Market Observations & Portfolio Commentary

Large Cap – 3Q2023 vs. R1000

 

Quarterly 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 Large Cap portfolio declined 3.8% (-3.9% net) during the quarter vs. a 3.2% drop in the Russell 1000 Index. Headwinds from stock selection offset a benefit from sector allocation.

• The Large Cap portfolio came up short of our long-term 75-80% downside capture target in Q3. The lack of exposure to Growth factors and limited benefit from Quality factors (sustainably high returns on capital & lower leverage ratios) were headwinds. The relative advantage of Quality factors was most pronounced down the market cap spectrum. Returns for the Magnificent 7 (Tesla, Amazon, Meta, Alphabet, Nvidia, Microsoft, and Apple) had little impact on relative performance during the quarter, but the opportunity cost from underexposure to this group has been a major a headwind year-to-date.

 

Top 3 Contributors to Relative Performance 

• Alphabet (GOOG) – GOOG outperformed in Q3, reflecting better than expected Search revenue and sustainable momentum in Cloud. Search ad revenue accelerated sequentially and remains the largest contributor to topline growth. Slower expense growth helped margins as management continued to focus on long-term profitable growth. 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 generates strong returns.

• NewMarket (NEU) – NEU outperformed early in Q3 after a strong earnings report that showed some recovery in pricing and margins after a long period of higher base oil and chemical prices. The stock flattened out later in the quarter as oil prices rose. NEU also used stronger cash flow to repay debt and repurchase company shares.

• Old Dominion Freight Line (ODFL) – ODFL delivered significant positive performance during Q3 as a large LTL (less-than-truckload) competitor, Yellow Corp., began losing business ahead of a looming strike of its mostly unionized workforce. Yellow eventually filed for Chapter 11 bankruptcy, and ODFL made a bid for its terminal assets. The stock also responded positively as the lingering freight recession and inventory de-stocking showed some possible signs of coming to an end.

 

Top 3 Detractors from Relative Performance 

• Albemarle (ALB) – ALB underperformed due to declining lithium spot prices in the quarter. We remain attracted to ALB, reflecting its low cost position in two consolidated industries (lithium & bromine). However, we recognize quarterly results can be volatile, driven by short-term supply-demand dynamics for the underlying commodities. It is important to note that ALB’s favorable position on the cost curve means the company can likely maintain healthy profitability even at trough prices.

• Martin Marietta (MLM) – MLM underperformed during Q3 after a strong start to the year. Quarterly results revealed lower than expected aggregate shipments, which have been negatively impacted by a softer residential market and adverse weather. Despite shipment declines and ongoing input cost headwinds, MLM’s robust pricing strategy has led to material gross profit increases this year. MLM maintains a leadership position within aggregates and its exposure to key markets continue to give us confidence that it will benefit from growth in construction and infrastructure spending for many years.

• Norfolk Southern (NSC) – NSC underperformed during Q3 as the East Palestine, Ohio derailment has been a disruption for the company in terms of time and money. That said, the rail improved service levels during the quarter and has some tailwinds behind it, including industrial on-shoring pricing relative to truck, disruption in the freight market from Yellow and UPS, and continued service level improvement.

 

Sector Influence

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

• What Helped: Underweight Info. Technology (a weaker performing sector) & overweight Financials (a better performing sector)
• What Hurt: Underweight Energy (a better performing sector) & an overweight Materials (a weaker performing sector)

 

Trades During the Quarter

• There were no trades during the quarter.

 

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.

 

Weakness typically works its way up from the bottom. While the full benefits of Quality investing have recently been delayed at the Large Cap level, we don’t believe that they will be denied in the long-term.

 

Annualized Returns 

As of 9/30/2023

Inception date: 6/30/1994. Past performance should not be taken as a guarantee of future results. Performance is preliminary. Subject to change.