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QTD Mid Cap-2Q2022 vs. RMC


Market Observations & Portfolio Commentary

Quarterly Market Update 

US stocks posted double-digit declines during Q2 reflecting concerns about persistently high inflation, rising interest rates, and slowing global economic growth. For the quarter, the broader market, as measured by the Russell 3000 Index, declined 16.7%. Most of the data released during the quarter pointed to deceleration in the economy. On a positive note, the US consumer remains in reasonably good shape, buoyed by solid household balance sheets and a strong labor market. With regard to monetary policy, the Federal Reserve’s outsized focus on inflation led to a more aggressive pace of rate hikes following the liftoff in March. The specter of aggressive monetary policy, the broadening of tighter financial conditions, and growth concerns weighed on sentiment and exacerbated volatility in Q2.

Stocks were weak across the market cap spectrum with little difference in returns for Small, Mid, or Large companies. Value significantly outperformed Growth, and more defensive stocks outperformed more cyclical companies. In terms of market factors that drove performance, Value (lower valuation), Yield (higher), and Quality had a positive impact on relative returns. Volatility and Growth factors had a negative impact.

 

Key Performance Takeaways for the Year

  • The London Company Mid Cap portfolio declined -9.0% gross (-9.1% net) during the quarter vs. a -16.9% decrease in the Russell Midcap. Outperformance was driven by both positive stock section and sector exposure.

  • The Mid Cap portfolio performed as it’s designed to do and held up well against the market turmoil in Q2. The Mid Cap portfolio meaningfully exceeded our 75% downside capture target for the quarter. This more than offset weakness in Q1, leading to year-to-date outperformance.

  • Thus far, in 2022, it has a been tale of two quarters. During the atypical, valuation-driven sell-off in Q1, we received limited benefit from our Quality orientation. Fast forward to the risk-off atmosphere of Q2, and we benefited from the market’s increased attention to profitability, leverage levels, and credit risk. Periods like Q2 help validate our approach and highlight the benefits of protecting capital when it matters most. We believe the Mid Cap portfolio is well positioned for a slowing economy and greater volatility in the months ahead.

 

Top 3 Contributors to Relative Performance 

  • Lamb Weston (LW) – LW had a good quarter led by the recovery in overall fry demand and better than expected pricing. Pricing actions have more than offset the higher costs per pound and demand for fries at quick service restaurants has rebounded significantly. The supply chain and global container headwinds have improved a bit, which has led to margins stabilizing.

  • Post Holdings (POST) – POST is benefitting from a bounce-back in demand for value cereal as consumers trade down in the current inflationary environment. Additionally, the Foodservice segment continues to recover from pandemic lows. Management is using the proceeds from the BellRing (BRBR) spin-off to pay down high rate debt.

  • Black Knight (BKI) – During Q2, BKI announced it entered into an agreement to be acquired by Intercontinental Exchange, Inc. BKI held up well relative to the market because of this pending acquisition, but there is skepticism about the prospects of the FTC approving the deal.

 

Top 3 Detractors from Relative Performance 

  • Entegris (ENTG) – ENTG underperformed during Q2 reflecting industry-wide challenges around raw material sourcing, supply chains, and increased inflationary costs. The demand side remains in good shape, specifically in leading-edge and high-performance computing, but there are concerns around deceleration. ENTG’s unit-driven business continues to outperform the market due to more chemicals needed and purity demands. ENTG has drastically increased its size and scale to become one of the most diversified players in the semi-materials industry

  • Skyworks (SWKS) – SWKS was weak during Q2 and YTD as rumors persisted that Apple (a large SWKS customer) was dramatically trimming its forecasts for iPhone production. There were also lingering investor concerns that Apple may bring RF semiconductor design and production in-house, thus rendering SWKS obsolete. For myriad reasons we believe that not only is this improbable, but we believe that industry structure makes it impossible.

  • Vulcan Materials (VMC) – While construction stocks were generally weak during Q2, VMC experienced a greater relative decline reflecting a dispute with the Mexican government over a quarry and port. VMC initially downplayed the issue, but ultimately the Mexican government did not grant the operating permit, which VMC estimates will cost them up to $100MM in EBITDA. While not devastating, this impact is certainly material and we expect VMC will have to fully resolve the issue before confidence in the stock is restored.

