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QTD Large Cap – 4Q2022 vs. R1000

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 for the Year

  • The London Company Large Cap portfolio returned 10.4% gross (10.3% net) during the quarter vs. a 7.2% increase in the Russell 1000. Outperformance was driven by stock selection, partially offset by sector exposure.

  • The Large Cap portfolio closed 2022 on a high note. It posted strong absolute & relative performance in Q4—exceeding expectations of 85-90% upside capture in a rising market. Strong performance from several large positions more than offset continued sector headwinds—particularly having zero Energy exposure.

  • 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 

  • 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.

  • 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.

  • O’Reilly Auto Parts (ORLY) – ORLY outperformed during Q4 reflecting share gains with Pro customers and solid do-it-yourself results. ORLY has been successful in passing on higher costs and customers have not traded down to lower-priced products. ORLY remains the gold standard for service, part 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 continues to return capital to shareholders through its buyback program.


Top 3 Detractors from Relative Performance 

  • Meta Platforms (META) – META underperformed the broader market during the brief period that we owned the shares in Q4. We sold the stock in October reflecting headwinds to topline growth along with concerns about future spending.

  • Alphabet (GOOG) – GOOG underperformed in Q4 reflecting the slowdown in digital ad spending and concerns around expense controls in a softening environment. The Search business decelerated sequentially and there is uncertainty in the ad business. YouTube continues to take ad dollar share from linear TV and the Cloud business continues to ramp up. Management started to right size the cost structure of the business by realigning resources, reducing the pace of hiring, and reallocating capex spending. GOOG has a solid balance sheet, significant market share, and has become more shareholder friendly with its capital allocation decisions.

  • CarMax (KMX) – KMX underperformed during the quarter due to concerns around vehicle affordability, worsening macro conditions, and mortgage delinquencies. Vehicle depreciation negatively affected the business, but helped affordability. Despite the weakening macro environment, KMX continues to maintain high gross profit per unit. Management’s cost-saving initiatives should help preserve profitability in this environment. KMX’s reinvestments in digital offerings and reconditioning processes should benefit the company over the long term. KMX continues to disrupt the used car ecosystem and we maintain our conviction in the stock.


Sector Influence

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

  • What Helped: Overweight Materials & Financials (two better performing sectors)
  • What Hurt: Overweight Cons. Discretionary (a weaker performing sector) & underweight Energy (the best performing sector)


Trades During the Quarter

  • Exited: Meta Platforms (META) – Exit reflects near term headwinds to topline growth and management’s plans for elevated spending. The stock underperformed the broader market over our holding period, reflecting numerous issues (Apple’s IDFA change, competition from TikTok, and a macroeconomic slowdown leading to weaker ad spending). While META faced headwinds to revenue growth, management remained intent on spending on numerous initiatives. While the spending could lead to strong growth in the future, the willingness to spend in the face of a more uncertain revenue outlook was a concern. There were no insider purchases from company executives on this weakness, which further reduced our conviction and led us to sell the shares.

  • Increased: Starbucks (SBUX) – We used excess cash to add to our existing SBUX position. We first purchased a roughly 2% position in SBUX in September. This addition brings the position size to roughly 3.5%.


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

4Q22 Large Cap vs Russell 1000 Annualized Returns

Inception date: 6/30/1994. Past performance should not be taken as a guarantee of future results.

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