FY Small Cap – 2022 vs. R2000
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 versus 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 Small Cap portfolio declined -9.1% gross (-9.7% net) during the year vs. a -20.4% decrease in the Russell 2000. Outperformance was driven by stock selection, partially offset by sector exposure.
The Small Cap portfolio performed particularly well in 2022, significantly exceeding 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 the portfolio overcome some significant obstacles, particularly being underweight Energy & Utilities—two of the best performing sectors.
Performance this year was aided, in part, by a handful of acquisition announcements and having limited exposure to the expensive, lower quality growth segment of the market. Overall, the portfolio played excellent defense when it mattered most, and it still managed to remain very competitive amidst the market rebounds.
Our downside protection focus played a key role in the Small Cap strategy’s full year relative performance. Periods like 2022 remind us of how important preserving capital in down markets can be for relative returns.
Top 3 Contributors to Relative Performance
Murphy USA (MUSA) – MUSA had a strong year in 2022. The entire convenience store industry is recognizing structural increases in fuel margins, however MUSA is positioned to gain profitable share in this environment. MUSA’s low-cost model is advantaged compared to peers who face larger headwinds from labor inflation. This allows them to maintain everyday low prices at the pump and gain volume share. We are impressed by MUSA’s management team and applaud their thoughtful capital allocation model to return elevated cash flow back to shareholders through a heavy buyback program (shares down -9.5% y/y) and a small, but growing dividend.
White Mountains (WTM) – Consistent with other insurance stocks, WTM performed well in 2022. This was further compounded by their sale of their NSM division (and subsequent share repurchases), capitalizing on a hot M&A market for insurance brokers. We believe management will continue to create value for shareholders with their opportunistic asset purchases and sales, as they have before.
Lancaster Colony (LANC) – LANC outperformed the benchmark in both Q4 and 2022. LANC’s earnings results continue to outpace expectations. The quality of LANC’s brands has enabled them to push pricing at retail and alleviate some of the heavy gross margin pressure from input cost increases. The outlook for margins looks favorable heading into 2023. We’re attracted to LANC’s cash balance sheet and willingness/ability to invest in high-return, organic projects.
Top 3 Detractors from Relative Performance
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.
Moelis (MC) – MC shares were weak reflecting a weak M&A environment due to lower equity valuations. We maintain a positive outlook for the industry based on relatively low interest rates, high cash balances, and strong cash flow by many acquisitive companies.
Cannae Holdings (CNNE) – CNNE’s underperformance in 2022 primarily reflects the decline in market value in its holding companies. The Dun & Bradstreet investment remains an important value driver, and while fundamentals are improving, investors need convincing that the turnaround is sustainable. The decline in CNNE’s stock price has prompted management to accelerate the pace of buybacks and monetize assets to simplify the portfolio. We believe these capital allocation decisions along with an increased emphasis on private company acquisitions will help improve investor sentiment. The stock continues to trade at a material discount to the fair value of its underlying investments, and we are confident in Bill Foley’s value creation efforts.
We are bottom-up stock pickers, but sector exposures influenced relative performance as follows:
- What Helped: Underweight Healthcare & Info. Technology (two weaker performing sectors)
- What Hurt: Underweight Energy (the best performing sector) & overweight Cons. Discretionary (a weaker performing sector)
Portfolio Characteristics & Positioning
We believe the Small 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). Typically, a higher quality portfolio of companies will trade at a premium, but the Small Cap portfolio currently trades at a discount to the benchmark. We feel this enhances our margin of safety on the downside. 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: 9/30/1999. Past performance is no guarantee of future results.