3 Detractors from Relative Performance
Diageo (DEO) – DEO’s underperformance in 2023 was primarily the result of demand normalization and a weaker macro environment. The critical U.S. market continues to be soft as retailers worked through excess inventory. Management lowered its financial outlook due to weaker regional trends and higher reinvestment needs to support growth. Overall, we remain confident in DEO’s leading portfolio of brands across key categories and regions, which gives it an entrenched market position in the attractive spirits industry.
Dominion Energy (D) – D underperformed in 2023 reflecting company-specific concerns as well as a rotation away from the Utilities sector. D’s portfolio review extended through the year, and its formal investor update was delayed. Though the update is coming later than initially planned, we note that D has made substantial progress regarding asset sales and balance sheet improvement. With the stock trading at a discount to its peers, we continue to believe patience will be rewarded.
Air Products (APD) – APD’s stock came under pressure in 2023 due to weakening global industrial production and fears of inflation affecting the cost of megaprojects. At this point, the majority of APD’s project pipeline has been de-risked with updated project costs and these investments are all expected to achieve return thresholds >10%. CEO Seifi Ghasemi purchased >$5M worth of stock in November on a pullback in the stock price.
We are bottom-up stock pickers, but sector exposures influenced relative performance as follows:
What Helped: Overweight Info. Technology (a better performing sector) & underweight Health Care (a weaker performing sector)
What Hurt: Underweight Communication Services (a better performing sector) & overweight Consumer Staples (a weaker performing sector)
Portfolio Characteristics & Positioning
We believe the Income Equity portfolio is positioned for long-term durability and possesses the fundamental ingredients that stand the test of time: wide moats, sustainably high returns on capital, strong free cash flow generation, low leverage ratios, 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 access to capital becomes more difficult and the cost of that capital is more expensive, we believe companies with strong balance sheets and the ability to self-fund their operations could have a structural advantage in 2024 and beyond. In an environment of possibly lower returns and greater volatility, we believe the Income Equity portfolio offers an attractive option for equity investors.
After such a strong 2023, we believe investors should temper expectations for 2024. Stocks defied rate hikes, wars, collapsed banks, and recession fears in 2023. Now, calls for a soft landing are consensus; sentiment is overly optimistic; and markets are priced for very little risk. Predicting the future direction of the economy is always challenging. While we do agree the odds of a recession have come down, they are still elevated. A soft landing remains in reach, but much of that hinges on whether the Fed eases soon enough to avoid an employment problem. Perhaps this time it will be different, but historically the odds of sticking the landing have been very low. Even though we have greater clarity over the Fed’s path from here, there still remains a long list of items creating uncertainty that could lead to greater volatility in 2024.
In terms of the equity market, we believe returns in the near term may be modest, with shareholder yield (dividends, share repurchase, debt reduction) comprising a significant percentage of the total return. Economic growth is likely to slow; earnings estimates appear optimistic; and valuations are somewhat elevated. Moreover, investors continue to expect a faster pace of rate cuts than members of the FOMC currently suggest. The difference in the pace of rate reductions could lead to greater levels of volatility in 2024. Markets are impossible to outguess in the short run, but we believe the antidote to uncertainty is quality and that solid company fundamentals will lead to strong risk-adjusted returns in the long run. With that in mind, the characteristics of our portfolios remain attractive, and we believe we’re well positioned for an uncertain future.
We believe the Income Equity portfolio is positioned for long-term durability and possesses the fundamental ingredients that stand the test of time.
As of 12/31/2023
Inception date: 12/31/1999. Past performance should not be taken as a guarantee of future results. Performance is preliminary. Subject to change.