QTD Small Cap – 3Q2023 vs. R2000
Market Observations & Portfolio Commentary
Small Cap – 3Q2023 vs. R2000
Quarterly 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 for the Quarter
The London Company Small Cap portfolio declined 1.2% (-1.4% net) during the quarter vs. a 5.1% decrease in the Russell 2000 Index. Both sector exposure and stock selection were tailwinds.
The Small Cap portfolio protected well on the downside versus its benchmark and exceeded our long-term 75%-80% downside capture target. The Quality tilt (sustainably high returns on capital & lower leverage ratios) of the portfolio aided relative performance as numerous unprofitable companies (roughly 40%) of the Russell 2000 have significantly underperformed.
Top 3 Contributors to Relative Performance
Tempur Sealy (TPX) – TPX continued to outperform as quarterly results demonstrated solid execution in a challenging market environment. Industry volumes remain weak, but there are signs of sequential improvement. Strategic investments will allow for continued share gains as TPX launches new products, captures incremental wholesale opportunities, and spends more on advertising to support its premium brands. Valuation remains compelling and robust free cash flow generation, strong brand equity, and solid management execution support our investment thesis.
Qualys (QLYS) – QLYS reported solid 2Q23 earnings, including double-digit sales growth and an acceleration in bookings despite the challenging macroeconomic environment. QLYS continues to execute on their new go-to-market strategy, following the addition of a new Chief Revenue Officer. We have a strong conviction in QLYS’s ability to maintain its industry-leading profitability driven by a variety of cybersecurity products for small and medium sized businesses.
NewMarket (NEU) – NEU outperformed early in Q3 after a strong earnings report that showed some recovery in pricing and margins after a long period of higher base oil and chemical prices. The stock flattened out later in the quarter as oil prices rose. NEU also used stronger cash flow to repay debt and repurchase company shares.
Top 3 Detractors from Relative Performance
Enovis (ENOV) – ENOV declined in Q3 after outperforming to start the year. ENOV’s orthopedic implant portfolio continues to generate healthy growth and gain market share, while demand for its industry leading bracing products has proven resilient. More recently, concerns that weight-loss drugs might affect the number of orthopedic procedures longer-term have weighed on sentiment, but we believe that any impact is manageable and fails to consider offsetting positive factors. We have conviction that ENOV’s attractive and diversified portfolio of orthopedic offerings will help support a long runway for continued earnings growth.
Lancaster Colony (LANC) – LANC underperformed during Q3 reflecting expectations for slower growth in the future. Higher pricing has aided revenue growth in recent quarters, but those benefits are expected to moderate. Fortunately, the fundamentals at LANC remain strong. The company should realize tailwinds to margins and free cash flow over the next 12 months with capacity expansions complete, and mix continuing to shift towards margin-accretive volumes. LANC has attractive opportunities for growth, and a strong balance sheet (net cash) is available to support investment.
Ingevity (NGVT) – NGVT underperformed in Q3 after lowering full-year guidance reflecting unexpectedly persistent raw material cost inflation and soft demand in the company’s industrial specialties segment (part of the performance chemicals division). We believe the business is improving, as NGVT is investing in alternative fatty acid production capacity, which will enable the business to enter new markets, support a cost advantage, and enable feedstock selection. We believe this should provide better products for customers and enable the business to mitigate CTO (NGVT’s current key raw material) cost inflation. We believe NGVT’s current valuation is attractive (roughly 6.5x EV/EBITDA), and the company’s diverse product mix, growing pavement technology business, and monopoly position in activated carbon for automobiles provide ample downside protection.
We are bottom-up stock pickers, but sector exposures influenced relative performance as follows:
What Helped: Underweight both Health Care & Utilities (two weaker performing sectors)
What Hurt: Underweight both Energy & Financials (two better performing sectors)
Trades During the Quarter
Increased: Armstrong World Industries (AWI) – Added to the existing position on recent weakness. We remain confident in the long-term outlook for the business. We believe AWI trades at an attractive discount to intrinsic value.
Increased: Cable One (CABO) – Added to the existing position in CABO reflecting weakness in the shares and our comfort with the long-term thesis. We believe CABO trades at an attractive discount to intrinsic value.
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.
Looking ahead, 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 9/30/2023
Inception date: 9/30/1999. Past Performance should not be taken as a guarantee of future results. Performance is preliminary. Subject to change.