QTD SMID Cap-2Q2022 vs. R2500
Market Observations & Portfolio Commentary
Quarterly Market Update
US stocks posted double-digit declines during Q2 reflecting concerns about persistently high inflation, rising interest rates, and slowing global economic growth. For the quarter, the broader market, as measured by the Russell 3000 Index, declined 16.7%. Most of the data released during the quarter pointed to deceleration in the economy. On a positive note, the US consumer remains in reasonably good shape, buoyed by solid household balance sheets and a strong labor market. With regard to monetary policy, the Federal Reserve’s outsized focus on inflation led to a more aggressive pace of rate hikes following the liftoff in March. The specter of aggressive monetary policy, the broadening of tighter financial conditions, and growth concerns weighed on sentiment and exacerbated volatility in Q2.
Stocks were weak across the market cap spectrum with little difference in returns for Small, Mid, or Large companies. Value significantly outperformed Growth, and more defensive stocks outperformed more cyclical companies. In terms of market factors that drove performance, Value (lower valuation), Yield (higher), and Quality had a positive impact on relative returns. Volatility and Growth factors had a negative impact.
Key Performance Takeaways for the Year
The London Company Small-Mid portfolio declined -7.5% gross (-7.7% net) during the quarter vs. a -17.0% decrease in the Russell 2500. Outperformance was driven by positive stock selection, partially offset by negative sector exposure.
The Small-Mid Cap performed as it’s designed to do, and it meaningfully exceeded our 75% downside capture target for Q2. This more than offset weakness in Q1, leading to YTD outperformance. The lack of Energy exposure has been a big headwind YTD, and the primary reason why the portfolio slightly trails our downside capture expectations for the year.
Thus far, in 2022, it has been a tale of two quarters. During the atypical, valuation-driven sell-off in Q1, we received limited benefit from our Quality orientation. Fast forward to the risk-off atmosphere of Q2, and we benefited from the market’s increased attention to profitability, leverage levels, and credit risk. Periods like Q2 help validate our approach and highlight the benefits of protecting capital when it matters most. We believe the Small-Mid portfolio is well positioned for a slowing economy and greater volatility in the months ahead.
Top 3 Contributors to Relative Performance
Lamb Weston (LW) – LW had a good quarter led by the recovery in overall fry demand and better than expected pricing. Pricing actions have more than offset the higher costs per pound, and demand for fries at quick service restaurants has rebounded significantly. The supply chain and global container headwinds have improved a bit, which has led to margins stabilizing.
White Mountains (WTM) – WTM performed well in Q2 following the announced sale of its NSM division (specialty underwriter), capitalizing on a hot M&A market for insurance brokers. We believe management will continue to create value for shareholders with their opportunistic asset purchases and sales, as they have done for decades.
Post Holdings (POST) – POST is benefitting from a bounce-back in demand for value cereal as consumers trade down in the current inflationary environment. Additionally, the Foodservice segment continues to recover from pandemic lows. Management is using the proceeds from the BellRing (BRBR) spin-off to pay down high rate debt.
Top 3 Detractors from Relative Performance
Entegris (ENTG) – ENTG underperformed during Q2 reflecting industry-wide challenges around raw material sourcing, supply chains, and increased inflationary costs. The demand side remains in good shape, specifically in leading-edge and high-performance computing, but there are concerns around deceleration. ENTG’s unit-driven business continues to outperform the market due to more chemicals needed and purity demands.
First Industrial Realty (FR) – FR shares underperformed the broader market despite posting reasonably strong quarterly results. Tenant demand remains solid, and combined with a tight market, elevated rent growth should persist. However, investors remain concerned about Amazon slowing the rapid expansion of its fulfillment network.
Martin Marietta (MLM) – While MLM is experiencing strong underlying demand and positive pricing across all end markets, profitability continues to be impacted by significant cost inflation. Management expressed a favorable outlook for the remainder of the year on pricing acceleration, tightness in supply, and positive demand trends. The new infrastructure package also increases highway funding and provides greater visibility into future demand for aggregates.
