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QTD Income Equity – 1Q2024 vs R1000V

Market Observations & Portfolio Commentary

Income Equity – 1Q2024 vs R1000V


Market Update

U.S. stocks posted solid gains in 1Q as stable economic growth, decelerating inflation, and some weakening in the labor market suggest a greater chance of a soft landing. Still, sticky inflation data and a tight labor market pushed out the timeline for the Fed’s first rate cut, leading to a rise in yields. Nevertheless, the S&P 500 notched its strongest start since 2019. For the quarter, the broader market, as measured by the Russell 3000 Index, rose 10%. Stocks were higher across the market cap spectrum, but larger companies exposed to growth factors posted the strongest gains. The Artificial Intelligence (AI) hype that powered 2023’s market rally extended its momentum into 2024. Although there were signs of some rotation away from the dominance of mega-caps, leadership dynamics largely remained unchanged. Market performance continued to be driven by Momentum, Growth, and Volatility market factors, while Yield, Value, and Quality factors lagged behind.


Key Performance Takeaways

  • The London Company Income Equity portfolio gained 5.6% (5.6% net) during the quarter vs. a 9.0% increase in the Russell 1000 Value Index. Sector exposure and stock selection were both headwinds to relative performance.

  • The Income Equity portfolio produced solid absolute returns, but relative results came up short of our 85-90% upside capture expectations. Our focus on Quality and Yield factors faced headwinds in a market favoring Momentum, Growth, and Volatility. Limited exposure to Energy and Banks (two the best performing groups in the Value index) plus pockets of weakness in several Info. Technology, Materials, & Consumer holdings were additional obstacles.


Top 3 Contributors to Relative Performance 

  • Progressive (PGR) – PGR was up 31% during 1Q as it continues to report better margins and faster growth compared to the industry. PGR’s policy in force (PIF) delivered positive growth, and it achieved necessary pricing actions with existing customers. Profitability remains better than peers as PGR has been successful at lowering ad spending while growing its mix of preferred customers. PGR’s underwriting risk segmentation continues to be a competitive advantage as it has delivered industry-leading accident frequency results.

  • Fidelity National Information Services (FIS) – FIS shares outperformed during 1Q as the new management team continues to execute on its turnaround plan. FIS sold its majority ownership stake in the Merchant Solutions business earlier this year, which has enabled greater financial flexibility and operational focus. Quarterly results demonstrated early progress on its growth and productivity initiatives, and guidance suggests further margin expansion and demand acceleration this year. We remain attracted to FIS’s durable business model with its leadership position across its core segments & provides mission critical services to its customers.

  • Fastenal (FAST) – FAST outperformed in 1Q after impressive operational execution and disciplined expense management underpinned earnings results that beat expectations. Looking beyond the quarter, FAST is consistently executing on its value-generative growth initiatives, including onsite location expansion and increasing digital footprint sales. With low leverage, strong cash generation, productive reinvestments, & strong shareholder returns, we also believe the management team is demonstrating exemplary capital allocation.


Top 3 Detractors from Relative Performance 

  • Apple (AAPL) – 1Q was a very busy quarter of news flow, and most of it resulted in negative sentiment for the stock. Despite announcing the availability of the long-awaited Vision Pro in early February, AAPL’s stock underperformed following increasing scrutiny from US and EU regulators and an earnings report that failed to inspire the masses. Add in weakness in AAPL device sales in China, and the market capitulated on the stock. Furthermore, the halo of artificial intelligence exposure that was bestowed on so many companies by the market failed to touch AAPL, as the company’s AI plans remain shrouded in development and mystery. We remain attracted to AAPL’s growing services business, its strong balance sheet, excellent cash flow generation and capital allocation.

  • Air Products (APD) – Stock weakness continued in 1Q as slower industrial production in the China and semis markets is weighing on the base business. APD’s multiple compressed significantly in past months to 19.5x PE (vs. close peer Linde {LND} at 30.5x) which points to investor skepticism in both management’s ability to execute competitively in the core business and in the capital allocation strategy focused on clean energy megaprojects. In Q1, we spoke with the CEO and he is prioritizing the restoration of investor trust while also protecting APD’s long-term strategy. We believe the stock is positioned to both re-rate as APD delivers consistent execution in the base business, and compound over time as offtake agreements offer tangible return profiles for megaprojects.

