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QTD Income Equity – 2Q2024 vs R1000V

Market Observations & Portfolio Commentary

Income Equity – 2Q2024 vs R1000V


Market Update

U.S. stocks posted mixed results during 2Q24. The broader market, measured by the Russell 3000 Index, rose 3.2% with gains concentrated in large companies with ties to spending on artificial intelligence. The S&P 500 reached new all-time highs during the quarter, but market breadth (a measure of how many stocks are participating in the rally) sharply declined once again. The Russell 2000 Small Cap Index was down 3.3%. Economic data released during the quarter reflected decelerating growth, some weakening in the labor market, and lower inflation, which collectively support the notion of rate cuts beginning in the next few months. Corporate earnings were solid, but there were signs of greater caution from consumers. Investors continued to favor Large Cap, Growth and Momentum factors, consistent with trends in recent quarters. Value and Yield factors continued to face headwinds, while Quality & Volatility had a mixed impact.


Key Performance Takeaways

  • The London Company Income Equity portfolio declined 1.6% (1.7% net) during the quarter vs. a 2.2% decrease in the Russell 1000 Value Index. Both sector allocation and stock selection were modest tailwinds to relative performance.

  • The Income Equity portfolio outperformed its benchmark in 2Q and exceeded our 75-80% downside capture expectations. Exposure to Quality factors was additive to results as was our Yield orientation—which was a welcome relief after several quarters of detraction. Since inception, the strategy has now outperformed the Russell 1000 Value in 25 of 29 quarter of negative return quarters for the Index.


Top 3 Contributors to Relative Performance 

  • Apple (AAPL) – Shares rallied during 2Q after posting strong results with improvement in China. AAPL also announced an $110B share repurchase authorization and a 4% increase in the dividend. iPhone revenue was down a bit although there were some moving pieces that made y/y comparisons challenging. Positive comments about potential with AI helped drive the shares.

  • Texas Instruments (TXN) – TXN rallied in 2Q despite declining revenue in its latest update. TXN is beginning to see some encouraging signs of destocking nearing an end and some sub-segments of the market are experiencing improving demand. TXN continued to spend on capex and should begin to see positive benefits to cash flow next year from the CHIPS Act.

  • Philip Morris (PM) – Shares rallied in 2Q after muted performance to start the year. The smoke free category continues to be the primary driver with notable strength from ZYN nicotine pouches. IQOS growth has been fueled by ongoing innovation and smoker conversions, while the US remains a large and untapped commercialization opportunity on the horizon. Successful execution of the portfolio transition has resulted in smoke-free products now contributing nearly 40% of total net revenues and gross profit. Guidance suggests a continued acceleration in the adoption of reduced-risk products, which will drive overall volume growth and market share gains. We believe that the growth potential of the smoke-free category combined with a resilient and profitable combustibles portfolio will lead to significant and sustainable free cash flow generation.


Top 3 Detractors from Relative Performance 

  • Norfolk Southern (NSC) – NSC pre-announced weaker results in early April. Revenue declined in its latest quarter driven by lower fuel surcharges, an unfavorable product mix, and lower intermodal ancillary fees. Costs continued to rise. Activist involvement may lead to lower costs in the future.

  • Fastenal (FAST) – After a strong start to the year, FAST underperformed during 2Q due to sluggish broad-based demand, and a slowdown in customer acquisition. FAST is delivering on its various growth drivers, including on-site signings ahead of target, increasing e-commerce and digital footprint sales, and ongoing growth in Fastenal Managed Inventory signings. Despite the slowdown in its end markets, FAST’s balance sheet remains in good shape and its cash generation is strong. FAST’s counter-cyclical free cash flow profile is appealing in the current economic environment and provides ample downside protection.

  • Lowe’s (LOW) – LOW underperformed as sales at the company were negatively affected by falling do-it -yourself spending from consumers. Sales to Pro customers remained positive. Decelerating consumer spending and weaker housing data is likely weighing on results at LOW. On a positive note, consumers staying in their homes due to higher interest rates and the aging of homes around the country is typically a positive for home improvement spending.


Sector Influence

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

  • What Helped: Underweight Health Care (a weaker performing sector) & overweight Consumer Staples (a better performing sector)

  • What Hurt: Underweight Utilities (a better performing sector) & overweight Consumer Discretionary (a weaker performing sector)


Trades During the Quarter

  • Reduced: Fastenal (FAST) – Trimmed position following recent strength in shares. There’s no change to our long-term thesis.

  • Increased: Nestle (NSRGY) – Added to position following recent weakness in the shares. There is no change in the thesis for either holding, but we note that NSRGY trades at an attractive valuation and recent insider purchases gives us greater conviction in the timing of the additions

  • Increased: Nintendo (NTDOY) – Addition reflects our positive long-term outlook for the business and our desire to reduce cash in the portfolio.

  • Exited: Verizon (VZ) – Sale reflects heightened competitive activity from both AT&T and T-Mobile. While VZ has the highest quality network, we are concerned that its competitors’ focus on market share gains could continue to negatively affect VZ’s business, resulting in both lower margins and returns on capital.

  • Initiated: TE Connectivity (TEL) – TEL designs and manufactures connectors and sensors, supplying solutions to the transportation, industrial, and communications industries. The critical components that TEL sells have long life cycles and they make up a small percent of the overall cost of materials for a complex electronic systems (i.e. low cost but high-cost failure products), creating high switching costs and barriers to entry. TEL has leading share in the global connector market (including 30-35% share in automotive) with leverage to secular growth from the ‘electrification’ of multiple end markets. TEL’s management team has enacted successful cost-realignment strategies, driving significant margin improvement and leading to mid-teens returns on invested capital. TEL fits our process well. It has a low level of net debt, generates healthy cash flows, returns a significant amount of capital back to shareholders through its dividend and buyback program, and it currently trades at a discount to our estimate of intrinsic value and a discount to its peers. Given its strong competitive position, capital allocation philosophy, and favorable industry tailwinds, we believe TEL presents an opportunity to own a high quality compounder.


Looking Ahead

Conditions are trending in a positive direction for the Fed to begin reducing rates. Inflation is still higher than the Fed’s target, but it has continued to drift lower. The labor market remains strong, but there have been some signs of weakening. Together with signs of weakness in some recent economic data, we could see the Fed shift to a less restrictive policy and reduce rates before year-end. 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 1.5-2% range driven by growth in the labor force and improving productivity.

In terms of equities, we note that narrow, top-heavy markets are fragile markets. 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 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. In our view, this uncertain economic backdrop warrants an investment approach that prioritizes consistency and stability—not excessive wagers. Owning great businesses at reasonable prices and allowing them to compound is still a winning, long-term strategy.


Annualized Returns 

As of 6/30/2024

Income Equity - 2Q2024 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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