We are bottom-up stock pickers, but sector exposures influenced relative performance as follows:
- What Helped: Overweight Consumer Staples & Materials (two better performing sectors)
- What Hurt: Underweight Utilities & Energy (two better performing sectors)
Trades During the Quarter
- Exited: GCP Applied Technologies (GCP) – GCP is set to be acquired by Saint Gobain, a French conglomerate, and the deal is expected to close by the end of the year. We elected to trim the position earlier in Q2 as it was trading close to the deal price. We ultimately sold the remaining position and used the proceeds to establish a new position
- Initiated: Lancaster Colony (LANC) – LANC is a manufacturer and distributer of specialty foods. The business is split between Retail and Foodservice. Most Foodservice sales are under private label products (i.e. Chick-fil-A sauces), and LANC serves 15/25 top national chains of quick service restaurants (QSR). Retail sales primarily leverage LANC’s owned brands such as Marzetti dips and Simply Dressed salad dressings, in addition to license agreements with brands such as Olive Garden, Buffalo Wild Wings and Chick-fil-A. Its higher margin licensing business is gaining traction with QSRs. LANC’s legacy retail brand portfolio holds #1 or #2 position in each of its categories, and few foodservice suppliers are capable of manufacturing at the scale needed to meet growing QSR demand. LANC has an impressive organic growth profile, and plans to shift its revenue mix toward license sales which could lead to higher overall margins. LANC is adding capacity for license products and the pipeline for similar deals appears vast. Other attractive characteristics include >20% insider ownership, member of founding family is Chairman, no debt on the balance sheet.
- Increased: Hasbro (HAS) – Addition reflects attractive valuation, plus a recent proxy fight has led to some improvement in the Board, which we believe could give HAS better direction in growing key segments. HAS trades at a considerable discount to the broader market despite stable growth and a solid history of dividend growth.
- Exited: BellRing (BRBR) – We eliminated the small position in BRBR that was spun out of Post Holdings.
- Reduced: Citrix (CTXS) – CTXS rallied in recent months following announcement it is being acquired by Vista Equity Partners and Evergreen Coast Capital. The deal should close mid-2022. With the proceeds from the trim, we initiated a new position.
- 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 with long-term secular tailwinds including a record number of vehicles in operation, a steady increase in the average age of cars on the road, and an increase in total loss frequency. The threat of new entrants is minimal given the technology investments, towing logistics, and land required to scale the business. Volumes and higher fees on less damaged cars have translated to a low double-digit topline CAGR over the last 20 years. The consignment business is an asset-light business 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.
Risks remain in the near term as the Fed battles persistently high inflation and a tight labor market. We recognize the difficulty in navigating a soft landing, so the odds of a recession over the next 12-18 months have increased. Having said that, the resiliency of the US consumer should not be underestimated. Labor markets are historically tight and household balance sheets remain solid for now—powerful forces that can ballast the US economy. Longer term, we remain positive on the US economy and expect real GDP growth in the 2-3% range driven by growth in the labor force and improving productivity.
In terms of the equity market, we note that multiple compression may continue reflecting both higher interest rates as well as higher than desired inflation. A slowing economy may also lead to weaker earnings for many companies. If the economy continues to decelerate or we experience a recession, we should assume many estimates of profitability will decline. 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. In recent years, companies with a high story-to-substance ratio were rewarded. Longer term, we continue to believe that quality attributes and solid company fundamentals will lead to strong risk adjusted returns over time. The companies in London portfolios overall generate much higher returns on capital with stronger balance sheets at reasonable valuations relative to the broader market.
As of 6/30/2022
Inception date: 3/31/2009. Past performance should not be taken as a guarantee of future results.
The London Company’s performances are size weighted and annualized based on calculations for the period ending June 30, 2022. 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. Composite may include accounts under dual contract.
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.
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. For example, an account that earned 15% per year for 10 years would have an accumulated return of 305% before fees and 270% after fees, assuming a 1% fee. 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.