QTD Income Equity – 2Q2023 vs R1000
Market Observations & Portfolio Commentary
Income Equity – 2Q2023 vs R1000
Quarterly Market Update
U.S. stocks posted positive returns during Q2, with most of the gains generated during the month of June. The broader market, as measured by the Russell 3000 Index, returned 8.4%. Slowing inflation, optimism around the potential benefits of artificial intelligence (AI), and better than expected economic news driven by solid consumer spending combined to lift the market higher. While growth of the overall economy has slowed, a strong labor market with rising wages has allowed the economy to avoid a much anticipated recession.
Shares of larger, technology related companies led the equity market. Market leadership was narrow as seven large cap companies drove the Core and Growth indices. Market performance was bifurcated across the market cap spectrum, with Large and Mega Cap stocks materially outperforming. Style, sector, and factor leadership largely mimicked Q1. Growth continued to dominate Value, and the Growth-oriented Info Technology, Cons. Discretionary and Comm. Service sectors generally led across the market cap spectrum. Turning to market factors, companies exposed to Growth and Volatility factors (higher beta) posted the best results, while Yield and Value factors were laggards. Quality and Momentum factors had a mixed impact.
Key Performance Takeaways
The London Company Income Equity portfolio returned 2.1% gross (2.0% net) during the quarter vs. an 8.6% increase in the Russell 1000 Index. Both sector allocation and stock selection were headwinds to relative performance.
The Income Equity portfolio came up short of our long-term 85-90% upside capture expectations in Q2. Headwinds from exposure to slower growth, lower beta, higher quality holdings, as well as the concentration of the S&P 500 led to challenging relative performance. We also do not expect our portfolios to keep up when the broader market is posting annualized double-digit returns.
The ‘Magnificent 7’ (Tesla, Amazon, Meta, Alphabet, Nvidia, Microsoft, and Apple) drove roughly 73% of the total return in Q2 for the Russell 1000 Index. Underexposure to this group accounted for most of our underperformance. While the Income Equity portfolio had a sizeable position in Apple and Microsoft, the benchmark weight and concentrated strength of this group diminished our ability to differentiate from the index. We do not own the other five stocks, as none of the companies pay a dividend and current valuations assume strong growth for many years. Additionally, Yield factors have dramatically lagged so far in 2023, which was another headwind for our Income Equity portfolio.
Top 3 Contributors to Relative Performance
Lowe’s (LOW) – Despite headwinds from the housing market, LOW outperformed in Q2 after reporting stronger sales in the Pro channel and achieving SG&A leverage. Looking ahead, we believe that LOW is positioned to gain market share, while improving margins, and increasing share in the Pro business.
Nintendo (NTDOY) – NTDOY performed well in Q2 due to a couple of positive data points. First, NTDOY released The Super Mario Bros. movie in April, which set a record for debut global box office for an animated film. NTDOY benefits from the box office through a revenue-share with Illumination Studios, which should provide a material lift to earnings this year. Second, the company released the Zelda sequel in May, which broke the record for fastest-selling NTDOY videogame in an opening weekend. The company is executing well and capitalizing on the value of its intellectual property
Charles Schwab (SCHW) – SCHW was added to the portfolio in March. The company continues to add new client accounts and assets to their platform (over $7T in client assets). Some of the concerns from earlier in the year (cash sorting, rising rates leading to lower valuation of it bond portfolio) are fading and the stock trades at a discounted valuation. Net interest margin will likely compress the rest of the year, but we believe the long-term outlook remains attractive.
Top 3 Detractors from Relative Performance
Target (TGT) – TGT lagged the broader market in Q2 reflecting headwinds that include a more challenging macro environment and the impending return of student loan payments. These headwinds may lead to slower traffic in stores and could temper the pace of recovery in TGT’s EBIT margin from trough levels in 2022. Additionally, the retailer faced backlash and negative press this quarter regarding Pride-related merchandise. We view these headwinds as near-term in nature and expect TGT can return to a structural EBIT margin well above current levels in the medium-term.
Crown Castle (CCI) – CCI, the only REIT in the portfolio, underperformed during Q2, reflecting expectations for slower than normal growth in the next couple of years. The slower growth is due to the impact of higher interest rates on outstanding debt and the loss of revenue from T-Mobile ($200M) following the Sprint merger. Most of the debt carries fixed rates (only 12% variable rate debt) with longer dated maturities. The tower business (70% of revenue) remains solid with high visibility toward mid-single digit revenue growth, driven by increases in demand for wireless data. The stock offers a dividend yield over 5% and stable growth.
Progressive (PGR) – PGR underperformed during Q2 due to concerns about additional price hikes needed to maintain its targeted profitability ratio. PGR continues to increase auto policies in force, but recent costs were higher than expected. To combat weaker than expected margins, PGR is reducing advertising spending and increasing prices on insurance. Looking ahead, we believe PGR remains well positioned reflecting its more flexible pricing platform and tech solutions that monitor and price for distracted driving.
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 Cons. Staples (a weaker performing sector)
Trades During the Quarter
- Reduced: Progressive (PGR) – Trim reflects the recent strength in the shares and the relatively high valuation of the stock (4.8x Price/Book). We remain confident in the long-term fundamentals of the business, but felt that reducing it to a 3% position was prudent. PGR continues to gain market share while adhering to conservative underwriting principles.
- Increased: Charles Schwab (SCHW) – Addition follows initiation of the position back in March. With the recent bank volatility negatively affecting shares of SCHW, we decided to build a full position slowly. There is no change in our positive outlook for the long-term growth of the business.
Uncertainty remains high as we enter the second half of 2023. Continued progress on the inflation front is encouraging, and labor market strength may continue to underpin consumer resilience. That said, we note that core inflation remains above the Federal Reserve’s long-term target of 2%, and it is likely the Fed maintains a restrictive posture if the labor market strength continues. Importantly, monetary policy works with a lag, and we have probably not felt the full impact of prior rate increases or the full effects of tighter lending standards. We remain cautious, as the odds of a recession are still high and the risks of a credit crunch are elevated.
Narrow markets can be quite fragile. The concentrated, top-heavy nature of the market creates an environment prone to risk reversals, and we continue to expect greater volatility in the months ahead. In addition, valuations appear relatively high vs. history, despite concerns about a pending recession and higher interest rates. As inflation concerns subside, we believe growth and employment will come into greater focus. Since the October 2022 bear market low, 100% of the market’s rally has been attributable to P/E valuation multiple expansion. Meanwhile, earnings growth has been weak, and it could weaken further if we enter a recession. We may experience muted returns in the near term, given recession odds and elevated valuations. In that environment, companies that are higher quality, reasonably valued, and prudently returning capital to shareholders are likely better positioned. By that measure, we believe the attractive shareholder yields, quality value orientation, and high active share of our portfolios provide us with a compelling advantage in a fragile market environment with elevated uncertainty.
As we face an economic slowdown with a higher cost of capital environment, we believe companies with strong balance sheets and the ability to self-fund their operations should have a tangible advantage in 2023 and beyond.
As of 6/30/2023
Inception date: 12/31/1999. Past performance should not be taken as a guarantee of future results. Performance is preliminary. Subject to change.