QTD Small Cap – 1Q2023 vs. R2000
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 for the Quarter
The London Company Small Cap portfolio returned 7.7% gross (7.5% net) during the quarter vs. a 2.7% increase in the Russell 2000. Both stock selection & sector exposure were tailwinds to relative performance.
The Small 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 2000 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
Vontier (VNT) – VNT outperformed during Q1, as the company continued to show progress on its portfolio transformation efforts while driving efficiencies in the core business. Quarterly results demonstrated strong demand for retail fueling products and carwash technology, while supply constraints began to ease. Management also announced encouraging 2023 guidance, as they appear to be moving beyond the notable electric vehicle headwinds that have weighed on sentiment. We believe VNT’s portfolio of highly profitable and resilient franchises remains well positioned to serve its large customer base with a variety of value-added solutions and to capitalize on emerging trends within the mobility market.
Evoqua Water Technologies (AQUA) – AQUA rallied after news of a pending acquisition by Xylem (XYL) in an all-stock transaction. The offer of 0.48 XYL shares per each AQUA share, implies an offer price of $52.30/share. The acquisition is expected to close by the middle of this year.
Tempur Sealy International (TPX) – TPX continued to outperform as quarterly results demonstrated solid execution in a challenging market environment, while bedding units appear to be stabilizing from record declines last year. Despite softer demand for bedding, TPX has been able to push price and gain significant market share, which has helped to offset sales declines. Management has taken advantage of its strong financial position to invest in various growth initiatives and return significant capital to shareholders. Valuation remains compelling, and our investment thesis is supported by robust free cash flow generation, strong brand equity, and solid management execution.
Top 3 Detractors from Relative Performance
LivaNova (LIVN) – LIVN underperformed in Q1 following a disappointing 4Q22 earnings update. Headline numbers were above expectations, but the company noted weaker than expected trends in new patient implants of the vagus nerve stimulator for epilepsy. Additionally, pipeline news was negative as LIVN announced plans to wind down the trial studying vagus nerve stimulation for heart failure due to futility. Overall, the news flow in the quarter was more negative than positive, but we continue to believe the market is undervaluing the core business, and we note that management has improved execution over the past few years in a tough environment.
Murphy USA (MUSA) – MUSA gave up some ground in Q1, after being a top outperformer in 2022. We do not believe this underperformance is due to any fundamental issues at the company, and point out that they reported favorable operating results in February. We are impressed by MUSA’s management team and applaud their thoughtful capital allocation model to return elevated cash flow back to shareholders through a heavy buyback program (shares down -12% y/y) and a small, but growing dividend.
White Mountains Insurance (WTM) – Shares of WTM underperformed, reflecting the recent turmoil triggered by SIVB and other banks. Meanwhile, that situation also brought additional scrutiny to accumulated other comprehensive income (AOCI) on other financial companies’ balance sheets, including insurers (who aren’t subject to the same duration mismatch as banks). As a result, insurers were down across the board, including WTM, resulting in relative underperformance. We do not believe the market fully appreciates the differences between bank balance sheets and insurer balance sheets.
We are bottom-up stock pickers, but sector exposures influenced relative performance as follows:
What Helped: Overweight Cons. Discretionary (a better performing sector) & underweight Healthcare (a weaker performing sector)
What Hurt: Underweight Info. Technology (a better performing sector) & overweight Real Estate (a weaker performing sector)
Trades During the Quarter
- Exited: Penske Automotive (PAG) – Continued with the sale of our remaining position. Rally in the shares over time resulted in a market cap >$10B, which is too large the for Small Cap portfolio.
- Initiated: Enovis (ENOV) – ENOV is an orthopedics medical technology company that provides products across the continuum of care, with segments including prevention, rehabilitation & reconstruction. ENOV has a strong competitive position within its prevention and rehabilitation product portfolios, which have strong brands and leading positions. Meanwhile, we believe ENOV’s reconstruction portfolio is underappreciated. Specifically, its unique technology, favorable product mix, and industry tailwinds have helped its implant portfolio gain share while growing significantly faster than the market over the last decade. We view ENOV as an attractive, smaller scaled player that continues to benefit from industry tailwinds and a favorable product mix. It generates solid free cash flow, has good runway to expand margins, and a healthy balance sheet.
- Received Cash & Shares: IAA, Inc. (IAA) & Ritchie Bros. (RBA) – The acquisition of IAA by RBA closed, and we received both cash and shares of RBA.
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: 9/30/1999. Past Performance should not be taken as a guarantee of future results.