Market Observations & Portfolio Commentary

Mid Cap – 3Q2023 vs. RMC

 

Market Update 

U.S. equities traded lower during Q3 reflecting rising long-term interest rates, higher energy prices, and growing acceptance of the higher for longer message from the Federal Reserve. After three consecutive quarterly gains, equities broadly declined, with the Russell 3000 Index down -3.3% in Q3. While there were headwinds, most of the economic data released during the quarter was better than expected, and the odds of a soft landing have improved.

While stocks traded lower across the market cap spectrum, shares of large companies held up best. For a third consecutive quarter this year, there was a preference for larger and growthier. On the opposite side of the spectrum, smaller and value-oriented equities fared worst in Q3. Energy was the best performing sector, bolstered by higher oil prices. Turning to market factors that influenced the broad market, Growth and Quality factors posted the best results in Q3, while Yield factors continued to generate the weakest returns. Value, Volatility, and Momentum factors had a mixed impact.

 

Key Performance Takeaways

• The London Company Mid Cap portfolio declined 3.0% (-3.1% net) during the quarter vs. a 4.7% drop in the Russell Midcap Index. Outperformance was driven by positive stock selection, partially offset by headwinds from sector exposure.

• The Mid Cap portfolio protected well on the downside versus its benchmark in Q3 and exceeded our long-term 75%-80% downside capture target. The relative advantage of our Quality-orientation (sustainably high returns on capital & lower leverage ratios) has been strongest down the market cap spectrum, as numerous unprofitable companies of the Russell Midcap have significantly underperformed.

 

Top 3 Contributors to Relative Performance 

• Black Knight (BKI) – BKI rallied as it became clear that its pending acquisition by Intercontinental Exchange (ICE) would close. To allow the deal to close, BKI had to sell its Empower and Optimal Blue divisions. We sold BKI shares from the portfolio just before the closing of the ICE deal as the stock was trading close to the deal price.

• Lennox International (LII) – LII continued to perform well, reflecting a faster than expected recovery in its Commercial HVAC segment. We have been pleased with LII’s operational performance and progress on exiting non-core business lines since CEO, Alok Maskara, took over. While we remain attracted to the business longer term, we took advantage of strength and trimmed the position in the quarter.

• Old Dominion Freight Line (ODFL) – ODFL delivered significant positive performance during Q3 as a large LTL (less-than-truckload) competitor, Yellow Corp., began losing business ahead of a looming strike of its mostly unionized workforce. Yellow eventually filed for Chapter 11 bankruptcy, and ODFL made a bid for its terminal assets. The stock also responded positively as the lingering freight recession and inventory de-stocking showed some possible signs of coming to an end.

 

Top 3 Detractors from Relative Performance 

• Dollar Tree (DLTR) – DLTR’s underperformance in Q3 reflected ongoing profitability challenges brought on by an unfavorable mix shift toward lower margin consumables, shrink, and higher operating and remodeling costs. We believe the investments the business is making today will be supportive of improved profitability going forward, and that the challenges the business has faced recently are transitory in nature. DLTR’s management team now consists of the best operators in the retail industry, the business is well positioned to benefit in today’s economic climate, and we view the stock’s current valuation (roughly 10x EV/EBITDA) as attractive.

• Lamb Weston (LW) – LW underperformed after the company reported lower volumes and provided a cautious outlook. This sparked fears that the industry could have too much capacity as volumes slow. However, management has been clear that the majority of the lower volume for LW has been intentional by shedding lower margin contracts. On a positive note, the fry attachment rate remained high. We remain attracted to LW’s market share, pricing power, and industry tailwinds.

• Entegris (ENTG) – Following a strong first half performance, shares of ENTG underperformed during Q3 following lackluster guidance from management for the back half of the year. ENTG is gaining market share, but industry sales are down. Looking ahead, we believe ENTG is well positioned for future growth in semiconductor capital spending. We remain attracted to the industry’s high barriers to entry, limited competition, and high switching costs.

 

Sector Influence

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

• What Helped: Underweight both Health Care & Comm. Services (two weaker performing sectors)

• What Hurt: Underweight both Energy & Financials (two better performing sectors)

 

Trades During the Quarter

• Increased: M&T Bank (MTB) & Cincinnati Financial (CINF) – Addition reflects recent weakness in the shares and our confidence in the long-term thesis for both companies.
• Exited: Black Knight (BKI) – Sold our position on strength as the stock recently rallied after BKI announced plans to divest two divisions (Empower and Optimal Blue), which significantly increased the odds of the pending acquisition of BKI by Intercontinental Exchange (ICE). BKI shares were trading close to the deal price, so we decided to sell.
• Reduced: Lennox International (LII) – Trimmed our position on strength. LII is up over 50% so far in 2023.
• Initiated: Fidelity National Information Services (FIS) – FIS is a leading provider of technology services for financial institutions globally. The stock has underperformed in recent years, but we feel FIS is attractive following the announcement of the sale of a majority stake in Worldpay, its merchant acquiring business. The pending sale should enable greater financial flexibility and operational focus for the two separate companies. FIS’s Banking Solutions segment is comprised of outsourced central account processing and back-office technology infrastructure for banks, while FIS’s Capital Markets business offers industry-specific software for a variety of financial services firms. Collectively, these business units are characterized by long-term contracts, strong client retention, high recurring revenue and >40% EBITDA margins. A recovery in the stock will take time, but we believe the odds of success are high, given its greater focus on the banking and capital markets businesses. Its compelling sum-of-the-parts valuation gives us further confidence in downside support.
• Initiated: Waters Corporation (WAT) – WAT designs, manufactures, sells, and services high-performance liquid chromatography (HPLC), mass spectrometry (MS), and thermal analysis technologies. These solutions are critical for analyzing substances, making them invaluable tools in R&D and quality control processes for industries like pharmaceuticals, life sciences, and food & beverage. Sources of moat include its entrenched leadership position, the heavily regulated nature of drug production, high switching costs, & its Empower software—which is the standard in HPLC Quality Assurance/Quality Control settings. WAT is a good fit to The London Company process, given its strong balance sheet, predictable cash flows (~60% recurring revenue), and compelling economic moat. WAT has a diverse customer base and a global footprint, and we believe its reputation, with a history of innovation, positions it favorably for long-term growth.

 

Looking Ahead

As we head into the final months of 2023, the macro outlook remains increasingly uncertain. Potential positives include a strong labor market, rising wages, and lower inflation. Potential negatives include higher interest rates, elevated energy prices, tighter bank lending standards, and the drawdown of savings accumulated by consumers during the pandemic. While the odds of a recession over the next 12-18 months remain elevated, there are signs that suggest a soft landing may be possible. Predicting the future direction of the economy is always challenging, but we remain positive on the U.S. economy’s longer-term outlook.

In terms of the equity market, we recognize the difficulty in determining what investors have priced into stocks at a specific point in the economic cycle. Valuations based on near term earnings are somewhat elevated in the context of higher interest rates and a possible recession. Moreover, we still have a top-heavy market with narrow leadership in the richly valued Magnificent 7. Narrow markets tend to be fragile markets, and we continue to expect greater volatility in the months ahead. We believe that equity returns in the near term may be muted, with shareholder yield (dividends, share repurchase, debt reduction) comprising a significant percentage of the total return from equities. The companies in London Company portfolios generate sustainably high returns on capital, with low leverage ratios, at reasonable valuations relative to the broader market, and possess attractive shareholder yields. We believe these attributes provide us with a compelling advantage in a fragile market environment with elevated uncertainty.

 

Annualized Returns 

As of 9/30/2023

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