FY SMID Cap-2021 vs. R2500
Market Observations & Portfolio Commentary
2021 Market Update
US stocks posted another year of double-digit returns and new all time highs. A strong rebound in the US economy in 2021 and historically strong earnings momentum offset concerns over COVID-19 variants, elevated inflation and pandemic related supply chain disruptions. On balance, it was a micro-driven year, and the market rewarded profitability across sectors, size and styles. Large Cap stocks led Smaller Caps. Stylistically, Growth outperformed Value in the Large Cap space, while Value significantly led Growth among Small and Mid Caps. Defensive shares outperformed the more cyclical shares, but the difference in returns was more evident in the Small Cap space. With regard to factors driving performance, most categories had a positive influence on returns, but the results were mixed within Growth, Volatility, and Momentum factors.
Key Performance Takeaways for the Year
- The London Company Small-Mid Cap portfolio returned 20.7% gross (19.8% net) for the year vs. a 18.2% increase in the Russell 2500 Index. Sector exposure contributed to relative outperformance, partially offset by negative stock selection.
- We are bottom-up stock pickers, but sector exposures influenced relative performance as follows:
- What Helped: Underweight Healthcare (the weakest performing sector) & overweight Materials (a better performing sector)
- What Hurt: Underweight Energy (the best performing sector) & overweight Cons. Staples (a weaker performing sector)
- A strong rally in Q4 led to better than expected relative returns for the year. As the year progressed, the market rewarded profitable companies and penalized expensive, non-earners— which was a welcome reversal from 2020. Unprofitable, growth oriented Healthcare and Tech companies in the Small Cap space were among the hardest hit. The SMID portfolio participated in the Quality rebound, and our companies played particularly solid defense amidst the volatility in the second half of 2021, leading to significant outperformance.
Top 3 Contributors to Relative Performance
- Entegris (ENTG) – ENTG outperformed its end markets and continued to gain share. Increased die size and a push to smaller nodes requires more wafer starts and more advanced contamination control, which are long term industry tailwinds. ENTG has drastically increased its size and scale while becoming one of the most diversified players in the semi materials industry. The recent CMC Materials acquisition will further strengthen the company’s competitive moat.
- MBIA (MBI) – MBIA shares were strong all year. MBIA is no longer writing business, but is running off its book, which includes returning cash to shareholders via share repurchase. MBIA trades at a discount to adjusted book value, and we believe it will continue to return excess capital to shareholders.
- Martin Marietta (MLM) – MLM stock outperformed in 2021, largely driven by the passing of a new infrastructure bill. The $1 trillion bill reauthorizes key surface transportation programs for the next five years, significantly increasing highway funding over previous levels and providing greater visibility to the outlook for aggregates. Demand has also been driven by strength in industrial projects and single-family housing across the country.
Top 3 Detractors from Relative Performance
- Citrix (CTXS) – A number of internal issues have negatively impacted CTXS in recent quarters including a shift to subscription based sales, a complicated technical selling process and activist led changes to management. CTXS products remain very relevant in cloud computing and work from home environments; meanwhile, margins are attractive and the balance sheet is solid.
- Cannae Holdings (CNNE) – CNNE’s underperformance in 2021 was the result of declines in the market value of its largest public holdings (Dun and Bradstreet, Ceridian, and PaySafe). The investment theses for its larger holdings remain intact, but some have taken longer to materialize than expected. Its SPAC investments have also been impacted by waning market sentiment for SPAC vehicles. CNNE trades at a discount to the fair value of its underlying investments, and we believe further upside will come from Foley’s value creation efforts.
- Lamb Weston (LW) – LW shares have been weak in recent months due to ongoing pandemic related challenges, particularly supply chain issues and inflationary costs (shipping and fertilizers). Making matters worse was a weak potato crop this year. Fortunately, volumes have recovered, but LW has not been able to pass through the higher costs yet, so margins are down. We think demand will remain strong, capacity utilization rates throughout the industry will bounce back leading to price increases, and margins for LW will rebound.
Portfolio Characteristics & Positioning
We believe the SMID strategy is well positioned based on the strength of the companies owned and the overall quality characteristics of the portfolio, measured by sustainably high returns on capital and modest leverage. The market is expensive by historical standards, but the portfolio still trades at reasonable relative valuation, given the level of quality. We believe this enhances the margin of safety on the downside, but also provides room for further upside should the market grind higher.
We remain positive regarding the economic outlook. As we enter 2022, we expect solid, but moderating economic growth. COVID remains a risk; but fortunately, the latest Omicron wave appears to be having less of an impact on the broader economy than prior variants. Meanwhile, inflation is still elevated, and the Fed is set to reverse accommodative monetary policy, which could further weigh on economic growth. In terms of the equity market, we recognize valuations are on the rich side, while interest rates will likely remain low vs. history. The Fed is expected to begin increasing the funds rate later in 2022, but the increases will likely be in small increments. At current valuations along with various short term risks to the economic outlook (rising inflation, higher interest rates, potential tax increases), we expect greater volatility and possibly more muted returns in the near term. Given this backdrop, we believe a long term-approach, with a focus on Quality factors that help dampen volatility, will reward investors.
As of 12/31/2021
Inception date: 3/31/2009. Past performance should not be taken as a guarantee of future results.
The London Company’s performances are size weighted and annualized based on calculations for the period ending December 31, 2021. 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: March 31, 2009
Composite Definition: The Small-Mid Cap strategy is an extension of our Small Cap strategy with weighted market capitalization higher than our Small Cap portfolio, and is within the market capitalization ranges of the major domestic small to mid-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 2500 Index and has a creation and inception date of March 31, 2009. 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. Composite may include accounts under dual contract.
Benchmark Description: Primary: Russell 2500 Index measures the performance of the small to mid-cap segment of the U.S. equity universe, commonly referred to as “smid” cap. Russell 2500 is a subset of the Russell 3000 Index. It includes approximately 2500 of the smallest securities based on a combination of their market cap and current index membership. Secondary: Russell 2500 Value Index measures the performance of the small to mid-cap segment of the U.S equity universe. It includes those Russell 2500 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. For example, an account that earned 15% per year for 10 years would have an accumulated return of 305% before fees and 270% after fees, assuming a 1% fee. 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.