  • Starbucks (SBUX) – A handful of revenue headwinds weighed on SBUX’s results in the quarter. Boycotts due to conflict in the Middle East should be a shorter-term headwind to traffic. The dynamics in the China market may take a bit longer to shake out. Coffee entrants aggressively built up in China in the past few years, and since consumer spending has been slow to rebound, there is a level of irrationality starting to creep into the market. That said, as the China consumer gains strength there should be plenty of whitespace for a more rational, tiered market to prosper. The U.S. loyalty base remains strong as ever, cost cutting measures are being pulled forward to counter deleverage from lower revenue, and cash flow is healthy and growing (>4% FCF yield).


Sector Influence

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

  • What Helped: Underweight Health Care & Real Estate (weaker performing sectors)

  • What Hurt: Underweight Energy (a better performing sector) & overweight Info. Technology (a weaker performing sector)


Trades During the Quarter

  • Reduced: Apple (AAPL) – Reduction reflects strong performance in 2023 and resulting elevated valuation. We believe the outlook for AAPL remains strong with slow growth in iPhone (now #1 global market share) and faster growth in the higher margin services business. R&D will continue to drive new products and AAPL now has over 2 billion installed devices around the world. While near term earnings expectations appear reasonable, we felt it was prudent to reduce the position size based on risks to valuation.

  • Reduced: Microsoft (MSFT) – Reduction reflects strong performance in 2023 and resulting elevated valuation. We remain confident in the outlook driven by the shift to cloud computing and growth in Azure products. MSFT should also benefit from the utilization of AI in various products. While future earnings growth should be solid, we felt it was prudent to reduce the position size based on risks to valuation.

  • Increased: Air Products (APD) – Addition follows recent weakness reflecting headwinds from higher inflationary costs and the associated impact potential on expected returns from some of APD’s largest projects. Fundamentally, APD is in a strong position to capitalize on the clean energy revolution due to their scale, experience, technology, and customer relationships. Management has shown they will allocate capital efficiently and effectively by walking away from deals that do not meet return thresholds, while taking advantage of government policies, tax credits, and favorable green bond prices. We remain confident in the long-term outlook, and a recent large share purchase by the CEO is a strong sign of conviction.


Looking Ahead

With slowing inflation, signs of better balance in the labor market, and normalized GDP growth expectations, the Fed will probably start to lower rates later this year. We believe the Fed will proceed with caution, attempting to balance the risk of easing policy too early against the risk of maintaining rates in a restrictive position for too long. While the odds of a recession in the near term have declined, risks remain. Longer term, we remain positive regarding the U.S. economy and expect real annualized GDP growth in the 2% range driven by growth in the labor force and improving productivity.

In terms of the equity market, we believe returns in the near term may be modest, with shareholder yield (dividends, share repurchase, debt reduction) comprising a significant percentage of the total return. After such a strong five-month rally, it’s fair to question the sustainability of the market’s strength. Narrow, top-heavy markets are fragile, and the recent surge in insider selling activity, especially in tech companies, likely reflects the extreme valuations and unsustainability of this AI momentum trade. The odds of a recession have come down, but our cautious posture persists due to high valuations, market concentration, looming debt challenges, and the lengthiest inversion of the yield curve in history. Continued multiple expansion in a higher rate environment is unlikely. We suspect the S&P 500 will eventually track earnings, so we would expect more volatility, especially in stocks where a lot of growth is already priced in. We see a greater opportunity for quality operators with durable cash flow generation, strong balance sheets, and attractive shareholder yields in the years ahead.


Annualized Returns 

As of 3/31/2024

Income Equity - 1Q2024 vs R1000V Annualized Returns

Inception date: 12/31/1999. Past performance should not be taken as a guarantee of future results. Performance is preliminary. Subject to change.

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