QTD Large Cap-2Q2022 vs. R1000V
Market Observations & Portfolio Commentary
Quarterly Market Update
US stocks posted double-digit declines during Q2 reflecting concerns about persistently high inflation, rising interest rates, and slowing global economic growth. For the quarter, the broader market, as measured by the Russell 3000 Index, declined 16.7%. Most of the data released during the quarter pointed to deceleration in the economy. On a positive note, the US consumer remains in reasonably good shape, buoyed by solid household balance sheets and a strong labor market. With regard to monetary policy, the Federal Reserve’s outsized focus on inflation led to a more aggressive pace of rate hikes following the liftoff in March. The specter of aggressive monetary policy, the broadening of tighter financial conditions, and growth concerns weighed on sentiment and exacerbated volatility in Q2.
Stocks were weak across the market cap spectrum with little difference in returns for Small, Mid, or Large companies. Value significantly outperformed Growth, and more defensive stocks outperformed more cyclical companies. In terms of market factors that drove performance, Value (lower valuation), Yield (higher), and Quality had a positive impact on relative returns. Volatility and Growth factors had a negative impact.
Key Performance Takeaways for the Year
The London Company Large Cap portfolio declined -13.4% gross (-13.5% net) during the quarter vs. a -12.2% decrease in the Russell 1000 Value. Sector exposure was a headwind to relative performance, partially offset by positive stock selection..
The Large Cap portfolio outperformed the Russell 1000 index but trailed the Russell 1000 Value benchmark in Q2. The lack of Energy exposure and few deep value holdings have been headwinds thus far in 2022 and the portfolio has lagged our downside capture expectations versus the Value index.
As a reminder, we note that short-term performance can be quite volatile with a concentrated portfolio. Over the long term, we expect roughly 85-90% upside capture in rising markets and 75% downside capture in falling markets. Keep in mind, the longer term numbers are still very attractive. We believe the portfolio is well positioned for a slowing economy and greater volatility and could make up additional ground in the months ahead.
Top 3 Contributors to Relative Performance
Progressive (PGR) – PGR outperformed during Q2 reflecting improved profitability in its latest quarterly results. PGR continues to execute its plan to slow premium growth in favor of maintaining its 96% combined ratio. Results in the Personal Auto Loss ratio have improved suggesting its pricing actions have continued to stick and rate hikes have been successful. PGR’s segmentation and virtuous cycle of risk selection should translate to a more profitable book coming out of this cycle.
FedEx (FDX) – FDX outperformed as investor sentiment improved following the handoff of the CEO role from founder Fred Smith to Raj Subramanium. As part of this transition, FDX announced a handful of initiatives to enhance shareholder value including improving management compensation plans, raising the dividend by over 50%, and improving its board structure and composition.
Air Products & Chemicals (APD) – APD’s international exposure and margin sensitivity to energy prices has been a headwind in the current environment; however, diligent pricing actions are starting to alleviate some of the margin pressure. APD took as high as 22% price increases in Europe in the most recent quarter, and believes continued actions will allow the company to return to its previous margin profile. Over 50% of APD’s businesses is under long-term take-or-pay contracts, which provides downside protection during volatile times. We view the recent announcement of on-site projects wins and new low-carbon hydrogen projects as positive.
Top 3 Detractors from Relative Performance
Apple (AAPL) – AAPL was weak during Q2 as rumors persisted that the company may dramatically trim its forecasts for iPhone production. COVID-based lockdowns in China were the leading contributor to the expectation of lagging sales. As the leading driver of the business, iPhone sales are very important to AAPL. We remain optimistic longer term about the outlook for iPhone as well as other AAPL products.
Alphabet (GOOG) – GOOG shares underperformed due to increasing macro risks and concerns around digital ad spending slowing. The latest quarter included headwinds from lower fees, Russia (1% of ad rev), FX rates, and difficult comps, yet GOOG posted strong double-digit top line growth and high incremental margins led by Search. GOOG’s capital allocation priorities have been favorable as the company continues to invest in the business and return capital to shareholders via its buyback program.
Charles Schwab (SCHW) – SCHW underperformed the broader market during Q2 reflecting concerns about higher interest rates leading to greater cash sorting from clients. Cash sorting involves clients moving cash in their accounts to money market accounts, which results in a reduction in net interest income to SCHW in the near term. Net interest income declines from client cash sorting as SCHW has to pay a higher rate on money market funds vs. very little interest paid on cash in client accounts. Longer term, higher interest rates should be a positive to net interest margin for SCHW as it finds better reinvestment options and client cash sorting normalizes. We remain attracted to SCHW for its strong competitive positioning ($7T in client assets on its platform) and the prospects for consistent growth in the future.
