QTD Large Cap – 3Q2022 vs. R1000V
Market Observations & Portfolio Commentary
Quarterly Market Update
U.S. equities declined for a third consecutive quarter in Q3 as tighter monetary policy from the Federal Reserve and decelerating economic growth led the market lower. The broader market, as measured by the Russell 3000 Index, declined 4.5%. Most of the data released during Q3 pointed to deceleration in the economy, but fortunately U.S. consumer fundamentals remain broadly solid. The Fed raised its benchmark rate by 75 basis points for a third consecutive meeting, and the pace of its quantitative tightening (balance sheet reduction) ramped up. The Fed’s hawkish commentary progressively ratcheted up during Q3, setting ‘higher for longer’ policy expectations to combat inflation. These hawkish moves were underpinned by stubbornly high inflation readings and a labor market that remains tight. Bond yields moved higher, and the U.S. dollar rose in value vs. almost every other currency, creating disruption abroad. The yield curve remained inverted at the end of the quarter.
Stocks traded lower across the market cap spectrum, but Small Caps outperformed Large Cap equities. The Growth indices outperformed the Value across the board, and cyclical stocks outperformed shares of more defensive companies. In terms of market factors that drove performance, Volatility factors had a positive impact, while Growth was neutral. Value, Yield, and Quality mostly presented headwinds.
Key Performance Takeaways for the Year
The London Company Large Cap portfolio declined -4.1% gross (-4.2% net) during the quarter vs. a -5.6% decrease in the Russell 1000 Value. Outperformance driven by positive stock selection, partially offset by negative sector exposure.
Our Large Cap portfolio exceeded our 75% downside capture target in Q3, but it remains behind the Russell 1000 Value index for the year.
Among the sector headwinds this year, having zero exposure to Energy and Utilities (the two best performing sectors) has had a negative impact on relative YTD performance of roughly 250bps and 55bps, respectively.
Importantly, long-term results remain very strong and the portfolio characteristics are very attractive vs. the Value index, reflecting superior Returns on Capital and much lower leverage ratios.
Looking ahead, we believe the portfolio remains well positioned for a slowing economy and greater volatility.
Top 3 Contributors to Relative Performance
STORE Capital (STOR) – STOR rallied after announcing the potential acquisition of the company by two private equity firms for $32.25 per share. The deal should close in early 2023.
O’Reilly Auto Parts (ORLY) – ORLY outperformed during Q3 led by share gains and the recovery in its Pro customers. Auto parts stocks have historically outperformed when consumers are experiencing higher inflation. However, lapping stimulus payments and the severity of winter weather along with the delay in spring weather impacted ticket count. ORLY remains the gold standard for service, parts availability, and logistics in this industry. The average age of cars on the road continues to rise and is now in the sweet spot for auto repairs and failures. ORLY has a strong balance sheet and recent insider buying activity has been favorable.
Charles Schwab (SCHW) – SCHW held up well despite the volatility in the market, as the company is a net beneficiary of rising rates through their banking arm. Client cash sorting also came in lower than expected in 2Q22. We like SCHW for its strong competitive positioning and the prospects for better monetizing on client assets going forward.
Top 3 Detractors from Relative Performance
FedEx (FDX) – FDX shares underperformed late in Q3 after the company significantly lowered guidance reflecting declining global shipping activity, as well as capacity issues in Asia and service problems in Europe. As a result, the company enacted an extensive multi-year restructuring plan to regain its competitive position. Further, it used $1.5 billion of capital to repurchase company shares after the downdraft.
Alphabet (GOOG) – GOOG underperformed the broader market due to increasing macro risks and concerns around a slowdown in ad spending. The Search business continues to remain resilient, but investors worry about the sensitivity and margin pressure during a slowdown as advertisers reduce spending. YouTube ad revenue is up more than 80% pre-Covid and Cloud is still in the early innings. 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. GOOG has a solid balance sheet, significant market share, and the stock trades at reasonable valuation (13x EV/EBITDA).
CarMax (KMX) – KMX underperformed the broader market during Q3 as concerns around affordability and macro conditions worsened. Consumer spending on big-ticket discretionary items has slowed and consumer confidence has weakened. Despite the weak macro environment, KMX continues to gain market share and maintains high gross profits per unit. Management is focused on growing profitable market share in multiple channels by offering a seamless experience across all platforms. KMX continues to disrupt the used car ecosystem and we maintain our conviction in the stock.
We are bottom-up stock pickers, but sector exposures influenced relative performance as follows:
- What Helped: Overweight Cons. Discretionary (a better performing sector) & underweight Real Estate (a weaker performing sector)
- What Hurt: Underweight Energy (a better performing sector) & overweight Info. Technology (a weaker performing sector)
Trades During the Quarter
- Initiated: Starbucks (SBUX) – SBUX is a retailer of specialty coffee with 33K stores across 83 markets, with 2/3s of its stores located in the US & China. The coffee industry has favorable tailwinds, and SBUX is very well positioned given its leading share (~60% US & ~40% globally), strong loyalty program, and pricing power. SBUX has extremely attractive unit economics and reinvestment opportunities with its owned stores, and it has additional high quality royalty income streams via partnerships with Pepsi and Nestle. SBUX has high margins, excellent returns on capital, and a very flexible balance sheet.
Conditions remain fragile. As the Fed attempts to navigate a soft landing, economic growth may continue to decelerate. The combination of persistently high inflation and a tight labor market mean additional rate hikes are likely; meanwhile, Quantitative Tightening is set to continue. We recognize the lagged impact of monetary policy on the broader economy, so the odds of a recession over the next 12-18 months remain elevated. On a positive note, the U.S. consumer remains in reasonably good shape (i.e. low unemployment, rising wages, excess savings, etc.) With consumer spending such an important part of U.S. GDP, the strong labor market could limit the downside risk to the economy over the next few months. That said, things could change quickly and higher rates may lead to slower growth and greater job losses. Longer term, we remain positive on the U.S. economy and expect annualized 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 do not attempt to time the market, but hope that much of the bad news is reflected in equity valuations after a 25% YTD decline in the broader Russell 3000 Index. That said, multiple compression may continue in the near term and a slowing economy may lead to weaker earnings from many companies. 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. For us at The London Company, we find comfort in the durable competitive advantages and financial health of our companies. We believe the strong cash flow generation and capital flexibility of our businesses should provide meaningful protection if market fundamentals continue to deteriorate.
We believe the strong cash flow generation and capital flexibility of our businesses should provide meaningful protection if market fundamentals continue to deteriorate.
As of 9/30/2022
Inception date: 6/30/1994. Past performance should not be taken as a guarantee of future results.