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QTD Small Cap – 2Q2024 vs. R2000

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Market Observations & Portfolio Commentary 

Small Cap – 2Q2024 vs. R2000

 

Market Update 

U.S. stocks posted mixed results during 2Q24. The broader market, measured by the Russell 3000 Index, rose 3.2% with gains concentrated in large companies with ties to spending on artificial intelligence. The S&P 500 reached new all-time highs during the quarter, but market breadth (a measure of how many stocks are participating in the rally) sharply declined once again. The Russell 2000 Small Cap Index was down 3.3%. Economic data released during the quarter reflected decelerating growth, some weakening in the labor market, and lower inflation, which collectively support the notion of rate cuts beginning in the next few months. Corporate earnings were solid, but there were signs of greater caution from consumers. Investors continued to favor Large Cap, Growth and Momentum factors, consistent with trends in recent quarters. Value and Yield factors continued to face headwinds, while Quality & Volatility had a mixed impact.

 

Key Performance Takeaways for the Quarter

  • The London Company Small Cap portfolio fell 5.8% (5.9% net) during the quarter vs. a 3.3% decrease in the Russell 2000 Index. During the quarter, a positive impact from sector allocation was offset by stock selection.

  • The Small Cap portfolio came up short of our 75-80% downside capture expectations in 2Q. Our focus on high Quality and low Volatility factors faced headwinds in a market favoring Momentum and Growth. Having no exposure to Utilities, the best performing sector, and weakness in some of the portfolio’s Consumer Staples, Healthcare, and Materials holdings were additional obstacles. For the year, the portfolio is outperforming its benchmark and exceeding our 85-90% upside capture expectations.

 

Top 3 Contributors to Relative Performance 

  • ACI Worldwide (ACIW) – We added to our ACIW stake in April and the stock subsequently outperformed during 2Q. ACIW started 2024 on good footing with organic volume growth running ahead of schedule. We have greater conviction that ACIW can sustainably command higher organic growth levels than it did a few years ago. We also note ACIW’s favorable capital allocation, as it reduced leverage to its lowest point in 10 years, and announced a large buyback plan representing ~10% of market cap.

  • Matson (MATX) – MATX ocean freight services are benefiting from rising shipping rates and improving market conditions. Global ocean freight pricing has been driven up by the ongoing disruption in the Red Sea, coupled with ramping peak season demand and healthier trade volumes. MATX’s success since the onset of the pandemic has led to permanent volume additions in the China trade lane, a transformed balance sheet, and significant share count reduction. MATX remains strategically positioned as a US Jones Act shipping operator and its expedited freight service continues to offer an attractive value proposition for its customers.

  • Murphy USA (MUSA) – Investors were cautious about the fuel market environment after MUSA’s 1Q report showed margin pressure in the face of steep fuel price increases. That trend reversed in 2Q with fuel prices falling ~15% peak to trough, leading to MUSA’s outperformance. While there is a level of short-term volatility in MUSA’s results due to fuel price fluctuations, we prefer to assess the business with a view to the long term. We continue to believe that the business is structurally improving and management’s favorable capital allocation policies should yield attractive shareholder returns.

 

Top 3 Detractors from Relative Performance 

  • Enovis (ENOV) – ENOV underperformed in 2Q due to slower than expected growth in orthopedic implants, exacerbated by integration headwinds from its recent Lima Corporate acquisition. Lima should strengthen ENOV’s competitive positioning, particularly within extremities, and provide attractive cross-sell opportunities in the future. The Reconstruction portfolio continues to generate healthy growth, while demand for ENOV’s industry leading bracing products has proven resilient. We have conviction that ENOV’s attractive and diversified portfolio of orthopedic offerings will help support a long runway for continued earnings growth.

  • Certara (CERT) – Investor skepticism around guidance for an improving revenue outlook intensified following CERT’s most recent earnings report, causing the stock to underperform the broader market. We believe CERT owns unique software assets in an underpenetrated industry with plenty of whitespace for future growth. We are encouraged to see them investing through the cycle to come out the other side with a larger salesforce, a more cohesive software platform, and more abilities for cross selling. These actions should further solidify their already leading and protected positioning in bio simulation.

  • Tempur Sealy (TPX) – TPX underperformed in 2Q as a weak bedding market weighed on recent results. Despite the challenging backdrop, TPX’s strong pricing power and significant share gains have helped dampen the negative volume impact. Recent investments in distribution, advertising, and product innovation lay the groundwork for future growth, while visibility into margin recovery is improving on the back of lower input costs and operational efficiencies. The planned acquisition of Mattress Firm has the potential to be materially accretive and strengthen TPX’s overall competitive position. However, the market appears to be pricing in skepticism that the deal will ultimately receive regulatory approval. Robust free cash flow generation, strong brand equity, and solid management execution support our investment thesis.

