FY Mid Cap – 2022 vs. RMC
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 Mid Cap portfolio declined -14.9% gross (-15.1% net) during the year vs. a -17.3% decrease in the Russell Midcap index. Both stock selection & sector exposure contributed to relative outperformance.
The Mid Cap portfolio outperformed its benchmark for the year, but slightly trailed our longer-term expectations for 75% downside participation in falling markets. For such a macro-dominant year, we were encouraged to see the quality of our Mid Cap portfolio overcome some significant obstacles. 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 areas, was a major headwind for the portfolio. Fortunately, Mid Cap was able to overcome these hurdles and outperform for the year by playing solid defense when it mattered most.
We believe the Mid 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
Lamb Weston (LW) – LW’s outperformance reflected the recovery in overall fry demand, better than expected pricing, and the execution of its cost-saving initiatives. Fry attachment rates are higher than ever despite total restaurant traffic remaining below pre-pandemic levels. LW has proactively invested in additional capacity to meet demand over the long term. Pricing actions have offset higher costs and demand has been stable. This is a consolidated industry and the long-term outlook remains very favorable. We remain attracted to LW’s market share, pricing power, and industry tailwinds.
Alleghany (Y) – Y outperformed early in the year after it was announced that Berkshire Hathaway had agreed to acquire Y for a ~33% premium to their last trading price. The deal closed late in the year.
Post Holdings (POST) – During 2022, POST benefitted from a bounce-back in demand for value cereal as consumers traded down in the current inflationary environment. Additionally, the Foodservice segment continued to recover from pandemic lows, which is positive for volumes and margins; finally, the recent avian flu outbreak should support higher egg prices in the near-term. We appreciate that management is using the proceeds from the BellRing (BRBR) spin-off to pay down high rate debt and replace it with low-cost convertible debt.
Top 3 Detractors from Relative Performance
Entegris (ENTG) – Despite outperforming end markets, ENTG underperformed due to demand uncertainties and elevated debt levels after the CMC Materials acquisition. Industry-wide challenges around excess capacity, elevated inventory, and higher costs have pressured semiconductor names this year. Despite short-term uncertainty, we believe demand will be a tailwind in the future driven by leading edge nodes and digitalization. ENTG is one of the most diversified players in the semi-materials industry with its size and scale. We remain attracted to the industry’s high barriers to entry, limited competitors, and high switching costs.
CarMax (KMX) – After outperforming the market 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. Management is focused on growing profitable market share in multiple channels while implementing measures to improve SG&A metrics. 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.
Armstrong World Industries (AWI) – AWI underperformed the broader market late in the year reflecting project delays and macro related uncertainty. While company earnings are sensitive to changes in the economy, we note that roughly 70% of sales are for repair and renovations, which have remained stable in prior economic contractions. AWI remains well positioned as the leader in the market for ceiling tile.
We are bottom-up stock pickers, but sector exposures influenced relative performance as follows:
- What Helped: Overweight Cons. Staples (a better performing sector) & underweight Info. Technology (a weaker performing sector)
- What Hurt: Underweight Energy & Utilities (the two best performing sectors)
Portfolio Characteristics & Positioning
We believe the Mid 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 currently trades at a premium to the benchmark, but we believe this is reasonable given the superior returns on capital. 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: 3/31/2012. Past performance should not be taken as a guarantee of future results.