QTD Income Equity – 3Q2023 vs R1000
Market Observations & Portfolio Commentary
Income Equity – 3Q2023 vs R1000
Quarterly Market Update
U.S. equities traded lower during Q3 reflecting rising long-term interest rates, higher energy prices, and growing acceptance of the higher for longer message from the Federal Reserve. After three consecutive quarterly gains, equities broadly declined, with the Russell 3000 Index down -3.3% in Q3. While there were headwinds, most of the economic data released during the quarter was better than expected, and the odds of a soft landing have improved.
While stocks traded lower across the market cap spectrum, shares of large companies held up best. For a third consecutive quarter this year, there was a preference for larger and growthier. On the opposite side of the spectrum, smaller and value-oriented equities fared worst in Q3. Energy was the best performing sector, bolstered by higher oil prices. Turning to market factors that influenced the broad market, Growth and Quality factors posted the best results in Q3, while Yield factors continued to generate the weakest returns. Value, Volatility, and Momentum factors had a mixed impact.
Key Performance Takeaways
The London Company Income Equity portfolio declined -5.6% gross (-5.7% net) during the quarter vs. a -3.2% decrease in the Russell 1000. Stock selection was a headwind to performance, partially offset by positive sector exposure.
The Income Equity portfolio came up short of our long-term 75-80% downside capture target in Q3. The lack of exposure to Growth factors, the persistent underperformance of higher yielding securities, and limited benefit from Quality factors (sustainably high returns on capital & lower leverage ratios) were headwinds. Returns for the Magnificent 7 (Tesla, Amazon, Meta, Alphabet, Nvidia, Microsoft, and Apple) had little impact on relative performance during the quarter, but the opportunity cost from underexposure to this group has been a major a headwind year-to-date.
Weakness typically works its way up from the bottom, and the relative advantage of Quality factors thus far has been most pronounced down the market cap spectrum. While the full benefits of Quality & Dividend investing have recently been delayed at the Large Cap level, we don’t believe that they will be denied in the long-term.
Top 3 Contributors to Relative Performance
Chevron (CVX) – CVX outperformed the broader market due to rising crude oil prices. While we do not make commodity price forecasts, we retain a high degree of confidence in CVX management to continue to run the company with a healthy degree of conservatism and discipline on capital structure and capital allocation. We expect CVX to maintain discipline through a high oil price environment and stick to its “higher returns, lower carbon” strategy. The dividend yield is roughly 3.5% and CVX is planning to buy back over 5% of outstanding shares each year.
Progressive (PGR) – PGR outperformed during Q3 reflecting strong pricing and positive reserve adjustments. Management continues to execute its plan to improve profitability despite continued inflationary pressures. 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.
Paychex (PAYX) – PAYX outperformed the broader market as the labor market for small- and medium-sized businesses has remained resilient. PAYX continues to grow profitably via record retention levels, selling a greater number of HR services to each client, and raising prices. PAYX’s float portfolio also benefits from higher interest rates, buffering results with a highly accretive income stream. A strong management team and a cash balance sheet offer additional elements of downside protection.
Top 3 Detractors from Relative Performance
Crown Castle (CCI) – CCI underperformed reflecting its relatively high debt levels (leading to higher interest expense), and a slowdown in capital spending from carriers. The slowdown in carrier capex was more abrupt than in previous cycles as all carriers decreased tower spending in unison. While carrier’s spending on 5G is expected to return to normalized levels, the long-term driver for tower activity is the significant growth in data traffic generated on US wireless networks. CCI has strong visibility on tower activity with 75% of leasing activity contracted under longer-term agreements and additional growth generated from new leasing activity. We like CCI’s stable revenue stream, long-term tailwinds on growth in data consumption, and its ability to return cash to shareholders through its dividend policy.
Texas Instruments (TXN) – TXN underperformed during Q3 after its earnings report showed a continued weak global demand picture for all end markets other than automotive. Near-term profits are being negatively affected by TXN’s long-term plan to build out its fab footprint to address what they see as longer-term stronger demand. Additionally, not having meaningful exposure to artificial intelligence applications affected sentiment on the stock.
