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QTD Income Equity – 4Q2022 vs R1000V

Market Observations & Portfolio Commentary

Quarterly Market Update 

U.S. stocks traded higher during Q4, reflecting softening inflation data and a slowdown in the pace of interest rate increases from the Federal Reserve. For the quarter, the broader market, as measured by the Russell 3000 Index, rose 7.2%. Q4 started strong following reports that broader inflationary pressures were beginning to moderate.  Shares reversed course in December as more hawkish commentary from the Fed led to falling prices. Fear of a pending recession remains high and the yield curve remained inverted at the end of the quarter. Stocks traded higher across the market cap spectrum led by strength in Mid Cap companies. Stylistically, Value had one of its strongest quarters of relative performance versus Growth since the popping of the Tech Bubble. Cyclical sectors generally had the edge over Defensive.

In terms of market factors that drove performance, Value (lower valuation) and Yield (higher) had a positive impact on relative returns. Volatility factors presented headwinds, while Growth, Quality, and Momentum factors had a mixed impact.


Key Performance Takeaways

  • The London Company Income Equity portfolio returned 9.9% gross (9.8% net) during the quarter vs. a 12.4% increase in the Russell 1000 Value. Both stock selection & sector exposure were headwinds to performance.

  • The Income Equity portfolio trailed the Russell 1000 Value in Q4 and came up just short of our longer-term expectations for 85-90% upside capture. The quarter, just like the year, was a historically strong period for large cap value—with Q4 being one of the best quarters for the Russell 1000 Value Index vs Growth since the popping of the Tech Bubble.

  • As was the case all year, our limited exposure to Energy, an overweight position in Information Technology, and a lack of deep value holdings were headwinds to relative performance.

  • Looking ahead, we believe the strong cash flow generation and capital flexibility of our businesses should provide meaningful protection if market fundamentals continue to deteriorate.


Top 3 Contributors to Relative Performance 

  • Air Products & Chemicals (APD) – APD reported favorable results in November that highlighted the stability in the business model through take-or-pay contracts and benefits of pricing power in a rational, oligopolistic industry. APD is pushing through 20%+ pricing increases that are helping them to recapture margin lost from energy inflation. Additionally, APD’s megaprojects in the U.S. have recently become more attractive, and new projects are reaching the return threshold to move forward, due to provisions for blue and green hydrogen included in the Inflation Reduction Act.

  • Blackrock (BLK) – BLK outperformed in Q4 after under-performing for the first three quarters of 2022. In the short term, BLK tends to trade with market sentiment due to the bulk of revenue tied to assets under management. Longer term, we see BLK as a high quality compounder that will likely outperform the asset management industry over full cycles. We remain attracted to BLK’s strong competitive positioning, low leverage, high margins, and healthy capital return. 

  • Merck (MRK) – MRK benefitted from strong earnings and defensive market positioning during Q4. MRK continues to leverage its strength in oncology with its leading Keytruda franchise, which has demonstrated success in earlier-stage launches and new combination therapies. MRK is also seeing continued momentum for its human papillomavirus vaccine, Gardasil, across its markets globally. We remain attracted to MRK’s strong bullpen of drugs and vaccines and believe MRK’s new leadership team can accelerate its drug pipeline and supplement growth with business development opportunities


Top 3 Detractors from Relative Performance 

  • Apple (AAPL) – AAPL shares consistently underperformed the broader market as the Fed raised rates, which caused a broad rotation out of technology stocks. Additionally, there has been concern about iPhone supply and demand as the global economy weakens and China grapples with a new round of Covid incidents. We continue to believe that AAPL has a wide moat thanks to its nearly impenetrable ecosystem of hardware and services.

  • Dominion Energy (D) – D underperformed in Q4 as the company announced results in-line with expectations, but surprised analysts by announcing a portfolio review, which will likely include some asset sales and may attempt to address the regulatory framework in Virginia. The announcement implies that the previously articulated medium-term EPS growth guidance should no longer be relied upon. In our view, many analysts and investors took a “shoot first” approach, selling on uncertainty. We note that management clearly stated that they will not be considering actions that would result in a cut to the dividend, and we believe it is better to get more color on the plan and reassess as opposed to reactively selling into negative sentiment.

  • Crown Castle (CCI) – CCI underperformed reflecting its relatively high debt levels and timing issues related to network equipment deployment. Higher interest rates continued to cause much of the multiple compression. The tower business continues to be resilient and activity is growing as carriers are spending to enhance networks and deploy spectrum. We believe CCI is in a good position for future growth in towers and should start to benefit from scaling the small cell business as co-located nodes deliver higher yields. 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.  


Sector Influence

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. Staples (a better performing sector)
  • What Hurt: Overweight Info. Technology (a weaker performing sector) & underweight Energy (the best performing sector)


Trades During the Quarter

  • Increased: Fidelity National Information Services (FIS) – Using excess cash, we elected to add to our existing position in FIS, reflecting the stock’s significant discount to our estimate of intrinsic value. The recent weakness in FIS’s merchant acceptance business has overshadowed the healthy growth trends within FIS’s banking & capital markets business, which represent 70% of revenues and boast long-term contracts with price escalators, high customer retention, and high switching costs. Using peer multiples for the banking and capital markets segments, FIS’s share price implied no value for the merchant acceptance business, despite its growing revenue and cash flow generation. We believe that valuation discount will correct over time. Finally, the stock offers a 2.7% dividend yield and the dividend was increased 20% during the year. Management plans to increase the dividend payout ratio with plans for another 20% dividend increase in 2023.


Looking Ahead

As we enter 2023, conditions remain fragile, and the lagged effect of 2022’s rate hikes and Quantitative Tightening (QT) may lead to further economic weakness. Inflation remains higher than desired, but inflation readings have improved from peak levels. Meanwhile, the labor market remains tight and the service side of our economy remains strong. As the Fed continues to balance its goals of stable pricing and full employment, additional rate hikes are likely early in the year. It is hard to predict what could happen longer term, but the message from the Fed is that rates will stay higher for longer. Much will depend on the level of inflation and the performance of the broader economy.

In terms of the equity market, we recognize the difficulty in determining what is already factored into stock prices at this point in the economic cycle. With higher interest rates likely, equity valuations may experience multiple compression, while a slowing economy may lead to weaker earnings from many companies. The next phase of this slowdown will likely hinge on the path of earnings, credit spreads, and employment. 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. Longer term, we continue to believe that quality attributes and solid company fundamentals will lead to strong risk-adjusted returns.


Looking ahead, we believe the strong cash flow generation and capital flexibility of our businesses should provide meaningful protection if market fundamentals continue to deteriorate.

Annualized Returns 

As of 12/31/2022

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.

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