QTD SMID Cap – 2Q2023 vs. R2500

July 19, 2023

QTD SMID Cap – 2Q2023 vs. R2500V

Market Observations & Portfolio Commentary

SMID Cap – 2Q2023 vs. R2500

Quarterly Market Update

U.S. stocks posted positive returns during Q2, with most of the gains generated during the month of June. The broader market, as measured by the Russell 3000 Index, returned 8.4%. Slowing inflation, optimism around the potential benefits of artificial intelligence (AI), and better than expected economic news driven by solid consumer spending combined to lift the market higher. While growth of the overall economy has slowed, a strong labor market with rising wages has allowed the economy to avoid a much anticipated recession.

Shares of larger, technology related companies led the equity market. Market leadership was narrow as seven large cap companies drove the Core and Growth indices. Market performance was bifurcated across the market cap spectrum, with Large and Mega Cap stocks materially outperforming. Style, sector, and factor leadership largely mimicked Q1. Growth continued to dominate Value, and the Growth-oriented Info Technology, Cons. Discretionary and Comm. Service sectors generally led across the market cap spectrum. Turning to market factors, companies exposed to Growth and Volatility factors (higher beta) posted the best results, while Yield and Value factors were laggards. Quality and Momentum factors had a mixed impact.

Key Performance Takeaways

The London Company Small-Mid Cap portfolio returned 8.5% gross (8.3% net) during the quarter vs. a 5.2% increase in the Russell 2500 Index. Stock selection was positive, partially offset by headwinds from sector exposure.
The SMID portfolio outperformed the Russell 2500 in Q2, and exceeded our 85-90% upside capture expectations. Despite headwinds from factor performance, the portfolio outperformed the benchmark in a strong market environment. As fundamentals have come under pressure down the market capitalization spectrum, our Quality orientation has stood out.

Top 3 Contributors to Relative Performance

Entegris (ENTG) – ENTG outperformed during Q2, gaining share in its end markets, while highlighting an improving outlook with a potential recovery later this year. Strong demand for mission-critical products, such as liquid filters, and the easing of supply chain constraints were highlights. Its value-added offerings allow for above-average growth relative to the rest of the industry across all cycles. ENTG has drastically increased its size and scale to become one of the most diversified players in the semi-materials industry. Management remains focused on debt reduction. We remain attracted to the industry’s high barriers to entry, limited competitors, and high switching costs.
Trex Company (TREX) – TREX outperformed in Q2, reflecting better sentiment around macro conditions. Meanwhile, operations are tracking a bit better than expected. We initiated a position in the stock in late 2022, after the valuation had adjusted to reflect slower demand and de-stocking in the channel. Fundamentals do not appear to have deteriorated further, and the company has done a good job of controlling the things it can control. TREX entered the slowdown with a strong balance sheet, and responded quickly with cost reductions to protect margin and opportunistic share repurchases. We believe the company’s position as the market leader in composite decking is stable, and we believe that the penetration trend driving the growth of the category remains intact. We continue to view TREX as a solid business that is likely to get stronger over time.
Deckers Outdoor (DECK) – DECK manages top brands in the footwear industry, which has allowed them to generate resilient results in the current environment. UGG and HOKA are benefitting from brand heat, and management has done a thoughtful job of acquiring and retaining customers. The company continues to diversify revenue through the growth of HOKA (non-seasonal), and the expansion of UGG into new categories. The cash balance sheet with no debt is an additional element of downside protection.

Top 3 Detractors from Relative Performance

Hanover Insurance Group (THG) – Shares of THG lagged the broader market reflecting exposure to commercial real estate (CRE). THG has broad exposure to CRE through ownership of commercial mortgage backed securities. While there is certainly risk within the office space, we do not believe the broader CRE asset class as a whole is in significant danger; additionally, THG has significant tranche seniority in their mortgage backed securities book. Investment portfolio aside, we continue to have confidence in THG’s discipline and strategy in navigating this challenging underwriting environment.
UniFirst (UNF) – UNF experienced a challenging environment with higher costs (rental garments and one-time items) and management reduced guidance reflecting sustained cost pressures. Margins remain meaningfully compressed relative to pre-pandemic levels. On a positive note, pricing remains strong, as customers seem to understand the justification of higher cost of service. We believe UNF should be able to normalize margin over time, due to the oligopolistic nature of the industry.
Sensata Technologies (ST) – ST underperformed the broader market in Q2 as margins declined reflecting the impact of recent acquisitions, as well as softer demand in its end markets. ST has repositioned its portfolio with a focus on electrification for the auto and industrial industries. ST should benefit from tailwinds including higher content per vehicle and sticky client contracts. Management recently increased the dividend, and plans to continue to reduce company debt.

Sector Influence

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

What Helped: Underweight Utilities & Financials (two weaker performing sectors)
What Hurt: Overweight Cons. Staples (a weaker performing sector) & underweight Info. Technology (a better performing sector)

Trades During the Quarter

There were no trades during the quarter

Looking Ahead

Uncertainty remains high as we enter the second half of 2023. Continued progress on the inflation front is encouraging, and labor market strength may continue to underpin consumer resilience. That said, we note that core inflation remains above the Federal Reserve’s long-term target of 2%, and it is likely the Fed maintains a restrictive posture if the labor market strength continues. Importantly, monetary policy works with a lag, and we have probably not felt the full impact of prior rate increases or the full effects of tighter lending standards. We remain cautious, as the odds of a recession are still high and the risks of a credit crunch are elevated.

Narrow markets can be quite fragile. The concentrated, top-heavy nature of the market creates an environment prone to risk reversals, and we continue to expect greater volatility in the months ahead. In addition, valuations appear relatively high vs. history, despite concerns about a pending recession and higher interest rates. As inflation concerns subside, we believe growth and employment will come into greater focus. Since the October 2022 bear market low, 100% of the market’s rally has been attributable to P/E valuation multiple expansion. Meanwhile, earnings growth has been weak, and it could weaken further if we enter a recession. We may experience muted returns in the near term, given recession odds and elevated valuations. In that environment, companies that are higher quality, reasonably valued, and prudently returning capital to shareholders are likely better positioned. By that measure, we believe the attractive shareholder yields, quality value orientation, and high active share of our portfolios provide us with a compelling advantage in a fragile market environment with elevated uncertainty.

As we face an economic slowdown with a higher cost of capital environment, we believe companies with strong balance sheets and the ability to self-fund their operations should have a tangible advantage in 2023 and beyond.

Annualized Returns

As of 6/30/2023

SMID Cap - 2Q2023 vs. R2500 Annualized Returns

Inception date: 3/31/2009. Past performance should not be taken as a guarantee of future results. Performance is preliminary. Subject to change.

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

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