Market Observations & Portfolio Commentary

Quarterly Market Update 

US stocks posted double-digit declines during Q2 reflecting concerns about persistently high inflation, rising interest rates, and slowing global economic growth. For the quarter, the broader market, as measured by the Russell 3000 Index, declined 16.7%. Most of the data released during the quarter pointed to deceleration in the economy. On a positive note, the US consumer remains in reasonably good shape, buoyed by solid household balance sheets and a strong labor market. With regard to monetary policy, the Federal Reserve’s outsized focus on inflation led to a more aggressive pace of rate hikes following the liftoff in March. The specter of aggressive monetary policy, the broadening of tighter financial conditions, and growth concerns weighed on sentiment and exacerbated volatility in Q2.

Stocks were weak across the market cap spectrum with little difference in returns for Small, Mid, or Large companies. Value significantly outperformed Growth, and more defensive stocks outperformed more cyclical companies. In terms of market factors that drove performance, Value (lower valuation), Yield (higher), and Quality had a positive impact on relative returns. Volatility and Growth factors had a negative impact.

 

Key Performance Takeaways

• The London Company Income Equity portfolio declined -11.8% gross (-11.9% net) during the quarter vs. a -12.2% decrease in the Russell 1000 Value. Outperformance was driven by positive stock selection, partially offset by sector exposure.

• The Income Equity portfolio performed as it’s designed to do and held up well against the market turmoil in Q2. The Income Equity portfolio outperformed the Russell 1000 Value Index in Q2.

• The portfolio trailed our target vs. the Value Index.

• Having limited Energy exposure and few deep value holdings have been headwinds thus far in 2022. We believe the Income Equity portfolio is well positioned for a slowing economy and greater volatility and could make up additional ground in the months ahead.

 

Top 3 Contributors to Relative Performance 

• Progressive (PGR) – PGR outperformed during Q2 reflecting improved profitability in its latest quarterly results. PGR continues to execute its plan to slow premium growth in favor of maintaining its 96% combined ratio. Results in the Personal Auto Loss ratio have improved suggesting its pricing actions have continued to stick and rate hikes have been successful. PGR’s segmentation and virtuous cycle of risk selection should translate to a more profitable book coming out of this cycle. We remain attracted to its best-in-class operations and conservative underwriting philosophy.

• Merck (MRK) – Shares of MRK benefitted from strong earnings and the flight to safety amidst broader market declines. MRK continues to leverage its strength in oncology with its leading Keytruda franchise that has demonstrated tremendous success across key tumor types. We remain attracted to the company’s strong bullpen of drugs and vaccines and believe MRK’s new leadership team can accelerate its drug pipeline and supplement growth with business development opportunities.

• Pfizer (PFE) – PFE shares outperformed the broader market as fundamentals should be relatively insulated from macroeconomic weakness. PFE has been the big winner in the pharma industry over the course of the pandemic with its Comirnaty vaccine and Paxlovid therapeutic. Vaccine profits positioned PFE with ~$24B of cash and equivalents on the balance sheet as of 3/31, and the company has commenced putting that cash to work on business development. Notably, PFE announced the acquisition of Biohaven in the quarter. As PFE deploys capital to expand the pipeline and continues to execute on R&D, concerns around medium-term growth should be addressed. PFE pays a growing dividend above 3%.

 

Top 3 Detractors from Relative Performance 

• Target (TGT) – TGT, along with other retail stocks, lagged amidst shifting consumer preferences to buy services rather than goods, while gas prices limited overall purchasing power. At the same time, retailers are being hit by higher cost of goods, wage and freight inflation, and undergoing inventory issues due to supply chain disruptions and shifting consumer behavior. The impact to TGT this year will be lower margins to the tune of ~5% EBIT margins, as opposed to long-term guidance of 8%+. TGT announced an inventory optimization plan this quarter to get ahead of a perceived glut of industry markdowns. While painful in the short-term, management believes this was the best choice to maintain a comfortable shopping experience with relevant merchandise. So far this year TGT has maintained healthy traffic growth.

• Apple (AAPL) – AAPL was weak during Q2 as rumors persisted that the company may dramatically trim its forecasts for iPhone production. COVID-based lockdowns in China were the leading contributor to the expectation of lagging sales. As the leading driver of the business, iPhone sales are very important to AAPL. We remain optimistic longer term about the outlook for iPhone as well as other AAPL products.

• Blackrock (BLK) – BLK underperformed reflecting the company’s ties to the broader equity market. We understand the correlation of BLK’s AUM and fee revenue to market moves in the near term, but we continue to see BLK as a very well-run company and a secular winner in the asset management industry. Despite market volatility, we expect underlying organic growth to continue

 

Sector Influence

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

• What Helped: Overweight Consumer Staples (a better performing sector) & underweight Financials (a weaker performing sector)
• What Hurt: Overweight Info. Technology (the weakest performing sector) & underweight Healthcare (the best performing sector)

 

Trades During the Quarter

• There were no trades during the quarter.

 

Looking Ahead

Risks remain in the near term as the Fed battles persistently high inflation and a tight labor market. We recognize the difficulty in navigating a soft landing, so the odds of a recession over the next 12-18 months have increased. Having said that, the resiliency of the US consumer should not be underestimated. Labor markets are historically tight and household balance sheets remain solid for now—powerful forces that can ballast the US economy. Longer term, we remain positive on the US economy and expect real GDP growth in the 2-3% range driven by growth in the labor force and improving productivity.

In terms of the equity market, we note that multiple compression may continue reflecting both higher interest rates as well as higher than desired inflation. A slowing economy may also lead to weaker earnings for many companies. If the economy continues to decelerate or we experience a recession, we should assume many estimates of profitability will decline. 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. In recent years, companies with a high story-to-substance ratio were rewarded. Going forward, we believe attributes like a strong balance sheet and the ability to self-finance operations are poised to stand out as competitive advantages in a higher cost of capital environment. Longer term, we continue to believe that quality attributes and solid company fundamentals will lead to strong risk adjusted returns over time. The companies in London Company portfolios overall generate much higher returns on capital with stronger balance sheets at reasonable valuations relative to the broader market.

In recent years, companies with a high story-to-substance ratio were rewarded. Going forward, we believe attributes like a strong balance sheet and the ability to self-finance operations are poised to stand out as competitive advantages in a higher cost of capital environment.

Annualized Returns 

As of 6/30/2022

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

 

Disclosure Notes

The London Company’s performances are size weighted and annualized based on calculations for the period ending June 30, 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: 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. Composite may include accounts under dual contract.

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.

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.