QTD Income Equity – 3Q2022 vs R1000V
Market Observations & Portfolio Commentary
Quarterly Market Update
U.S. equities declined for a third consecutive quarter in Q3 as tighter monetary policy from the Federal Reserve and decelerating economic growth led the market lower. The broader market, as measured by the Russell 3000 Index, declined 4.5%. Most of the data released during Q3 pointed to deceleration in the economy, but fortunately U.S. consumer fundamentals remain broadly solid. The Fed raised its benchmark rate by 75 basis points for a third consecutive meeting, and the pace of its quantitative tightening (balance sheet reduction) ramped up. The Fed’s hawkish commentary progressively ratcheted up during Q3, setting ‘higher for longer’ policy expectations to combat inflation. These hawkish moves were underpinned by stubbornly high inflation readings and a labor market that remains tight. Bond yields moved higher, and the U.S. dollar rose in value vs. almost every other currency, creating disruption abroad. The yield curve remained inverted at the end of the quarter.
Stocks traded lower across the market cap spectrum, but Small Caps outperformed Large Cap equities. The Growth indices outperformed the Value across the board, and cyclical stocks outperformed shares of more defensive companies. In terms of market factors that drove performance, Volatility factors had a positive impact, while Growth was neutral. Value, Yield, and Quality mostly presented headwinds.
Key Performance Takeaways
The London Company Income Equity portfolio declined -6.1% gross (-6.2% net) during the quarter vs. a -5.6% decrease in the Russell 1000 Value. Both stock selection & sector exposure were headwinds to performance.
The Income Equity portfolio struggled to keep pace with the robust, high beta-led bear market rally that dominated most of Q3. Income Equity played solid defense in September, as the market ultimately turned negative, but it wasn’t enough to offset weakness from earlier in the quarter.
The portfolio has lagged the Russell 1000 Value year-to-date, due primarily to limited exposure to Energy and fewer deep value holdings. Importantly, the portfolio characteristics are very attractive vs. the Value index, reflecting superior Returns on Capital and much lower leverage ratios.
Looking ahead, we believe the portfolio remains well positioned for a slowing economy and greater volatility.
Top 3 Contributors to Relative Performance
Lowe’s (LOW) – LOW performed well in Q3 after it reaffirmed its full year guidance and achieved operating leverage in a slower sales environment. The home improvement category remains attractive and resilient. Management is executing its Perpetual Productivity Improvement (PPI) initiatives, which have translated to share gains in both DIY and Pro customers as well as margin improvement. LOW has a very strong balance sheet with significant capacity to return cash to shareholders through share buybacks and its dividend.
Starbucks (SBUX) – We initiated a position in SBUX in March. The most recent earnings report highlighted strength in US coffee demand, which does not appear to be slowing amidst the inflationary environment. In September, we attended the investor day in Seattle where Starbucks introduced the new CEO and the Reinvention Plan characterized by targeted organic investments in US stores and employees. Recent insider buys by founder Howard Schultz ($15M), Chairwoman Mellody Hobson ($5M), and director Richard Allison ($1M) send a compelling message on valuation.
Apple (AAPL) – AAPL was essentially flat during Q3, outperforming the broader market. AAPL’s latest earnings release reflected strong demand for its products despite concerns about a weakened global consumer. AAPL continues to possess strong competitive advantages including brand equity and network effects, resulting in high returns on capital and significant cash flow generation.
Top 3 Detractors from Relative Performance
Cincinnati Financial (CINF) – CINF had a challenging quarter as accident loss ratios have increased across most lines, as management cited rising inflationary costs in the business. While prior management commentary and reserve takedowns in 2021 were likely too optimistic, we believe the current underwriting environment favors improving price/cost dynamics for insurers. Despite the recent volatility in the equity markets, we continue to like CINF’s large equity position.
Verizon (VZ) – VZ underperformed in Q3 as competition from other telecom carriers and cable companies accelerates in the wireless space. VZ’s strategy of offering a premium product to the market is not resonating as well with consumers amidst high inflation and improving 5G networks at peers. We will continue to monitor VZ’s new offerings in the market to see if it will accelerate subscriber growth. The stock offers a 6.9% dividend yield, which is covered 2x by net income and over 3x by operating cash flows.
Fidelity National Information Services (FIS) – FIS underperformed in Q3 as concerns over rising rates, foreign exchange headwinds, wage inflation, and lower consumer spending weighed on shares. Rising competition from newer fintech players has also been a drag on sentiment. However, 2Q22 results revealed strong momentum across all business units and management remains committed to accelerating capital returns to shareholders. We are attracted to FIS’s durable and diverse business model as it maintains a leadership position across its segments and provides mission critical services to its customers.
We are bottom-up stock pickers, but sector exposures influenced relative performance as follows:
- What Helped: Underweight Comm. Services (a weaker performing sector) & overweight Cons. Discretionary (a better performing sector)
- What Hurt: Underweight Energy (a better performing sectors) & overweight Info. Technology (a weaker performing sector)
Trades During the Quarter
- There were no trades during the quarter.
Conditions remain fragile. As the Fed attempts to navigate a soft landing, economic growth may continue to decelerate. The combination of persistently high inflation and a tight labor market mean additional rate hikes are likely; meanwhile, Quantitative Tightening is set to continue. We recognize the lagged impact of monetary policy on the broader economy, so the odds of a recession over the next 12-18 months remain elevated. On a positive note, the U.S. consumer remains in reasonably good shape (i.e. low unemployment, rising wages, excess savings, etc.) With consumer spending such an important part of U.S. GDP, the strong labor market could limit the downside risk to the economy over the next few months. That said, things could change quickly and higher rates may lead to slower growth and greater job losses. Longer term, we remain positive on the U.S. economy and expect annualized 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 do not attempt to time the market, but hope that much of the bad news is reflected in equity valuations after a 25% YTD decline in the broader Russell 3000 Index. That said, multiple compression may continue in the near term and a slowing economy may lead to weaker earnings from many companies. 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. For us at The London Company, we find comfort in the durable competitive advantages and financial health of our companies. We believe the strong cash flow generation and capital flexibility of our businesses should provide meaningful protection if market fundamentals continue to deteriorate.
We believe the strong cash flow generation and capital flexibility of our businesses should provide meaningful protection if market fundamentals continue to deteriorate.
As of 9/30/2022
Inception date: 12/31/1999. Past performance should not be taken as a guarantee of future results.