QTD SMID Cap – 3Q2022 vs. R2500V
Market Observations & Portfolio Commentary
Quarterly Market Update
U.S. equities declined for a third consecutive quarter in Q3 as tighter monetary policy from the Federal Reserve and decelerating economic growth led the market lower. The broader market, as measured by the Russell 3000 Index, declined 4.5%. Most of the data released during Q3 pointed to deceleration in the economy, but fortunately U.S. consumer fundamentals remain broadly solid. The Fed raised its benchmark rate by 75 basis points for a third consecutive meeting, and the pace of its quantitative tightening (balance sheet reduction) ramped up. The Fed’s hawkish commentary progressively ratcheted up during Q3, setting ‘higher for longer’ policy expectations to combat inflation. These hawkish moves were underpinned by stubbornly high inflation readings and a labor market that remains tight. Bond yields moved higher, and the U.S. dollar rose in value vs. almost every other currency, creating disruption abroad. The yield curve remained inverted at the end of the quarter.
Stocks traded lower across the market cap spectrum, but Small Caps outperformed Large Cap equities. The Growth indices outperformed the Value across the board, and cyclical stocks outperformed shares of more defensive companies. In terms of market factors that drove performance, Volatility factors had a positive impact, while Growth was neutral. Value, Yield, and Quality mostly presented headwinds.
Key Performance Takeaways for the Year
The London Company Small-Mid portfolio declined -2.1% gross (-2.3% net) during the quarter vs. a -4.5% decrease in the Russell 2500 Value. Outperformance was driven by stock selection, partially offset by negative sector exposure.
During the quarter, our Small-Mid portfolio meaningfully exceeded our 75% downside capture target versus the Russell 2500 Value. Despite continued sector headwinds, the portfolio has performed as it is designed to do, and it played solid defense amidst the market turmoil in late Q3. This more than offset weakness in the first half of the year, leading to year-to-date outperformance.
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
Deckers Outdoor (DECK) – DECK rallied after reporting a strong quarter characterized by continued brand strength driving the top-line. DECK continues to return cash to shareholders through an accelerated buyback on stock weakness (shares outstanding down -4% y/y) and an increased buyback authorization to $1.5B (17% of market cap).
STORE Capital (STOR) – STOR rallied after announcing the potential acquisition of the company by two private equity firms for $32.25 per share. The deal should close in early 2023.
Lancaster Colony (LANC) – LANC outperformed in Q3. The Consumer Staples sector in general held up well amidst the weak Q3 environment, but LANC was also helped by better than expected margins in the most recent quarter. We are attracted to LANC’s cash balance sheet and willingness to invest in high-return organic projects, such as expanding the manufacturing footprint to support licensed retail products with partners like Chick fil-A and Buffalo Wild Wings.
Top 3 Detractors from Relative Performance
Cable One (CABO) – CABO continues to be pressured by slower unit growth and fears over rising competition. The company’s 2Q22 results showed decelerating net customer additions and muted average revenue per user increases as broadband trends have begun to normalize from the pandemic-fueled growth. Management noted that churn remains at record lows suggesting that CABO is not experiencing a major impact from competition yet given their unique rural footprint. We believe CABO is well positioned as an advantaged provider of high-speed internet in rural markets, while its lower penetration and M&A prowess provide a long runway for subscriber growth.
Hayward Holdings (HAYW) – HAYW underperformed the broader market during Q3 after it reported a softer demand outlook and an oversupply of inventory in the channel. Concerns around pull-through demand and margin pressure from inflation weighed on the company. HAYW continues to gain share and backlogs are still strong, but investors worry that the share gains may not stick going forward. We remain attracted to the consolidated industry, the repair and maintenance dynamic of the installed base, and competitive moat of the business.
CarMax (KMX) – KMX underperformed the broader market during Q3 as concerns around affordability and macro conditions worsened. Consumer spending on big-ticket discretionary items has slowed and consumer confidence has weakened. Despite the weak macro environment, KMX continues to gain market share and maintains high gross profits per unit. Management is focused on growing profitable market share in multiple channels by offering a seamless experience across all platforms. KMX continues to disrupt the used car ecosystem and we maintain our conviction in the stock.
We are bottom-up stock pickers, but sector exposures influenced relative performance as follows:
- What Helped: Overweight Info. Technology (a better performing sector) & underweight Utilities (a weaker performing sector)
- What Hurt: Underweight Energy (a better performing sector) & overweight Cons. Staples (a weaker performing sector)
Trades During the Quarter
- Received Cash: Citrix (CTXS) – At the end of September, the CTXS acquisition by private equity closed. We received cash for our shares.
Conditions remain fragile. As the Fed attempts to navigate a soft landing, economic growth may continue to decelerate. The combination of persistently high inflation and a tight labor market mean additional rate hikes are likely; meanwhile, Quantitative Tightening is set to continue. We recognize the lagged impact of monetary policy on the broader economy, so the odds of a recession over the next 12-18 months remain elevated. On a positive note, the U.S. consumer remains in reasonably good shape (i.e. low unemployment, rising wages, excess savings, etc.) With consumer spending such an important part of U.S. GDP, the strong labor market could limit the downside risk to the economy over the next few months. That said, things could change quickly and higher rates may lead to slower growth and greater job losses. Longer term, we remain positive on the U.S. economy and expect annualized 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 do not attempt to time the market, but hope that much of the bad news is reflected in equity valuations after a 25% YTD decline in the broader Russell 3000 Index. That said, multiple compression may continue in the near term and a slowing economy may lead to weaker earnings from many companies. 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. For us at The London Company, we find comfort in the durable competitive advantages and financial health of our companies. We believe the strong cash flow generation and capital flexibility of our businesses should provide meaningful protection if market fundamentals continue to deteriorate.
We believe the strong cash flow generation and capital flexibility of our businesses should provide meaningful protection if market fundamentals continue to deteriorate.
As of 9/30/2022
Inception date: 3/31/2009. Past performance should not be taken as a guarantee of future results.