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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 1.0% increase in the Russell 1000 Value. Sector allocation was a tailwind to relative outperformance, partially offset by stock selection.

  • The balance sheet strength and quality of the Income Equity portfolio helped it outperform the Russell 1000 Value index, which is characterized by having weaker profitability and higher leverage ratios. Looking back at 2022’s valuation driven sell-off, balance sheet strength was more of a luxury than a necessity. Investors largely sought downside protection through cheap stocks, often overlooking fundamentals. Amid those conditions, the Income Equity portfolio came up short of expectations versus the Value index in 2022.

  • Flash forward to 2023, concerns over slowing growth and solvency led to investors bidding up companies with high interest coverage and fleeing highly levered businesses. 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 

  • Apple (AAPL) – AAPL outperformed during Q1 as investors rotated back into the largest-cap technology stocks that were weak in 2H22. AAPL’s earnings report also provided some tailwinds due to better-than-feared iPhone unit sales. Sentiment was further boosted late in the quarter as news spread that the company will be bringing a mixed-reality headset device to market later this year, and that they began to offer buy-now-pay-later (i.e. customer financing) options to their customers.

  • Microsoft (MSFT) – MSFT outperformed during Q1 as investors rotated back into the largest-cap technology stocks that were weak in 2H22. MSFT also received some positive momentum as it became more likely that the UK government would approve the pending acquisition of Activision Blizzard, which would give MSFT a dominant position in the growing videogame industry. We own MSFT reflecting its strong competitive position in enterprise software, cloud computing, and consumer markets, along with significant cash flow generation and balance sheet strength.

  • 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.


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.

  • Norfolk Southern (NSC) – NSC was a significant underperformer in Q1 reflecting weaker than expected earnings and news of a train derailment in Ohio. Historically, the financial impact from train derailments have been relatively small and NSC’s insurance coverage could help cushion the blow. We believe NSC will emerge from this incident relatively unscathed, but will have to reinforce some of their network due to changes made from precision scheduled railroading efforts.


Sector Influence

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

  • What Helped: Overweight Info. Technology (a better performing sector) & underweight Healthcare (a weaker performing sector)
  • What Hurt: Underweight Comm. Services (a better performing sector) & overweight Cons. Staples (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

Income Equity vs Russell 1000 Value Annualized Returns

Inception date: 12/31/1999. Past performance should not be taken as a guarantee of future results.

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