QTD Small Cap – 3Q2022 vs. R2000
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 for the Quarter
The London Company Small Cap portfolio declined -0.7% gross (-0.8% net) during the quarter vs. a -2.2% decrease in the Russell 2000. Outperformance was driven by positive stock selection, partially offset by negative sector exposure.
Our Small Cap portfolio outperformed the Russell 2000 in Q3, and remains ahead of our 75% downside capture expectations for the year.
The portfolio has continued to perform as it is designed to do, and it played solid defense amidst the market turmoil in Q3.
We believe the 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 has been an outsized beneficiary in the current environment, characterized by higher fuel margins and consumers seeking out value-prices at the pump. Management is diligently returning elevated cash flow back to shareholders through a heavy buyback program (shares outstanding down -9.5% y/y).
CTS Corp. (CTS) – CTS outperformed in Q3 after reporting strong quarterly results and increasing guidance. CTS has been able to leverage its fixed costs as it continues to win new contracts and scales the business, which has led to margin expansion. We remain attracted to CTS’ market share position in niche markets and management’s self-help initiatives.
Tempur-Sealy (TPX) – TPX rebounded in Q3 after underperforming in the first half of 2022. TPX’s 2Q22 results proved better than many feared as higher pricing partially offset volume declines. Despite the difficult market backdrop, TPX continues to take significant share and further establish its leading market position. TPX’s strong financial position has enabled investments in growth initiatives and significant share repurchases.
Top 3 Detractors from Relative Performance
Matson (MATX) – MATX trended lower in Q3 as its ocean freight services are beginning to feel the impact of a weaker macro environment. While 2Q22 results demonstrated continued momentum for their expedited China service, the transpacific freight market has quickly moderated from peak levels. Demand for retail-related goods has softened and ocean freight rates have declined in recent months. However, MATX’s success since the pandemic has enabled permanent volume additions in the China trade lane, a transformed balance sheet, and major share count reduction. It remains strategically positioned as a U.S. Jones Act shipping operator.
ACI Worldwide (ACIW) – ACIW reported 2Q22 numbers in-line with guidance; however, there was a negative reaction from investors related to the lumpiness of results, reflecting the timing of license renewals. ACIW has worked to reduce this through recurring revenue streams, but it has kept investors uneasy given the stock’s historical track record of missing guidance. We are attracted to the mission critical nature of ACIW’s products and the future growth potential as banks and retailers look to update payment software.
PriceSmart (PSMT) – PSMT underperformed the broader market in Q3 after reporting quarterly results that were challenged by an excess inventory of long lead-time items and markdowns that compressed margins. We view this challenge as temporary and are encouraged by PSMT’s commitment to work closely with local suppliers, which may limit this risk in the future. PSMT is posting healthy comparable sales growth and is pushing forward on opening new clubs across its existing markets.
We are bottom-up stock pickers, but sector exposures influenced relative performance as follows:
- What Helped: Underweight Financials & Utilities (two weaker performing sectors)
- What Hurt: Underweight Healthcare (a better performing sector) & overweight Real Estate (a weaker performing sector
Trades During the Quarter
- Exited: Energizer (ENR) – Sale reflects poor execution with recent M&A and the high debt level.
- Exited: Tejon Ranch (TRC) – Sale reflects limited liquidity and concerns about the ability to monetize the land value.
- Reduced: Murphy USA (MUSA) – Reduced on strength. Benefited from cost leadership position & rising oil prices.
- Increased: Essential Properties (EPRT) – Increased on weakness as we maintain confidence in the long-term thesis. EPRT maintains high occupancy with long-term lease agreements and price escalators.
- Initiated: Hanover Insurance (THG) – THG is an underwriter of property and casualty insurance, and distributes its policies exclusively via independent agencies. We believe the overall P&C industry is in the midst of a hard market, which means increasing pricing across most lines, and we think THG should benefit given its superior underwriting capabilities. THG possesses unprecedented visibility into its end-markets via its unique customer data collection technology that plugs into its partners’ agency management systems. This system provides improved risk selection capabilities and allows THG to be very discerning in where it wants to compete. Management has an excellent track record of capital allocation decisions and improving ROE. Further, we estimate THG’s balance sheet has never been stronger.
- Received Cash: ManTech (MANT) – Acquisition by The Carlyle Group closed.
- Initiated: IAA, Inc. (IAA) – IAA is a leading global digital marketplace that facilitates the marketing and sale of total-loss, damaged and low-value vehicles. IAA connects a full spectrum of sellers (including insurers, dealerships, fleet lease and rental car companies) with a global cohort of buyers (who seek parts and pieces they can repurpose) across 170 countries, creating a two-sided, scalable marketplace. IAA is a market leader in an oligopolistic industry. Volumes and higher fees on less damaged cars have translated to a low double-digit topline CAGR over the last 20 years. It’s asset-light with an attractive cost structure and sustainable margins. We believe recent weakness creates an opportunity to own an attractive business with wide moats, margin enhancement opportunities, and long-term secular industry tailwinds.
- Initiated: Vontier (VNT) – VNT is a collection of businesses that was spun out of Danaher. VNT services the transportation industry via two main segments: Mobility Technology (fueling infrastructure for convenience stores & IT solutions for the car wash industry) and Diagnostic & Repair Technology (complex vehicle repair diagnostics & aftermarket wheel service equipment). VNT is structurally advantaged as a market leader in highly consolidated industries with demonstrated pricing power, high barriers to entry & switching costs. VNT has a healthy balance sheet and generates significant free cash flow & strong ROC. The valuation is compelling, and we’re confident that product replacement cycles, emerging markets infrastructure buildouts & increased software adoption will drive retail fueling demand for many years.
- Received Cash: GCP Applied Technologies (GCP) – Acquisition by Saint Gobain closed.
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.
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: 9/30/1999. Past Performance should not be taken as a guarantee of future results.