 

Sector Influence

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

  • What Helped: Underweight Energy (a weaker performing sector) & overweight Consumer Staples (a better performing sector)

  • What Hurt: Underweight Utilities (a better performing sector) & overweight Consumer Discretionary (a weaker performing sector)

 

Trades During the Quarter

  • Exited: Malibu Boats (MBUU) – Sale reflects concerns following the surprising resignation of the CEO.

  • Reduced: Masonite (DOOR) – Trimmed position ahead of pending acquisition by Owens Corning. DOOR was trading slightly below the proposed deal price.

  • Reduced: NewMarket (NEU) & Tempur Sealy (TPX) – Trimmed both stocks on strength. We’re slowly exiting TPX now that its market cap exceeds $8B.

  • Increased: ACI Worldwide (ACIW), Haemonetics (HAE), ePlus (PLUS), Atlantic Union Bank (AUB), Enovis (ENOV), Cannae Holdings (CNNE), Marten Transport (MRTN), & Essential Properties Realty Trust (EPRT) –No change to our long-term thesis in any of the holdings. Added on weakness, taking advantage of recent stock price changes.

  • Received Cash: Masonite (DOOR) – Acquisition by Owens Corning closed in an all cash transaction.

  • Initiated: Gates Industrial (GTES) – GTES is a leading global manufacturer of power transmission belts, fluid power products, and other critical components used in a variety of heavy industrial and automotive applications. Its industry leading position is supported by its quality reputation, established client relationships, product breadth, and history of successful innovation. Nearly 2/3 of revenues are generated from replacement demand, providing greater earnings stability through the cycle and a good source of downside protection. GTES’s favorable margin profile and limited capital needs enable strong free cash flow generation and high returns on capital. End market weakness have weighed on sentiment, but these headwinds are abating. At roughly 9x EV/EBITDA, we feel the risks are largely priced in and downside is limited.

  • Initiated: DoubleVerify (DV) – DV develops software platforms for digital media measurement, data, and analytics. DV sells a critical insurance-like product known as “ad verification,” designed to create transparency, eliminate fraud, and drive ad-spending optimization. Ad verification has reached a point of mass acceptance among digital ad buyers due to its measurable low cost/high reward value proposition. DV operates in a duopoly where it commands the leading market position (>50% market share), by focusing on product innovation rather than sales expansion. DV’s business should continue to benefit from secular tailwinds in digital advertising. Incremental revenue growth should be accretive to returns on capital, given the its high cash margins and minimal capex needs. We initiated our position following a pullback, allowing us to purchase an advantaged company growing at a double-digit rate, with high margins, at a market multiple.

 

Looking Ahead

Conditions are trending in a positive direction for the Fed to begin reducing rates. Inflation is still higher than the Fed’s target, but it has continued to drift lower. The labor market remains strong, but there have been some signs of weakening. Together with signs of weakness in some recent economic data, we could see the Fed shift to a less restrictive policy and reduce rates before year-end. While the odds of a recession in the near term have declined, risks remain. Longer term, we remain positive regarding the U.S. economy and expect real annualized GDP growth in the 1.5-2% range driven by growth in the labor force and improving productivity.

In terms of equities, we note that narrow, top-heavy markets are fragile markets. The odds of a recession have come down, but our cautious posture persists due to high valuations, market concentration, looming debt challenges, and the lengthiest inversion of the yield curve in history. Continued multiple expansion in a higher rate environment is unlikely. We suspect the S&P 500 will eventually track earnings, so we would expect more volatility, especially in stocks where a lot of growth is already priced in. We believe returns in the near term may be modest, with shareholder yield (dividends, share repurchase, debt reduction) comprising a significant percentage of the total return. In our view, this uncertain economic backdrop warrants an investment approach that prioritizes consistency and stability—not excessive wagers. Owning great businesses at reasonable prices and allowing them to compound is still a winning, long-term strategy.

 

Annualized Returns 

As of 6/30/2024

Small Cap - 2Q2024 vs. R2000 Annualized Returns

Inception date: 9/30/1999. Past Performance should not be taken as a guarantee of future results. Performance is preliminary. Subject to change.

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Disclosure Notes

 

The London Company’s performances are size weighted and annualized based on calculations for the period ending June 30, 2024. 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.

 

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 GIPS® Report 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.

 

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 London Company 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. Prior to April 1, 2024 returns are calculated gross of withholding taxes on foreign dividends and interest. Starting April 1, 2024, performance is calculated net or gross of foreign withholding taxes on dividends and interest income dependent on custodian data. Dividends are reinvested. The accounts represented in the composite reflect actual London Company fees paid on the particular account which may be different from the fee normally offered to other clients. 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. An investment in a London Company strategy is subject to risks, including the loss of principal.  Referenced strategies may not be suitable for all investors. The appropriateness of a particular strategy will depend on individual circumstances and objectives. In making an investment decision, individuals should utilize other information sources and the advice of their investment advisor.

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