Norfolk Southern (NSC) – NSC underperformed during Q3 as the East Palestine, Ohio derailment has been a disruption for the company in terms of time and money. That said, the rail improved service levels during the quarter and has some tailwinds behind it including industrial on-shoring pricing relative to truck, disruption in the freight market from Yellow and UPS, and continued service level improvement.
We are bottom-up stock pickers, but sector exposures influenced relative performance as follows:
- What Helped: Underweight Info. Technology (a weaker performing sector) & overweight Financials (a better performing sector)
- What Hurt: Underweight Energy (a better performing sector) & overweight Cons. Staples (a weaker performing sector)
Trades During the Quarter
Reduced: Verizon (VZ) – Trim reflects continuing competitive pressures. While we believe VZ maintains the highest quality network, the cost to maintain the network and aggressive competitive behavior may weaken VZ’s industry leading margins and returns on capital. We maintain a positive view, but acknowledge the headwinds.
Increased: Norfolk Southern (NSC) – Addition reflects the improved outlook for NSC as service issues from the Ohio derailment have been mostly resolved, and NSC should benefit from longer-term margin improvement initiatives. Volume growth should remain solid in the years ahead, as shipping via rail remains a low cost option and NSC is positioned well with a large network across the eastern US.
Initiated: Northrop Grumman (NOC) – NOC is a defense contractor across aerospace, nuclear, aeronautics, and cyberspace platforms. Barriers to entry are high in the defense industry, as are switching costs. We believe NOC is the most attractive defense name and well-positioned for outsized growth due to its portfolio alignment with future defense spending needs (i.e. classified space systems, nuclear triad, the B-21) and exposure to high-priority projects that rebuild and modernize defense systems. NOC’s scale, breadth of platform offerings, and long cycle contracts translate to strong visibility and high returns on invested capital. We believe it has compelling margin expansion opportunities and the potential to significantly increase free cash flow in the years ahead.
Increased: Philip Morris (PM) – Added to our position on recent weakness, reflecting optimism around future growth in reduced risk products including iQOS and Zyn.
Exited: Target (TGT) – We trimmed and ultimately exited our position in TGT during Q3, reflecting concerns around future consumer spending on discretionary items.
Exited: Pfizer (PFE) – We trimmed and ultimately exited our position in PFE during Q3, reflecting headwinds to future revenue growth from patent expirations, the cost of rebuilding its drug pipeline, concerns about the level of recent M&A activity as well as the sustainability of its COVID vaccine and treatments.
Reduced: Apple (AAPL) – Trim reflects its size in the portfolio and concerns about valuation based on near term profitability (over 20x EV/EBITDA). We continue to believe AAPL is one of the best businesses we own and should continue to benefit from strong brands, network effects, over 2 billion in installed devices, significant levels of R&D spending leading to new product generation, and a strong balance sheet. We believe a smaller position in the stock is prudent and may reduce overall risk to the portfolio.
As we head into the final months of 2023, the macro outlook remains increasingly uncertain. Potential positives include a strong labor market, rising wages, and lower inflation. Potential negatives include higher interest rates, elevated energy prices, tighter bank lending standards, and the drawdown of savings accumulated by consumers during the pandemic. While the odds of a recession over the next 12-18 months remain elevated, there are signs that suggest a soft landing may be possible. Predicting the future direction of the economy is always challenging, but we remain positive on the U.S. economy’s longer-term outlook.
In terms of the equity market, we recognize the difficulty in determining what investors have priced into stocks at a specific point in the economic cycle. Valuations based on near term earnings are somewhat elevated in the context of higher interest rates and a possible recession. Moreover, we still have a top-heavy market with narrow leadership in the richly valued Magnificent 7. Narrow markets tend to be fragile markets, and we continue to expect greater volatility in the months ahead. We believe that equity returns in the near term may be muted, with shareholder yield (dividends, share repurchase, debt reduction) comprising a significant percentage of the total return from equities. The companies in London Company portfolios generate sustainably high returns on capital, with low leverage ratios, at reasonable valuations relative to the broader market, and possess attractive shareholder yields. We believe these attributes provide us with a compelling advantage in a fragile market environment with elevated uncertainty.
As of 9/30/2023
Inception date: 12/31/1999. Past performance should not be taken as a guarantee of future results. Performance is preliminary. Subject to change.