QTD Small Cap – 1Q2023 vs. R2000V

April 21, 2023

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 banks’ ‘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

The London Company Small Cap portfolio returned 7.7% gross (7.5% net) during the quarter vs. a -0.7% decrease in the Russell 2000 Value. 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 Value 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.
UniFirst (UNF) – UNF experienced a challenging quarter, resulting in management reducing guidance due to inflationary pressures. The reduction largely reflected higher expenses on leased merchandise and a lower than expected decline in energy prices. On a positive note, UNF finally found an opportunity to deploy its strong balance sheet via a larger acquisition (Clean Uniform), which has solid prospects for synergies and scale benefits.

Sector Influence

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

What Helped: Underweight Financials (a weaker performing sector) & overweight Cons. Discretionary (a better performing sector)
What Hurt: Underweight Utilities (a better performing sectors)

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.

Looking Ahead

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.

Annualized Returns

As of 3/31/2023

Inception date: 9/30/1999. Past performance should not be taken as a guarantee of future results.

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The London Company’s performances are size weighted and annualized based on calculations for the period ending March 31, 2023. 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: September 30, 1999

Composite Definition: The Small Cap strategy invests mainly in conservative, low-beta, small-cap equities with a focus on above-average downside protection. Primarily we seek profitable, financially stable small-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 small-cap indices. Accounts in this product composite are fully discretionary taxable and tax-exempt portfolios with a minimum of $100,000 in assets. The product is measured against the Russell 2000 Index and has a creation and inception date of September 30, 1999. 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. As of July 1, 2022 The London Company redefined the composites to exclude all dual contract relationship and any potentially bundled fee scenarios. This policy is not retroactive, but will continue to apply going forward.

Benchmark Description: Primary: Russell 2000 Index measures the performance of the small-cap segment of the U.S. equity universe. Russell 2000 is a subset of the Russell 3000 Index representing approximately 10% of the total market capitalization of that index. It includes approximately 2000 of the smallest securities based on a combination of their market cap and current index membership. Secondary: Russell 2000 Value Index measures the performance of the small-cap segment of the U.S. equity universe. It includes those Russell 2000 Index companies with lower price-to-book ratios and lower forecasted growth values. Benchmark returns are not covered by the report of independent verifiers. The Small Cap product is typically compared to the Russell 2000 Index. Any comparison to the Russell 2000 Value is for illustrative purposes only.

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. 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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