QTD Small Cap-2Q2022 vs. R2000
Market Observations & Portfolio Commentary
Quarterly Market Update
US stocks posted double-digit declines during Q2 reflecting concerns about persistently high inflation, rising interest rates, and slowing global economic growth. For the quarter, the broader market, as measured by the Russell 3000 Index, declined 16.7%. Most of the data released during the quarter pointed to deceleration in the economy. On a positive note, the US consumer remains in reasonably good shape, buoyed by solid household balance sheets and a strong labor market. With regard to monetary policy, the Federal Reserve’s outsized focus on inflation led to a more aggressive pace of rate hikes following the liftoff in March. The specter of aggressive monetary policy, the broadening of tighter financial conditions, and growth concerns weighed on sentiment and exacerbated volatility in Q2.
Stocks were weak across the market cap spectrum with little difference in returns for Small, Mid, or Large companies. Value significantly outperformed Growth, and more defensive stocks outperformed more cyclical companies. In terms of market factors that drove performance, Value (lower valuation), Yield (higher), and Quality had a positive impact on relative returns. Volatility and Growth factors had a negative impact.
Key Performance Takeaways for the Quarter
The London Company Small Cap portfolio declined -10.4% gross (-10.5% net) during the quarter vs. a -17.2% decrease in the Russell 2000. Outperformance was drive by both positive stock selection and sector exposure.
The Small Cap portfolio performed as it’s designed to do and held up well against the market turmoil in Q2. The Small Cap portfolio meaningfully exceeded our 75% downside capture target for Q2, which helped the strategy outperform YTD.
Thus far, in 2022, it has been a tale of two quarters. During the atypical, valuation-driven sell-off in Q1, we received limited benefit from our Quality orientation. Fast forward to the risk-off atmosphere of Q2, and we benefited from the market’s increased attention to profitability, leverage levels, and credit risk. Periods like Q2 help validate our approach and highlight the benefits of protecting capital when it matters most. We believe the Small Cap portfolio is well positioned for a slowing economy and greater volatility in the months ahead.
Top 3 Contributors to Relative Performance
Murphy USA (MUSA) – MUSA benefited from the current environment, characterized by higher fuel margins and consumers seeking value at the pump. Management is diligently returning elevated cash flow back to shareholders through a heavy buyback program (shares down -9% y/y) and a small, but growing dividend.
White Mountains (WTM) – WTM performed well in the Q2 following the announced sale of its NSM division (specialty underwriter), capitalizing on a hot M&A market for insurance brokers. We believe management will continue to create value for shareholders with their opportunistic asset purchases and sales, as they have done for decades.
Landstar System (LSTR) – LSTR shares outperformed during Q2 as near term results were stronger than expected. Many investors had assumed a more challenging environment for trucking and logistics companies. LSTR’s highly variable cost structure allows it to navigate both up and down cycles without significant margin and return volatility.
Top 3 Detractors from Relative Performance
Matson (MATX) – After outperforming to start 2022, MATX trended lower in 2Q on fears that a potential slowdown in consumer spending and a retailer inventory build up would reduce demand for its expedited freight services. Ocean freight rates also began to moderate, adding to investor concerns. MATX continues to benefit from supply chain disruption and management was confident in the outlook for the remainder of 2022. We believe MATX is well positioned as the leader in its markets while offering an attractive value proposition relative to alternative freight services.
Evoqua (AQUA) – While there has been no indication of fundamental deterioration, AQUA’s exposure to growth and a levered balance sheet (3x net debt/EBITDA) likely weighed on sentiment amidst the market sell-off. Organic revenues grew double-digit% in the quarter and backlog grew even quicker. We appreciate the elements of downside protection in the name including 80% recurring revenues with over 90% renewal rates, structured into long-term contracts.
Tempur-Sealy (TPX) – TPX has been operating in a challenging market environment with slowing consumer demand and raw material inflation weighing on margins. Despite the difficult market backdrop, TPX continues to take significant share and is investing heavily in its various growth initiatives. Valuation remains compelling, and our investment thesis is supported by robust free cash flow generation, strong brand equity, and solid execution.
We are bottom-up stock pickers, but sector exposures influenced relative performance as follows:
- What Helped: Overweight Consumer Staples (a better performing sector) & underweight Info. Technology (a weaker performing sector)
- What Hurt: Underweight Utilities (a better performing sector) & overweight Cons. Discretionary (a weaker performing sector)
Trades During the Quarter
- Exited: Kaman (KAMN) – Sale reflects our concerns about slowing growth in its aircrafts parts business. In recent years, KAMN sold its Industrial business, which we were waiting for. The business is now focused more on aircraft parts, where we see slowing growth in its Fuze program and limited pricing power in its Structures division. With an outlook for modest growth and low EBIT margins (below 10%), we decided to sell the stock.
- Increased: Tempur-Sealy (TPX) – We added to TPX following weakness early in the year (stock down 40% YTD). We continue to believe TPX is well positioned as the leader in mattress manufacturing. TPX continues to invest heavily in future growth, and management is actively repurchasing shares, taking advantage of the attractive valuation of the stock.
- Increased: Masonite International (DOOR) – We added to our existing position in DOOR on weakness (the stock was down 33% YTD). Supply chain issues and concerns around rising interest rates reducing housing related spending have impacted the shares in recent months. We believe DOOR has pricing power and should post higher margins and returns on capital in the years ahead. The consolidated industry is attractive and DOOR maintains leading market share.
Risks remain in the near term as the Fed battles persistently high inflation and a tight labor market. We recognize the difficulty in navigating a soft landing, so the odds of a recession over the next 12-18 months have increased. Having said that, the resiliency of the US consumer should not be underestimated. Labor markets are historically tight and household balance sheets remain solid for now—powerful forces that can ballast the US economy. Longer term, we remain positive on the US economy and expect 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 note that multiple compression may continue reflecting both higher interest rates as well as higher than desired inflation. A slowing economy may also lead to weaker earnings for many companies. If the economy continues to decelerate or we experience a recession, we should assume many estimates of profitability will decline. 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. In recent years, companies with a high story-to-substance ratio were rewarded. Going forward, we believe attributes like a strong balance sheet and the ability to self-finance operations are poised to stand out as competitive advantages in a higher cost of capital environment. Longer term, we continue to believe that quality attributes and solid company fundamentals will lead to strong risk adjusted returns over time. The companies in London Company portfolios overall generate much higher returns on capital with stronger balance sheets at reasonable valuations relative to the broader market.
In recent years, companies with a high story-to-substance ratio were rewarded. Going forward, we believe attributes like a strong balance sheet and the ability to self-finance operations are poised to stand out as competitive advantages in a higher cost of capital environment.
As of 6/30/2022
Inception date: 9/30/1999. Past Performance should not be taken as a guarantee of future results.
The London Company’s performances are size weighted and annualized based on calculations for the period ending June 30, 2022. 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. Composite may include accounts under dual contract.
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.
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. For example, an account that earned 15% per year for 10 years would have an accumulated return of 305% before fees and 270% after fees, assuming a 1% fee. 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.