QTD Mid Cap – 3Q2022 vs. RMC
Market Observations & Portfolio Commentary
Quarterly Market Update
U.S. equities declined for a third consecutive quarter in Q3 as tighter monetary policy from the Federal Reserve and decelerating economic growth led the market lower. The broader market, as measured by the Russell 3000 Index, declined 4.5%. Most of the data released during Q3 pointed to deceleration in the economy, but fortunately U.S. consumer fundamentals remain broadly solid. The Fed raised its benchmark rate by 75 basis points for a third consecutive meeting, and the pace of its quantitative tightening (balance sheet reduction) ramped up. The Fed’s hawkish commentary progressively ratcheted up during Q3, setting ‘higher for longer’ policy expectations to combat inflation. These hawkish moves were underpinned by stubbornly high inflation readings and a labor market that remains tight. Bond yields moved higher, and the U.S. dollar rose in value vs. almost every other currency, creating disruption abroad. The yield curve remained inverted at the end of the quarter.
Stocks traded lower across the market cap spectrum, but Small Caps outperformed Large Cap equities. The Growth indices outperformed the Value across the board, and cyclical stocks outperformed shares of more defensive companies. In terms of market factors that drove performance, Volatility factors had a positive impact, while Growth was neutral. Value, Yield, and Quality mostly presented headwinds.
Key Performance Takeaways
The London Company Mid Cap portfolio declined -4.3% gross (-4.4% net) during the quarter vs. a -3.4% decrease in the Russell Midcap. Stock selection was a headwind to performance, partially offset by positive sector exposure.
The Mid Cap portfolio struggled to keep pace with the robust, high beta-led bear market rally that dominated most of the quarter. The strategy played solid defense in September, as the market ultimately turned negative, but it wasn’t enough to offset weakness from earlier in the quarter.
Fortunately, the Mid Cap portfolio remains ahead of its benchmark year-to-date. Performance this year has been aided, in part, by a handful of acquisition announcements and activist investor involvement in some of our companies. We’ve been encouraged to see strategic buyers and institutional investors validate the strong value potential we see in our holdings.
We believe the portfolio is well positioned for a slowing economy and greater volatility in the months ahead
Top 3 Contributors to Relative Performance
STORE Capital (STOR) – STOR rallied after announcing the potential acquisition of the company by two private equity firms for $32.25 per share. The deal should close in early 2023.
Lamb Weston (LW) – LW continues to benefit from the recovery in overall French fry demand, higher attachment rates, and better than expected pricing. LW has performed well by focusing on pricing (up double digits for the quarter) and operational improvements with cost mitigation, reducing SKUs, and streamlining operations. This is a consolidated industry, and the long-term outlook remains very favorable. We remain attracted to LW’s market share, pricing power, and industry tailwinds
Vulcan Materials (VMC) – VMC outperformed during Q3 reflecting strong pricing power, dominant positions in local markets, and targeted exposure to high growth MSAs. We continue to view VMC’s pricing power through the cycle, exposure to publicly funded projects (42% of 2021 aggregates shipments) and strong balance sheet (2.5x net debt/EBITDA) as sources of downside protection. We believe VMC can continue to raise prices, and management communicated a favorable outlook for infrastructure spending and non-residential end markets. A slowdown in single-family residential housing (est. ~1/3 of sales) may be offset by accelerating infrastructure spending.
Top 3 Detractors from Relative Performance
CarMax (KMX) – KMX underperformed the broader market during Q3 as concerns around affordability and macro conditions worsened. Consumer spending on big-ticket discretionary items has slowed and consumer confidence has weakened. Despite the weak macro environment, KMX continues to gain market share and maintains high gross profits per unit. Management is focused on growing profitable market share in multiple channels by offering a seamless experience across all platforms. KMX continues to disrupt the used car ecosystem and we maintain our conviction in KMX.
Ball Corp (BLL) – 2022 has been a challenging year for BLL, between weaker than expected can volumes in the US, unfavorable weather and economics in Brazil, the Russian invasion of Ukraine, which forced BLL to sell its Russian operations at a discounted price, and FX headwinds. At its recent investor event, BLL reiterated its longer-term targets but acknowledged performance will likely be weaker in the near-term, doing little to improve sentiment. We continue to view BLL management favorably and view the beverage can industry as a rational oligopoly.
Hasbro (HAS) – HAS underperformed in Q3 after an earnings report that showed the Consumer Products segment continues to lag performance at its closest peer Mattel. Additionally, founder and President of eOne, will be leaving when his contract expires at year-end. Despite this, Hasbro management doubled down on owning this asset, which we feel investors view negatively. We attended HAS’ investor day in early October and believe the company has the potential to realize significant value by addressing the low-hanging fruit and allocating capital more appropriately.
We are bottom-up stock pickers, but sector exposures influenced relative performance as follows:
- What Helped: Underweight Real Estate & Communication Services (two weaker performing sectors)
- What Hurt: Overweight Cons. Staples & Materials (two weaker performing sectors)
Trades During the Quarter
- Received Cash: Citrix (CTXS) – At the end of September, the CTXS acquisition by private equity closed. We received cash for our shares.
- Increased: Steris (STE), Entegris (ENTG), AerCap (AER) & Old Dominion Freight Line (ODFL) – Added to four high conviction holdings on weakness, using excess cash in the portfolio. We are optimistic about the longer-term outlook for each business, but the stocks have all declined in sympathy with the broader market.
Conditions remain fragile. As the Fed attempts to navigate a soft landing, economic growth may continue to decelerate. The combination of persistently high inflation and a tight labor market mean additional rate hikes are likely; meanwhile, Quantitative Tightening is set to continue. We recognize the lagged impact of monetary policy on the broader economy, so the odds of a recession over the next 12-18 months remain elevated. On a positive note, the U.S. consumer remains in reasonably good shape (i.e. low unemployment, rising wages, excess savings, etc.) With consumer spending such an important part of U.S. GDP, the strong labor market could limit the downside risk to the economy over the next few months. That said, things could change quickly and higher rates may lead to slower growth and greater job losses. Longer term, we remain positive on the U.S. economy and expect annualized 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 do not attempt to time the market, but hope that much of the bad news is reflected in equity valuations after a 25% YTD decline in the broader Russell 3000 Index. That said, multiple compression may continue in the near term and a slowing economy may lead to weaker earnings from many companies. 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. For us at The London Company, we find comfort in the durable competitive advantages and financial health of our companies. We believe the strong cash flow generation and capital flexibility of our businesses should provide meaningful protection if market fundamentals continue to deteriorate.
We believe the strong cash flow generation and capital flexibility of our businesses should provide meaningful protection if market fundamentals continue to deteriorate.
As of 9/30/2022
Inception date: 3/31/2012. Past performance should not be taken as a guarantee of future results.