QTD Income Equity – 3Q2023 vs R1000V

October 23, 2023

QTD Income Equity – 3Q2023 vs R1000

Market Observations & Portfolio Commentary

Income Equity – 3Q2023 vs R1000V

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% (-5.7% net) during the quarter vs. a 3.2% drop in the Russell 1000 Value Index. Both sector allocation and stock selection were headwinds to relative performance.
The Income Equity portfolio came up short of our long-term 75-80% downside capture target in Q3. Limited exposure to the Energy sector (the best performing sector), the persistent underperformance of higher yielding securities, and limited benefit from Quality factors (sustainably high returns on capital & lower leverage ratios) were headwinds.
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

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.
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’s 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 on CVX is roughly 3.5% and the company is planning to buy back over 5% of outstanding shares each year.
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

Apple (AAPL) – AAPL underperformed after management provided weaker than expected guidance for the next quarter. Sentiment on the stock also suffered reflecting antitrust concerns for large tech companies in the U.S. abroad. Lastly, China’s supposed ban on iPhone use at sensitive government facilities was another negative. We believe that Apple’s ecosystem remains healthy and is the primary source of its very wide competitive moat.
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 U.S. 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.

Sector Influence

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

What Helped: Underweight both Utilities & Health Care (two weaker performing sectors)
What Hurt: Underweight Energy (a better performing sector) & overweight Cons. Discretionary (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.

Looking Ahead

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.

Annualized Returns

As of 9/30/2023

Income Equity vs Russell 1000 Value 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.

Connect

Get in touch with us to get started on your journey

The London Company’s performances are size weighted and annualized based on calculations for the period ending September 30, 2023. 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.

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. As of July 1, 2022 The London Company redefined the composites to exclude all dual contract relationships and any potentially bundled fee scenarios. This policy is not retroactive, but will continue to apply going forward.

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. 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. An investment in a London Company strategy is subject to risks, including the loss of principal. Referenced strategies may not be suitable for all investors. The appropriateness of a particular strategy will depend on individual circumstances and objectives. In making an investment decision, individuals should utilize other information sources and the advice of their investment advisor.

You are now leaving The London Company’s website. The link below is provided as a convenience, and The London Company is not responsible for the content provided on the destination site.

Continue

By continuing on this site or clicking Yes to Accept, you agree to our use of cookies and other technologies to process your personal data to personalize your experience and for other purposes.