FY Small Cap – 2022 vs. R2000

January 30, 2023

FY Small Cap – 2022 vs. R2000V

Market Observations & Portfolio Commentary

Small Cap – 2022 vs. R2000

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.

Sector Influence

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.

Source: FactSet

Looking Ahead

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.

Performance

As of 12/31/2022

Small Cap - 2022 vs. R2000 Annualized Returns

Inception date: 9/30/1999. Past performance is no guarantee of future results.

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The London Company’s performances are size weighted and annualized based on calculations for the period ending 12/31/2022. The characteristics discussed herein relate to a representative account, and not every client’s account will have these exact characteristics. As London manages its client portfolios according to each client’s specific investment needs and circumstances, London cannot affirm that the characteristics of the account shown are similar to all accounts participating in the strategy. This is due in part to the timing of trades by the Advisor, market conditions, cash availability, and the timing of client deposits and withdrawals. Therefore, prospective clients should not assume that similar performance results to those shown would have been achieved for their accounts had they been invested in the strategy during the period. None of the information contained herein should be construed as an offer to buy or sell securities, or as investment recommendations. An investment in a London Company strategy is subject to risks, including the loss of principal.

Definition of Firm: The London Company of Virginia is a registered investment advisor. Registration does not imply a certain level of skill or training. More information about the advisor, including full descriptions of its investment strategies, fees and objectives, can be found in the firm’s Form ADV Part 2, which is available upon request by calling 804.775.0317 or visiting www.TLCadvisory.com. The London Company claims compliance with the Global Investment Performance Standards (GIPS®). GIPS® is a registered trademark of CFA Institute. CFA Institute does not endorse or promote this organization, nor does it warrant the accuracy or quality of the content contained herein. Please visit www.TLCadvisory.com or contact us at 804.775.0317 to request a complete list and description of The London Company’s composites and/or a presentation that adheres to the (GIPS®) standards.

Composite Creation/Inception Date: September 30, 1999

Composite Definition: The Small Cap strategy invests mainly in conservative, low-beta, small-cap equities with a focus on above-average downside protection. Primarily we seek profitable, financially stable small-cap companies that consistently generate free cash flow, high returns on unleveraged operating capital, trade at significant discounts to their intrinsic values, and are run by shareholder-oriented management. Positions are usually within the market capitalization range of the major, domestic small-cap indices. Accounts in this product composite are fully discretionary taxable and tax-exempt portfolios with a minimum of $100,000 in assets. The product is measured against the Russell 2000 Index and has a creation and inception date of September 30, 1999. There is no use of leverage, derivatives, or short positions. All actual fee-paying discretionary portfolios are included in one or more composites that have been managed for a full calendar quarter with limited restrictions and similar objectives. As of July 1, 2022 The London Company redefined the composites to exclude all dual contract relationship and any potentially bundled fee scenarios. This policy is not retroactive, but will continue to apply going forward.

Benchmark Description: Primary: Russell 2000 Index measures the performance of the small-cap segment of the U.S. equity universe. Russell 2000 is a subset of the Russell 3000 Index representing approximately 10% of the total market capitalization of that index. It includes approximately 2000 of the smallest securities based on a combination of their market cap and current index membership. Secondary: Russell 2000 Value Index measures the performance of the small-cap segment of the U.S. equity universe. It includes those Russell 2000 Index companies with lower price-to-book ratios and lower forecasted growth values. Benchmark returns are not covered by the report of independent verifiers.

Performance and Fees: Gross of fee returns are calculated gross of management and custodian fees and net of transaction costs. Net of fee returns are calculated net of actual management fees and transaction costs and gross of custodian and other fees. Returns may be net of miscellaneous fund expenses. The gross figures do not reflect the deduction of investment advisory fees. Returns are calculated and stated in U.S. dollars. Returns are calculated gross of withholding taxes on foreign dividends and interest. Dividends are reinvested. Policies for valuing investments, calculating performance, and preparing GIPS Reports are available upon request.

Past performance should not be taken as a guarantee of future results. The report is for informational purposes only. Data, while obtained from sources we believe to be reliable, cannot be guaranteed and all statistics are subject to change. The statements contained herein are solely based upon the opinions of The London Company and the data available at the time of publication of this report, and there is no assurance that any predicted results will actually occur. Information was obtained from third-party sources, which we believe to be reliable but are not guaranteed as to their accuracy or completeness. This report contains no recommendations to buy or sell any specific securities and should not be considered investment advice of any kind. In making an investment decision, individuals should utilize other information sources and the advice of their investment advisor.

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