FY Large Cap – 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 Large Cap portfolio declined -14.2% gross (-14.6% 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 Large Cap portfolio trailed the Russell 1000 Value index for the year, and it came up short of our longer-term expectations for 75% downside participation in falling markets. 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. Having zero exposure to Energy & Utilities (the two best performing sectors), an overweight position in Information Technology, and a lack of deep value holdings were headwinds to relative performance vs. the Value Index all year. The portfolio outperformed the core Russell 1000 Index over the same period.
We believe the Large Cap 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
O’Reilly Auto Parts (ORLY) – ORLY was a top performer in 2022 due to its ability to gain wallet share and maintain strong margins in an uncertain retail environment. ORLY continues to drive unit growth and gross margin dollar across commercial and do-it-yourself customers. ORLY has a strong balance sheet and recent insider buying activity has been favorable.
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.
Altria (MO) – MO outperformed in a turbulent economy and a down market, demonstrating the defensive nature of tobacco, which remains a sticky business with strong pricing power. Current capital return is strong with a ~8% dividend yield and an active buyback program. Following the announcement that Philip Morris International (PM) would buy MO out of the IQOS partnership in the US, MO announced a new US heated tobacco JV with Japan Tobacco. MO also plans to collaborate with JT on RRPs outside the US in the future.
Top 3 Detractors from Relative Performance
Meta Platforms (META) – META lagged the broader market reflecting a confluence of headwinds. The largest downside surprise was a deterioration of the macroeconomic environment that led to reduced ad spending. Second, META was negatively impacted by Apple’s iOS privacy changes that reduce the company’s ability to target users and report on ad campaign attribution. Lastly, competition from TikTok was a headwind and META introduced a new product, Reels, to compete more effectively against TikTok. In the short-term, the user engagement shift towards Reels presents a revenue headwind (Reels monetizes at a lower rate per ad than Stories and Feed). We sold the stock in October reflecting the headwinds to growth and management’s plan to increase capital spending in an uncertain environment.
Alphabet (GOOG) – GOOG underperformed in 2022 due to increasing macro risks and concerns around a slowdown in digital ad spending. The concerns around weaker margins in a slowdown pressured the stock. The Cloud business continues to grow and profitability has improved. We remain attracted to GOOG’s significant market share and very strong balance sheet. Meanwhile, it’s returning capital to shareholders via its buyback program, and it trades at an attractive valuation.
CarMax (KMX) – After outperforming in 2021, KMX lagged the broader market in 2022 with the majority of the underperformance in the second half. Investors are concerned about affordability, increasing rates, and higher fixed costs given recent investments. KMX continues to disrupt the used car ecosystem by adding new capabilities and widening its moat with its omni-channel investments. We maintain our conviction in the stock.
We are bottom-up stock pickers, but sector exposures influenced relative performance as follows:
- What Helped: Overweight Cons. Staples (a better performing sector) & underweight Real Estate (a weaker performing sector)
- What Hurt: Underweight Energy (the best performing sector) & overweight Info. Technology (the weakest performing sector)
Portfolio Characteristics & Positioning
We believe the Large Cap 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: 6/30/1994. Past performance should not be taken as a guarantee of future results.
The Large Cap product is typically compared to the Russell 1000 Index. Any comparison to the Russell 1000 Value, or its corresponding ETFs, is for illustrative purposes only.