QTD Large Cap – 1Q2023 vs. R1000
Market Observations & Portfolio Commentary
Quarterly Market Update
US equities finished mostly higher during Q1. The broader market, as measured by the Russell 3000 Index, returned 7.2%. Q1 began on a positive note as stocks rallied reflecting moderating inflation and hope that we were nearing the peak Fed funds rate. Major indices gave back some of their gains as Q1 progressed. The Federal Reserve continued to hike interest rates and Fed Chairman Powell reiterated the central bank’s ‘higher for longer’ posture. In March, the failure of both Silicon Valley Bank and Signature Bank led to fears of a broader banking crisis, and added another layer of uncertainty to an already cloudy economic outlook. Due to the flip-flopping of Fed expectations, treasury yield volatility surged. The two-year treasury yield actually dropped during Q1, marking the first quarterly decline in short-term yields since 2020.
Growth stocks across the market cap spectrum were the biggest beneficiaries of the drop in yields, led by Large Caps. From a sector standpoint, the notable outperformers during Q1 (Tech, Comm. Services & Cons. Discretionary) were the biggest laggards of 2022. Turning to market factors, Growth and Volatility factors were additive to returns, while Value and Yield were negative. Quality was mixed, but balance sheet strength/low leverage factors were rewarded as solvency concerns and fears of a recessionary hard landing escalated.
Key Performance Takeaways
The London Company Large Cap portfolio returned 2.7% gross (2.6% net) during the quarter vs. a 7.5% increase in the Russell 1000. Both stock selection & sector exposure were headwinds to relative performance.
The Large Cap portfolio came up short of our 85-90% upside capture expectations versus the Russell 1000. Headwinds from owning lower beta, higher quality holdings had a negative impact on relative performance. In addition, the concentration of the large cap core indices in a handful of names made relative performance more challenging. Seven stocks (Tesla, Amazon, Meta, Alphabet, Nvidia, Microsoft, and Apple) drove 73% of the total return for the Russell 1000—all P/E multiple expansion. Underexposure to this group was a headwind.
As we face an economic slowdown with a higher cost of capital environment, we take comfort in the durable profitability, strong free cash flow, and balance sheet flexibility of our companies.
Top 3 Contributors to Relative Performance
FedEx (FDX) – FDX shares rebounded in Q1 following weakness in 2022. FDX was able to exceed lowered earnings expectations on better cost containment including trimming management ranks. We continue to own FDX shares reflecting its global parcel and freight networks, as well as the company’s potential to improve operating results to peer levels that would create significant shareholder value.
Old Dominion Freight Line (ODFL) – ODFL outperformed during Q1, reflecting strong operating performance in a negative freight market. ODFL has a relentless focus on service and quality, which resonates with customers in good times and bad. Management’s focus on cost containment this quarter resulted in record levels of profitability, and the company continues to execute on its long-term growth plan. ODFL is widely held as one of the best franchises in transportation.
Alphabet (GOOG) – GOOG rebounded during Q1 along with other large technology companies. While the industry is facing a pullback in ad spending, GOOG continues to find ways to monetize the business and improve efficiency. Management is committed to reengineering the cost structure and growing revenues faster than expenses. GOOG continues to invest in ways to expand its ecosystem (search, cloud, AI, and hardware) with a larger focus on privacy and security. GOOG continues to repurchase shares, maintains a solid balance sheet, and is the share leader in its primary markets.
Top 3 Detractors from Relative Performance
Charles Schwab (SCHW) – Shares of SCHW were weak during Q1. Despite solid execution on asset gathering, all eyes are on the pace of cash sorting, which dominated the discourse around SCHW. More importantly, the broader banking concerns gave rise to a bear narrative that SCHW would face insolvency from bank runs and client cash sorting. We disagree and believe that SCHW has ample short-term financing to shield them from having to realize any losses on their securities book. In a sign of conviction, multiple members of senior management and the board all stepped up to purchase SCHW shares. While we acknowledge that there may be short-term headwinds to earnings from elevated cash sorting, SCHW’s long-term earnings power remains intact.
Norfolk Southern (NSC) – NSC was a significant underperformer this quarter reflecting weaker than expected quarterly earnings and news of a train derailment in Ohio. Fortunately, there were no fatalities related to the derailment, but there was environmental damage. Historically, the financial impact from train derailments have been relatively small and NSC’s insurance coverage could help cushion the blow. We believe NSC will emerge from this relatively unscathed, but will have to reinforce some of their network due to changes made from precision scheduled railroading efforts.
BlackRock (BLK) – BLK underperformed in Q1, but our conviction in BLK remains high based on the durability of its competitive position, an under-levered balance sheet, persistently strong profitability, and capital return. BLK has experienced some margin pressure on market-driven AUM declines, but has responded with cost control measures. We continue to view BLK as a well-run company that is likely to outperform the industry over the long term.
We are bottom-up stock pickers, but sector exposures influenced relative performance as follows:
- What Helped: Underweight Healthcare (a weaker performing sector) & overweight Cons. Discretionary (a better performing sector)
- What Hurt: Underweight Info. Technology (a better performing sector) & overweight Financials (a weaker performing sector)
Trades During the Quarter
Received Cash: STORE Capital (STOR) – Following the closing of the acquisition of STOR by two private equity firms, we received cash for our shares.
Initiated: Chevron (CVX) – CVX is an integrated energy and chemical producer. Its upstream segment explores for, produces, processes and transfers energy products. Its downstream segment refines and markets these products in addition to industrial plastics and fuel and lubricant additives. Among the major oil companies, CVX is the most levered to oil and gas production; it has one of the most successful exploration programs and among the best production profiles. CVX also has less exposure to the downstream business, which provides an above-peer operating margin profile and supports CVX’s return on invested capital. CVX has one of the strongest balance sheets in the oil industry with net debt/EBITDA of just 0.1x. The combination of its low cost positioning and strong balance sheet gives us greater confidence in downside protection despite its ties to a volatile commodity. We’re attracted to management’s rational approach to capital allocation, with consideration for the full cycle. In terms of capital allocation, CVX just announced a $75B share repurchase plan, and it pays a healthy 3.5% dividend. We have owned CVX in the past and it is the only Energy exposure in the Large Cap portfolio.
The destination of tamed inflation and normalized interest rate policy hasn’t changed, but now the path ahead is more treacherous. Going forward, economic growth appears set to overtake inflation as the main concern for investors. Even before the banking turmoil, the corporate earnings landscape was already on the precipice of decline due to the lagged effect of the Fed’s tightening. The addition of the banking crisis and tighter lending standards likely means the macro environment gets worse before it gets better, and the risk of recession has increased. That said, employment levels are high and wages are growing, reflecting a strong labor market, which is important for maintaining solid consumer spending and GDP growth.
In terms of the equity market, we recognize the difficulty in determining what investors have priced into stocks at this point in the economic cycle. Valuations based on near-term earnings are relatively high versus history, despite concerns about a pending recession and higher interest rates. We don’t think we’re out of the woods yet, and believe caution is still warranted. As economic growth may continue to decelerate, equity valuations may compress while earnings estimates could decline. We believe the quality of our portfolios provides us with a tangible advantage as we enter a world that is more unpredictable with greater economic volatility.
We believe the quality of our portfolios provides us with a tangible advantage as we enter a world that is more unpredictable with greater economic volatility.
As of 3/31/2023
Inception date: 6/30/1994. Past performance should not be taken as a guarantee of future results.