 

Sector Influence

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

  • What Helped: Overweight Consumer Staples (a better performing sector) & underweight Communication Services (the worst performing sector)
  • What Hurt: Having zero exposure to Utilities & Energy (the two best performing sectors)

 

Trades During the Quarter

  • Exited: Haemonetics (HAE) – Sale reflects near term challenges in the business and lingering concerns around the loss of a large client and what that could mean to competitive dynamics in the industry.
  • Increased: Hasbro (HAS) – Addition reflects attractive valuation, plus a recent proxy fight has led to some improvement in the Board, which we believe could give HAS better direction and help with growth in key segments. HAS trades at a considerable discount to the broader market despite stable growth and a solid history of dividend growth.
  • Exited: Sensata (ST) – Exit reflects supply chain issues in the global auto market, as well as exposure to China (over 20% of sales), where sales could remain weak for a while. Roughly 75% of ST’s operating profits are tied to the sale of components in autos and other vehicles. Longer term, the shift in the vehicle fleet to electric vehicles may be a headwind to company margins as ST is currently heavily exposed to combustible engines. We maintain a position in ST in our SMID portfolio, but elected to use the small position (<2%) as a source of funds for an initiation of a new position.
  • Reduced: Cincinnati Financial (CINF) – We trimmed CINF on strength. With the rally in the shares, CINF was close to 5% of the portfolio and its valuation was elevated.
  • Increased: Skyworks (SWKS) – We added to SWKS on weakness (down over 40% YTD). We believe SWKS remains well positioned and its relationship with Apple (50% of sales) remains solid. SWKS produces semiconductors for wireless handsets and other devices which should continue to post solid growth reflecting the rollout of 5G, greater data usage, as well as growth in the number of devices.
  • Initiated: Lennox International (LII) – LII is an HVAC and refrigeration OEM, heavily tilted to residential, and mostly selling into the North American market. HVAC is big ticket item but non-discretionary, which limits elasticity of demand. LII operates in an oligopoly with a two-tiered distribution system that fosters pricing power and barriers to entry. LII has demonstrated an ability to earn excess returns and generate impressive returns on capital, plus it has a solid balance sheet with room for optimization. LII has fallen out of favor due to concerns around the macro environment and the residential HVAC replacement cycle. Over the full cycle, however, we believe LII should be a solid compounder, and the negative sentiment presents a good entry point. Aiding its downside protection attributes is the fact that it is a stable business with a large and growing install base. Ultimately, we view LII as a high quality, mature industrial with pricing power, long-term tailwinds, and shareholder-friendly capital allocation.

 

Looking Ahead

Risks remain in the near term as the Fed battles persistently high inflation and a tight labor market. We recognize the difficulty in navigating a soft landing, so the odds of a recession over the next 12-18 months have increased. Having said that, the resiliency of the US consumer should not be underestimated. Labor markets are historically tight and household balance sheets remain solid for now—powerful forces that can ballast the US economy. Longer term, we remain positive on the US economy and expect 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 note that multiple compression may continue reflecting both higher interest rates as well as higher than desired inflation. A slowing economy may also lead to weaker earnings for many companies. If the economy continues to decelerate or we experience a recession, we should assume many estimates of profitability will decline. 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. In recent years, companies with a high story-to-substance ratio were rewarded. Going forward, we believe attributes like a strong balance sheet and the ability to self-finance operations are poised to stand out as competitive advantages in a higher cost of capital environment. Longer term, we continue to believe that quality attributes and solid company fundamentals will lead to strong risk adjusted returns over time. The companies in London Company portfolios overall generate much higher returns on capital with stronger balance sheets at reasonable valuations relative to the broader market.

Annualized Returns 

As of 6/30/2022

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

 

Disclosure Notes

The London Company’s performances are size weighted and annualized based on calculations for the period ending June 30, 2022. 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. Composite may include accounts under dual contract.

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. For example, an account that earned 15% per year for 10 years would have an accumulated return of 305% before fees and 270% after fees, assuming a 1% fee. 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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