QTD Income Equity – 1Q2023 vs R1000

April 27, 2023

QTD Income Equity – 1Q2023 vs R1000V

Market Observations & Portfolio Commentary

Quarterly Market Update

US equities finished mostly higher during Q1. The broader market, as measured by the Russell 3000 Index, returned 7.2%. Q1 began on a positive note as stocks rallied reflecting moderating inflation and hope that we were nearing the peak Fed funds rate. Major indices gave back some of their gains as Q1 progressed. The Federal Reserve continued to hike interest rates and Fed Chairman Powell reiterated the central bank’s ‘higher for longer’ posture. In March, the failure of both Silicon Valley Bank and Signature Bank led to fears of a broader banking crisis, and added another layer of uncertainty to an already cloudy economic outlook. Due to the flip-flopping of Fed expectations, treasury yield volatility surged. The two-year treasury yield actually dropped during Q1, marking the first quarterly decline in short-term yields since 2020.

Growth stocks across the market cap spectrum were the biggest beneficiaries of the drop in yields, led by Large Caps. From a sector standpoint, the notable outperformers during Q1 (Tech, Comm. Services & Cons. Discretionary) were the biggest laggards of 2022. Turning to market factors, Growth and Volatility factors were additive to returns, while Value and Yield were negative. Quality was mixed, but balance sheet strength/low leverage factors were rewarded as solvency concerns and fears of a recessionary hard landing escalated.

Key Performance Takeaways

The London Company Income Equity portfolio returned 1.4% gross (1.3% net) during the quarter vs. a 7.5% increase in the Russell 1000. Both sector allocation and stock selection were headwinds.
Income Equity outperformed its primary, Russell 1000 Value benchmark, but it came up short of our 85-90% upside capture expectations versus the Russell 1000. Headwinds from owning lower beta, higher quality holdings had a negative impact on relative performance. In addition, the concentration of the large cap core indices in a handful of names made relative performance more challenging. Seven stocks (Tesla, Amazon, Meta, Alphabet, Nvidia, Microsoft & Apple) drove 73% of the total return for the Russell 1000—all P/E multiple expansion. Underexposure to this group was a headwind.
As we face an economic slowdown with a higher cost of capital environment, we take comfort in the durable profitability, strong free cash flow, and balance sheet flexibility of our companies.

Top 3 Contributors to Relative Performance

Texas Instruments (TXN) – TXN outperformed the broader market after reporting better than expected quarterly earnings. TXN plans for the long term and recently reviewed its decade-plus capital expansion and growth plans with investors. Due to expected strength in analog semiconductor content and demand from auto and industrial customers, and with subsidies and grants from the US Government, TXN is undergoing a very large fabrication expansion plan that will likely result in the doubling of their semiconductor capacity before the end of the decade.
Fastenal (FAST) – FAST outperformed in Q1 after reporting FY22 results. The business continues to expand onsite locations and post sales growth through its digital footprint. With low leverage, strong cash generation, and ongoing investments being made to support hub upgrades, automation, equipment & IT, we believe the business is well-positioned to further strengthen its already robust set of competitive advantages.
United Parcel Service (UPS) – UPS outperformed the broader market during Q1 after providing positive earnings results and guidance that calmed investor fears that peak parcel season (shopping period of mid-November through the returns period of mid-January) was not going well. We maintain a position in UPS due to the strength and scale of the company’s integrated global network for delivery parcels and freight, combined with the CEO’s plan to make UPS “better not bigger” across a variety of metrics.

Top 3 Detractors from Relative Performance

Fidelity National Information Services (FIS) – Shares of FIS underperformed during Q1 reflecting disappointing guidance related to the Merchant Solutions business, macro headwinds, as well as fears of contagion from turmoil in the banking industry. During Q1, FIS announced plans to spin off the merchant business, which we believe will unlock shareholder value. The banking turmoil led to some concerns over lower bank IT spending near-term, but we believe the impact to FIS is manageable. We remain attracted to FIS’s durable and diverse business model as it maintains a leadership position across its core segments and provides mission critical services to its customers.
Pfizer (PFE) – PFE underperformed as the market focused on declining COVID franchise earnings, upcoming patent expirations, and the announcement of the proposed Seagen acquisition. As long-term investors, we continue to see upside in PFE’s strong balance sheet, industry leading R&D productivity, and unique logistics capabilities. Further, we believe PFE is executing admirably in their efforts to offset upcoming patent expirations.
Johnson & Johnson (JNJ) – JNJ lagged in Q1, following strong outperformance in 2022. It is not surprising to see JNJ underperform in a strong market rebound, and we continue to view JNJ as a good fit to our downside protection discipline with low leverage and steady execution. Uncertainty around talc litigation continues to weigh on the stock, but considering the scale of JNJ cash flows and the conservative balance sheet, we expect the ultimate impact to be manageable. Meanwhile, JNJ continues to progress toward the separation of the consumer business, to be known as Kenvue.