We are bottom-up stock pickers, but sector exposures influenced relative performance as follows:
- What Helped: Overweight Consumer Staples (a better performing sector) & underweight Financials (a weaker performing sector)
- What Hurt: Underweight Healthcare (a better performing sector) & overweight Info. Technology (a weaker performing sector)
Trades During the Quarter
- Reduced: Berkshire Hathaway (BRK.B) – We trimmed BRK.B on recent strength. We maintain strong conviction in the company, but decided to reduce the position to closer to 7% of the portfolio.
- Reduced: Altria (MO) – We trimmed MO on recent strength. We maintain confidence in our long term thesis, but decided to reduce the position to closer to 4% of the portfolio.
- Increased: Blackrock (BLK) – We added to BlackRock on recent weakness. BLK traded off with the broader equity market. With roughly 50% of its $9.6T in AUM tied to equities, we realize it will trade with the broader equity market. That said, we believe BLK is well positioned for continued growth in its various ETF products, generates attractive EBIT margins (over 35%), and maintains a strong balance sheet. With the recent downdraft in the stock, we believe current valuation is an attractive time to add to our long-term holding.
Risks remain in the near term as the Fed battles persistently high inflation and a tight labor market. We recognize the difficulty in navigating a soft landing, so the odds of a recession over the next 12-18 months have increased. Having said that, the resiliency of the US consumer should not be underestimated. Labor markets are historically tight and household balance sheets remain solid for now—powerful forces that can ballast the US economy. Longer term, we remain positive on the US economy and expect 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 note that multiple compression may continue reflecting both higher interest rates as well as higher than desired inflation. A slowing economy may also lead to weaker earnings for many companies. If the economy continues to decelerate or we experience a recession, we should assume many estimates of profitability will decline. 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. In recent years, companies with a high story-to-substance ratio were rewarded. Going forward, we believe attributes like a strong balance sheet and the ability to self-finance operations are poised to stand out as competitive advantages in a higher cost of capital environment. Longer term, we continue to believe that quality attributes and solid company fundamentals will lead to strong risk adjusted returns over time. The companies in London Company portfolios overall generate much higher returns on capital with stronger balance sheets at reasonable valuations relative to the broader market.
In recent years, companies with a high story-to-substance ratio were rewarded. Going forward, we believe attributes like a strong balance sheet and the ability to self-finance operations are poised to stand out as competitive advantages in a higher cost of capital environment.
As of 6/30/2022
Inception date: 6/30/1994. Past performance should not be taken as a guarantee of future results.
The Large Cap product is typically compared to the Russell 1000 Index. Any comparison to the Russell 1000 Value, or its corresponding ETFs, is for illustrative purposes only.
The London Company’s performances are size weighted and annualized based on calculations for the period ending June 30, 2022. 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. An investment in a London Company strategy is subject to risks, including the loss of principal.
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: June 30, 1994
Composite Definition: The Large Cap strategy invests mainly in conservative, low-beta, large-cap equities with a focus on above-average downside protection. Primarily we seek profitable, financially stable, quality large-cap companies, which consistently generate free cash flow, high returns on unleveraged operating capital, trade at rational valuations, and are run by shareholder-oriented management. Positions are generally in the market capitalization range of the major domestic large-cap indices. Accounts included in this product composite are fully discretionary taxable and tax-exempt portfolios with a minimum of $1 million in assets. The product is measured against the Russell 1000 Index and has a creation and inception date of June 30, 1994. 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. Composite may include accounts under dual contract.
Benchmark Description: Russell 1000 Index measures the performance of the large-cap segment of the U.S. equity universe. The Russell 1000 is a subset of the Russell 3000 Index and includes approximately 1,000 of the largest securities based on a combination of their market cap and current index membership. The Russell 1000 represents approximately 92% of the U.S. market. Benchmark returns are not covered by the report of independent verifiers. The Large Cap product is typically compared to the Russell 1000 Index. Any comparison to the Russell 1000 Value S&P 500, or their corresponding ETFs, is for illustrative purposes only.
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. For example, an account that earned 15% per year for 10 years would have an accumulated return of 305% before fees and 270% after fees, assuming a 1% fee. 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. In making an investment decision, individuals should utilize other information sources and the advice of their investment advisor.