Market Observations & Portfolio Commentary

Mid Cap – 2Q2023 vs. RMC

 

Quarterly Market Update 

U.S. stocks posted positive returns during Q2, with most of the gains generated during the month of June. The broader market, as measured by the Russell 3000 Index, returned 8.4%. Slowing inflation, optimism around the potential benefits of artificial intelligence (AI), and better than expected economic news driven by solid consumer spending combined to lift the market higher. While growth of the overall economy has slowed, a strong labor market with rising wages has allowed the economy to avoid a much anticipated recession.

Shares of larger, technology related companies led the equity market. Market leadership was narrow as seven large cap companies drove the Core and Growth indices. Market performance was bifurcated across the market cap spectrum, with Large and Mega Cap stocks materially outperforming. Style, sector, and factor leadership largely mimicked Q1. Growth continued to dominate Value, and the Growth-oriented Info Technology, Cons. Discretionary and Comm. Service sectors generally led across the market cap spectrum. Turning to market factors, companies exposed to Growth and Volatility factors (higher beta) posted the best results, while Yield and Value factors were laggards. Quality and Momentum factors had a mixed impact.

 

Key Performance Takeaways

• The London Company Mid Cap portfolio returned 10.3% gross (10.2% net) during the quarter vs. a 4.8% increase in the Russell Midcap Index. Both sector exposure and stock selection were tailwinds.

• The Mid Cap portfolio outperformed the Russell Midcap in Q2, and exceeded our 85-90% upside capture expectations. Despite headwinds from factor performance, the portfolio outperformed the benchmark in a strong market environment. As fundamentals have come under pressure down the market capitalization spectrum, our Quality orientation has stood out.

 

Top 3 Contributors to Relative Performance 

• Entegris (ENTG) – ENTG outperformed during Q2, gaining share in its end markets, while highlighting an improving outlook with a potential recovery later this year. Strong demand for mission-critical products, such as liquid filters, and the easing of supply chain constraints were highlights. Its value-added offerings allow for above-average growth relative to the rest of the industry across all cycles. ENTG has drastically increased its size and scale to become one of the most diversified players in the semi-materials industry. Management remains focused on debt reduction. We remain attracted to the industry’s high barriers to entry, limited competitors, and high switching costs.

• Vulcan Materials (VMC) – Strong pricing power, dominant positions in local markets, and targeted exposure to high growth metropolitan areas contributed to VMC’s outperformance in Q2. As the largest aggregates business in the country, VMC is well positioned to benefit from the Infrastructure Investment and Jobs Act over the next several years. We continue to view VMC’s pricing power through the cycle, exposure to publicly funded projects and strong balance sheet as sources of downside protection. We also believe Vulcan’s ongoing investments in technology and market intelligence should continue to support the business’s market leadership, pricing power, and best-in-class operations capabilities over the long-term.

• Lennox International (LII) – LII outperformed during Q2. While residential HVAC volume turned negative, current trends are consistent with expectations. Additionally, the new CEO is executing well against stated objectives, specifically, on restoring profitability of the Commercial segment. We are also supportive of management’s decision to sell the international business, which we viewed as a subscale distraction. We see LII as a high quality business in a good industry with opportunities to improve, and we are pleased to see the company effectively attacking opportunities for improvement.

 

Top 3 Detractors from Relative Performance 

• UniFirst (UNF) – UNF experienced a challenging environment with higher costs (rental garments and one-time items), and management reduced guidance reflecting sustained cost pressures. Margins remain meaningfully compressed relative to pre-pandemic levels. On a positive note, pricing remains strong, as customers seem to understand the justification of higher cost of service. We believe UNF should be able to normalize margin over time, due to the oligopolistic nature of the industry.

• Skyworks Solutions (SWKS) – SWKS underperformed during Q2 reflecting slowing growth at smartphone manufacturers. In the most recent quarter, gross margins were temporarily impacted by a cut in fab utilization and the rightsizing of higher inventories. Looking longer-term, we believe SWKS’s expertise in RF semiconductor design and manufacturing, coupled with its broadening product portfolio are enduring competitive advantages.

• Cincinnati Financial (CINF) – Shares of CINF underperformed in Q2 reflecting an intentional reduction in sales growth to focus on profitability. The broader property and casualty insurance subsector underperformed the market, and CINF was no exception, as many carriers struggle to keep up with cost inflation. We believe CINF has the financial discipline and the right strategy to return to prior underwriting margins.

 

Sector Influence

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

• What Helped: Overweight Industrials (a better performing sector) & underweight Utilities (a weaker performing sector)

• What Hurt: Overweight Cons. Staples & Materials (two weaker performing sectors)

 

Trades During the Quarter

• There were no trades this quarter.

 

Looking Ahead

Uncertainty remains high as we enter the second half of 2023. Continued progress on the inflation front is encouraging, and labor market strength may continue to underpin consumer resilience. That said, we note that core inflation remains above the Federal Reserve’s long-term target of 2%, and it is likely the Fed maintains a restrictive posture if the labor market strength continues. Importantly, monetary policy works with a lag, and we have probably not felt the full impact of prior rate increases or the full effects of tighter lending standards. We remain cautious, as the odds of a recession are still high and the risks of a credit crunch are elevated.

Narrow markets can be quite fragile. The concentrated, top-heavy nature of the market creates an environment prone to risk reversals, and we continue to expect greater volatility in the months ahead. In addition, valuations appear relatively high vs. history, despite concerns about a pending recession and higher interest rates. As inflation concerns subside, we believe growth and employment will come into greater focus. Since the October 2022 bear market low, 100% of the market’s rally has been attributable to P/E valuation multiple expansion. Meanwhile, earnings growth has been weak, and it could weaken further if we enter a recession. We may experience muted returns in the near term, given recession odds and elevated valuations. In that environment, companies that are higher quality, reasonably valued, and prudently returning capital to shareholders are likely better positioned. By that measure, we believe the attractive shareholder yields, quality value orientation and high active share of our portfolios provide us with a compelling advantage in a fragile market environment with elevated uncertainty.  

 

As we face an economic slowdown with a higher cost of capital environment, we believe companies with strong balance sheets and the ability to self-fund their operations should have a tangible advantage in 2023 and beyond.

Annualized Returns 

As of 6/30/2023

Inception date: 3/31/2012. Past performance should not be taken as a guarantee of future results. Performance is preliminary. Subject to change.