QTD Mid Cap – 1Q2023 vs. RMC

April 21, 2023

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 Mid Cap portfolio returned 6.5% gross (6.4% net) during the quarter vs. a 4.1% increase in the Russell Midcap. Both sector allocation and stock selection were tailwinds to relative performance.
The Mid Cap portfolio produced strong relative and absolute performance that exceeded expectations. Performance was aided by strong stock selection and limited exposure to regional banks, which comprise a meaningful part of the Russell Midcap index.
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

Skyworks (SWKS) – SWKS shares significantly outperformed the broader market during Q1. Investor expectations were low reflecting fear of a slowdown in iPhones sales at Apple. SWKS derives 50-70% of revenue from AAPL in any given quarter, so any weakness at Apple can have a big impact on the financials of SWKS. The stock received a boost following earnings, as its more diversified wireless and non-wireless business performed strongly in terms of revenue growth and margin expansion. We own SWKS as it is one of a few global companies in the radio-frequency semiconductor market able to develop incredibly complex chips and supply customers with those chips at scale, while maintaining high margins and strong cash flow.
Copart (CPRT) – CPRT was one of the better performing stocks during Q1 reflecting market share gains. CPRT is benefiting from structural shifts in the industry such as an increase in vehicle complexity, higher repair costs, and stronger auction involvement from both domestic and international buyers. CPRT has leading market share in all of its markets and continues to widen its moat with capacity expansions. CPRT’s fundamentals and trends remain strong.
Entegris (ENTG) – ENTG rebounded in Q1 as the semiconductor industry showed signs of stabilization. We believe ENTG can continue to gain share due to its breadth of solutions, unit-driven business, and higher purity requirements. The transition of new technology and nodes will be tailwinds for some time. Over the years, ENTG has drastically increased its size and scale and expanded its addressable markets, becoming one of the most diversified players in the semi-materials industry. We remain attracted to the industry’s high barriers to entry, limited competition & high switching costs.

Top 3 Detractors from Relative Performance

M&T Bank (MTB) – MTB underperformed, along with other regional banks, on the failures of Silicon Valley Bank and Signature Bank and fear of broader contagion. Importantly, MTB has neither the same kind of client concentration risk nor duration risk that impacted Silicon Valley Bank. Particularly with respect to duration risk, MTB was an outlier in its conservatism with respect to buying shorter-term securities in a very low rate environment. MTB does have exposure to commercial real estate, including office real estate. While we do expect some elevated credit losses in this portion of the loan portfolio, we note MTB has historically been an effective manager of risk, and we remain confident that management has behaved with appropriate caution.
UniFirst (UNF) – UNF experienced a challenging quarter, resulting in management reducing guidance due to inflationary pressures. The reduction largely reflected higher expenses on leased merchandise and a lower than expected decline in energy prices. On a positive note, UNF finally found an opportunity to deploy its strong balance sheet via a larger acquisition (Clean Uniform), which has solid prospects for synergies and scale benefits.
Hasbro (HAS) – Both HAS and Mattel struggled this holiday season, seeing toy and game sales down over 20%. The inflation-pressed consumer spent less and sought out the largest promotions, and retailers left with excess inventory will place fewer orders in 2023. HAS set ambitious goals at its Investor Day to turn around the Consumer business, and execution against those initiatives will be paramount this year. A sale of the non-core eOne assets in 2023 should be accretive to margins and free up cash for higher return uses.

Sector Influence

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

What Helped: Underweight Financials & Energy (two weaker performing sectors)
What Hurt: Underweight Comm. Services & Info. Technology (two better 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: CBRE Group (CBRE) – CBRE is the largest commercial real estate (CRE) service provider in a highly fragmented, >$340B global market. It provides multiple integrated real estate services for owners and tenants including consulting, transactional work (property sales and leasing), facility management services, and more. The inflow of institutional investors and demand for outsourcing facility services are structural and secular tailwinds. CBRE is well positioned to benefit from these trends and gain share due to its impressive competitive advantages, which include unmatched scale, robust transaction data, service bundling capabilities, and its one-stop-shop offering for CRE needs. CBRE’s diversification strategy and shift in its advisory business have created better stability & higher quality earnings. Recent weakness created an opportunity for us to own the #1 player in an industry with long-term tailwinds and where scale is a key element of success.
Reduced: Lamb Weston (LW) – Trimmed on strength following a very strong rally over the last 15 months.
Increased: Black Knight (BKI) – Addition reflects BKI’s favorable long-term outlook, potential acquisition by Intercontinental Exchange (ICE) at a price much higher than the current market value, and large breakup fee ($725M) if ICE breaks the deal.

Looking Ahead

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.

Annualized Returns

As of 3/31/2023

Inception date: 3/31/2012. Past performance should not be taken as a guarantee of future results.

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The London Company’s performances are size weighted and annualized based on calculations for the period ending March 31, 2023. 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: March 31, 2012

Composite Definition: The Mid Cap equity strategy invests mainly in conservative, low-beta, mid-cap equities with a focus on above-average downside protection. Primarily, we seek profitable, financially stable mid-cap companies that consistently generate free cash flow, high returns on unleveraged operating capital, trade at significant discounts to their intrinsic values, and are run by shareholder-oriented management. Positions are usually within the market capitalization range of the major, domestic mid-cap indices. Accounts in this product composite are fully discretionary taxable and tax-exempt portfolios with a minimum of $100,000 in assets. This product is measured against the Russell Mid Cap Index and has a creation and inception date of March 31, 2012. 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. As of July 1, 2022 The London Company redefined the composites to exclude all dual contract relationships and any potentially bundled fee scenarios.

Benchmark Description: Primary: Russell Mid Cap Index measures the performance of the mid-cap segment of the U.S. equity universe. The Russell Mid Cap is a subset of the Russell 1000 Index. It includes approximately 800 of the smallest securities based on a combination of their market cap and current index membership. Secondary: Russell Mid Cap Value Index measures the performance of the mid-cap segment of the U.S. equity universe. It includes those Russell Mid Cap Index companies with lower price-to-book ratios and lower forecasted growth values. Benchmark returns are not covered by the report of independent verifiers.

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. 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.

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