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 for the Year
The London Company Small-Mid Cap portfolio returned 5.0% gross (4.8% net) during the quarter vs. a 1.4% increase in the Russell 2500 Value. 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. Outperformance was attributable to the quality of the portfolio, its balance sheet strength, plus a lack of regional bank exposure—which is a meaningful part of the Russell 2500 Value index. Looking back at 2022’s valuation driven sell-off, balance sheet strength was more of a luxury than a necessity. Investors largely sought downside protection through cheap stocks, often overlooking fundamentals.
Flash forward to 2023, concerns over slowing growth and solvency led to investors bidding up companies with high interest coverage and fleeing highly levered companies. 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 LW should drive margins higher as input costs normalize. 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 & 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 lagged 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 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 & high switching costs.
STORE Capital (STOR) – The acquisition of STOR by GIC and Oak Street closed in Q1. 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.
We are bottom-up stock pickers, but sector exposures influenced relative performance as follows:
What Helped: Underweight Financials (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.
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.
As of 3/31/2023
Inception date: 3/31/2009. Past performance should not be taken as a guarantee of future results.