QTD SMID Cap – 1Q2023 vs. R2500

April 21, 2023

QTD SMID Cap – 1Q2023 vs. R2500V

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 bank’s ‘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-Mid Cap portfolio returned 5.0% gross (4.8% net) during the quarter vs. a 3.4% increase in the Russell 2500. Sector exposure was a tailwind while stock selection had a slightly negative impact on relative results.
The SMID portfolio produced strong relative and absolute performance that exceeded expectations. Performance was aided by strong stock selection and having zero exposure to regional banks, which comprise a meaningful part of the Russell 2500 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

Churchill Downs (CHDN) – CHDN outperformed Q1 as the company continues to execute well and allocate capital effectively. Of note, in 4Q last year, CHDN closed the $2.75B acquisition of Peninsula Pacific Entertainment (P2E), expanding its gaming and historical racing footprint. P2E followed smaller historical racing acquisitions in New Hampshire and Kentucky. Separately, the profitability of CHDN’s Twinspires online betting business has improved dramatically, and Kentucky just passed a bill legalizing sports betting, which we expect to be a positive development for CHDN. Overall, we continue to be impressed with the durable cash flows from CHDN’s various gambling businesses and we remain confident in the ability of management to add value through capital allocation.
Lamb Weston (LW) – LW’s outperformance was driven by solid quarterly results, which included double-digit pricing actions, healthy demand, and higher productivity. Productivity savings helped generate higher incremental margins and the company should drive margins higher as input costs normalize. The fry attachment rate remains above pre-pandemic levels. This is a consolidated industry and the long-term outlook remains very favorable. We remain attracted to LW’s market share, pricing power, and industry tailwinds.
Entegris (ENTG) – ENTG rebounded in Q1 as the semiconductor industry showed signs of stabilization. We believe ENTG can continue to gain share due to its breadth of solutions, unit-driven business, and higher purity requirements. The transition of new technology and nodes will be tailwinds for some time. Over the years, ENTG has drastically increased its size and scale and expanded its addressable markets, becoming one of the most diversified players in the semi-materials industry. We remain attracted to the industry’s high barriers to entry, limited competition, and high switching costs.

Top 3 Detractors from Relative Performance

MBIA (MBI) – MBI no longer writes new municipal bond insurance, but the stock can move based on potential changes in the value of outstanding liabilities. In the latest quarter, there was some concern about the regulatory approval of the MBI’s last pending settlement in Puerto Rico (PREPA utility). MBIA has $2.4B in claims paying resources available to cover any remaining exposure to Puerto Rico, which is in the range of $700M. Separately, MBI management engaged Barclays to review strategic alternatives. Looking ahead, we believe that the company will be acquired or will continue to run-off the remaining liabilities in the near term.
Jack Henry (JKHY) – JKHY underperformed the broader market during Q1 after reporting lower de-conversion fees as well as weaker card processing revenue. Negative banking headlines also pressured the stock. JKHY continues to win new accounts from the competition and expand margins. It has limited direct banking exposure as it generates revenue based on assets, accounts, transactions, or monthly active users. We remain confident in management’s ability to execute and believe the business model is very attractive with recurring revenue, long-term contracts, and high switching costs.
STORE Capital (STOR) – The acquisition of STOR by GIC and Oak Street closed in Q1. Shares of STOR lagged in a rising market as the deal had rallied on the date of the announcement and were essentially flat until the deal closed.

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 Cons. Discretionary (a better performing sector)
What Hurt: Underweight Info. Technology & Comm. Services (two better performing sectors)

Trades During the Quarter

Received Cash: STORE Capital (STOR) – Following the closing of the acquisition of STOR by two private equity firms, we received cash for our shares.
Increased: Broadridge (BR) – Added to position using proceeds from STOR acquisition. Addition reflects our conviction in the long-term thesis for BR.
Increased: Jack Henry (JKHY) – Added to position using proceeds from STOR acquisition. Addition reflects our conviction in the long-term thesis for JKHY.
Initiated: Murphy USA (MUSA) – MUSA is the 6th largest fuel retailer nationally with most of its store network in Walmart parking lots or built in close proximity to high-traffic retailers. MUSA operates a low‐price, high-volume strategy and has an advantaged cost structure, due to its small footprint stores and high fuel volumes. This differentiated model has led to MUSA selling 3x the fuel volumes and 4-5x the merchandise volume of an average fuel retailer. MUSA is able to source fuel competitively and at an advantage to peers, due to its retention of the essential components of Murphy Oil’s (former parent company) midstream/downstream business. This vertical integration allows MUSA to maintain lower prices when there is volatility in the underlying commodity price. The company maintains a strong balance sheet and has a favorable track record of returning capital to shareholders. Since the spin-off from Murphy Oil in 2013, MUSA has repurchased roughly 50% of its outstanding shares.
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: 3/31/2009. Past performance should not be taken as a guarantee of future results.

Connect

Get in touch with us to get started on your journey

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: March 31, 2009

Composite Definition: The Small-Mid Cap strategy is an extension of our Small Cap strategy with weighted market capitalization higher than our Small Cap portfolio, and is within the market capitalization ranges of the major domestic small to mid-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 2500 Index and has a creation and inception date of March 31, 2009. 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 dual contract relationships and any potentially bundled fee scenarios. This policy is not retroactive, but will continue to apply going forward.

Benchmark Description: Primary: Russell 2500 Index measures the performance of the small to mid-cap segment of the U.S. equity universe, commonly referred to as “smid” cap. Russell 2500 is a subset of the Russell 3000 Index. It includes approximately 2500 of the smallest securities based on a combination of their market cap and current index membership. Secondary: Russell 2500 Value Index measures the performance of the small to mid-cap segment of the U.S equity universe. It includes those Russell 2500 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-Mid Cap product is typically compared against the Russell 2500 Index. Any comparison to the Russell 2500 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.

You are now leaving The London Company’s website. The link below is provided as a convenience, and The London Company is not responsible for the content provided on the destination site.

Continue

By continuing on this site or clicking Yes to Accept, you agree to our use of cookies and other technologies to process your personal data to personalize your experience and for other purposes.