Sector Influence

We are bottom-up stock pickers, but sector exposures influenced relative performance as follows:

What Helped: Underweight Healthcare & Energy (two weaker performing sectors)
What Hurt: Underweight Info. Technology (a better performing sector) & overweight Financials (a weaker performing sector)

Trades During the Quarter

Initiated: Charles Schwab (SCHW) – SCHW is one of the largest retail brokers in the US, with an excellent brand and a best‐in‐class platform that combines superior service with highly competitive pricing. SCHW is a superb asset gatherer (roughly $7T in client assets) and has a shareholder friendly management team. In mid-March, we used excess cash in the portfolio to initiate a 1.5% position. The stock was down ~30%, reflecting concerns about recent bank failures, most notably Silicon Valley Bank, along with client cash sorting (clients moving from cash to money market accounts, which reduces SCHW’s net interest income). We believe SCHW is well positioned and largely insulated from the turmoil facing some of the traditional banks, due to its ample liquidity and short-term financing options. Plus, we note client inflows continued to be robust and multiple insiders stepped up to buy nearly $7M of stock. While SCHW faces risks to near term earnings, we believe the long-term story is intact, and the negative sentiment presented a good entry point.

Looking Ahead

The destination of tamed inflation and normalized interest rate policy hasn’t changed, but now the path ahead is more treacherous. Going forward, economic growth appears set to overtake inflation as the main concern for investors. Even before the banking turmoil, the corporate earnings landscape was already on the precipice of decline due to the lagged effect of the Fed’s tightening. The addition of the banking crisis and tighter lending standards likely means the macro environment gets worse before it gets better, and the risk of recession has increased. That said, employment levels are high and wages are growing, reflecting a strong labor market, which is important for maintaining solid consumer spending and GDP growth.

In terms of the equity market, we recognize the difficulty in determining what investors have priced into stocks at this point in the economic cycle. Valuations based on near-term earnings are relatively high versus history, despite concerns about a pending recession and higher interest rates. We don’t think we’re out of the woods yet, and believe caution is still warranted. As economic growth may continue to decelerate, equity valuations may compress while earnings estimates could decline. We believe the quality of our portfolios provides us with a tangible advantage as we enter a world that is more unpredictable with greater economic volatility.

We believe the quality of our portfolios provides us with a tangible advantage as we enter a world that is more unpredictable with greater economic volatility.

Annualized Returns

As of 3/31/2023

Inception date: 12/31/1999. Past performance should not be taken as a 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 March 31, 2023. 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 Adviser, 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: December 31, 1999

Composite Definition: The Income Equity strategy invests mainly in common equities with a focus on higher overall dividend yield orientation, which may be supplemented with primarily investment grade, preferred equities. This strategy has a more conservative orientation, with a focus on capital preservation, income and growth, in order to provide greater yield and downside protection relative to our Large and Mid Cap strategies. Our Income Equity strategy is designed to generate above-average, absolute returns over full market cycles. Accounts in this product composite are fully discretionary taxable and tax-exempt portfolios with no minimum dollar amount of assets. The product is measured against the Russell 1000 Value Index and has a creation and inception date of December 31, 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 relationships and any potentially bundled fee scenarios. This policy is not retroactive, but will continue to apply going forward.

Benchmark Description: The Russell 1000 Value Index measures the performance of the large-cap value segment of the U.S. equity universe. It includes those Russell 1000 Index companies with lower price-to-book ratios and lower expected growth values. Benchmark returns are not covered by the report of independent verifiers. The Income Equity product is typically compared to the Russell 1000 Value Index. Any comparison to the Russell 1000, S&P 500 or their corresponding ETFs, is for illustrative purposes only.

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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