QTD Mid Cap – 1Q2023 vs. RMC
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.
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.
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.
As of 3/31/2023
Inception date: 3/31/2012. Past performance should not be taken as a guarantee of future results.