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QTD SMID Cap – 3Q2023 vs. R2500

Market Observations & Portfolio Commentary

SMID Cap – 3Q2023 vs. R2500


Market Update

U.S. equities traded lower during Q3 reflecting rising long-term interest rates, higher energy prices, and growing acceptance of the higher for longer message from the Federal Reserve. After three consecutive quarterly gains, equities broadly declined, with the Russell 3000 Index down -3.3% in Q3. While there were headwinds, most of the economic data released during the quarter was better than expected, and the odds of a soft landing have improved.

While stocks traded lower across the market cap spectrum, shares of large companies held up best. For a third consecutive quarter this year, there was a preference for larger and growthier. On the opposite side of the spectrum, smaller and value-oriented equities fared worst in Q3. Energy was the best performing sector, bolstered by higher oil prices. Turning to market factors that influenced the broad market, Growth and Quality factors posted the best results in Q3, while Yield factors continued to generate the weakest returns. Value, Volatility, and Momentum factors had a mixed impact.


Key Performance Takeaways

  • The London Company Small-Mid Cap portfolio declined 5.0% (-5.1% net) during the quarter vs. a 4.8% drop in the Russell 2500 Index. A benefit from sector exposure was offset by headwinds from stock selection.

  • The SMID portfolio came up short of our long-term 75%-80% downside capture target during Q3. The lack of exposure to the Energy sector (the best performing sector) was the primary reason for the underperformance. Importantly, the portfolio is well ahead of the Russell 2500 Index year-to-date.


Top 3 Contributors to Relative Performance 

  • Black Knight (BKI) – BKI rallied as it became clear its pending acquisition by Intercontinental Exchange (ICE) would close. To allow the deal to close, BKI had to sell its Empower and Optimal Blue divisions. We sold BKI just before the closing of the ICE deal as the stock was trading close to the deal price.

  • NewMarket (NEU) – NEU outperformed early in Q3 after a strong earnings report that showed some recovery in pricing and margins after a long period of higher base oil and chemical prices. The stock flattened out later in the quarter as oil prices rose. NEU also used stronger cash flow to repay debt and repurchase company shares.

  • Broadridge (BR) – BR outperformed, reflecting stronger than expected guidance from management. The stability of the investor communications division (proxy voting, etc.) was a positive despite some client hesitation in Europe. We remain attracted to BR’s portfolio offerings and strategy. Capital spending levels should decrease in the future as the heavy investment period in their integrated wealth platform has ended, which should free up cash flow for other purposes.


Top 3 Detractors from Relative Performance 

  • Lamb Weston (LW) – LW underperformed after the company reported lower volumes and provided a cautious outlook. This sparked fears the industry could have too much capacity as volumes slow. However, management has been clear the majority of the lower volume for LW has been intentional by shedding lower margin contracts. On a positive note, the fry attachment rate remained high. We remain attracted to LW’s market share, pricing power, and industry tailwinds.

  • Churchill Downs (CHDN) – CHDN underperformed as 2Q recent results were a bit weaker than expected reflecting softness in the casino business and partially due to a temporary issue in the live racing business. We are not overly concerned about the issues that have pressured the stock, and we continue to have a very favorable view of the long-term outlook for CHDN. In our view, CHDN has a thoughtful and long-term oriented management team running a portfolio of highly cash-generative assets, with a very attractive set of investment opportunities.

  • Lancaster Colony (LANC) – LANC underperformed during Q3 reflecting expectations for slower growth in the future. Higher pricing has aided revenue growth in recent quarters, but those benefits are expected to moderate. Fortunately, LANC fundamentals remain strong. The company should realize tailwinds to margins and free cash flow over the next 12 months with ERP and capacity expansions complete, and mix continuing to shift towards margin-accretive volumes. LANC has attractive opportunities for growth, and a strong balance sheet (net cash) is available to support investment.


Sector Influence

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

  • What Helped: Underweight Health Care (a weaker performing sector) & overweight Cons. Staples (a better performing sector)

  • What Hurt: Underweight both Energy & Financials (two better performing sectors)


Trades During the Quarter

  • Exited: RB Global (RBA) – Sold after receiving shares in partial compensation for the company’s acquisition of IAA.

  • Exited: Sensata (ST) – Sold due to increased reliance on M&A for growth & electric vehicle adoption headwinds.

  • Reduced: Lamb Weston (LW), Churchill Downs (CHDN) & Deckers (DECK) – Trimmed each on strength. We maintain a positive outlook & meaningful positions in each stock.

  • Initiated: Vail Resorts (MTN) – MTN owns 41 ski resorts and regional ski hills across North America, Australia & Europe. MTN has aggregated quality assets in a supply-constrained industry. Its scale and diverse portfolio offers a competitive advantage. Its season pass program, Epic Pass, promotes customer loyalty and generates recurring revenue. We believe MTN’s growth outlook is favorable and aligns with trends favoring outdoor and experience-based tourism. MTN has a solid balance sheet and trades at an attractive valuation coming out of a disappointing ski season.

  • Initiated: Waters Corporation (WAT) – WAT designs, manufactures, sells, and services high-performance liquid chromatography (HPLC), mass spectrometry (MS), and thermal analysis technologies. These solutions are invaluable tools in R&D and quality control processes for industries like pharmaceuticals, life sciences, and food & beverage. Sources of moat include its entrenched leadership position, the heavily regulated nature of drug production, high switching costs, & its Empower software—which is the standard in HPLC Quality Assurance/Quality Control settings. We’re attracted to its strong balance sheet, predictable cash flows (~60% recurring revenue), and compelling economic moat.

  • Initiated: Zebra Technologies Corporation (ZBRA) – ZBRA is the largest player in the global automatic identification and data capture (AIDC) market. It sells purpose-built, enterprise-grade devices (i.e. barcode scanners, RFID technology, & mobile computing devices) that require substantial engineering prowess and robust support and servicing for mission critical applications. Sources of moat include scale, a vast, global distribution network, close customer relationships, a reputation for innovation, a comprehensive solution set, and bargaining power. We’re attracted it its strong balance sheet, compelling valuation and secular tailwinds. ZBRA’s ability to provide automation, data analytics, and supply chain visibility solutions positions it well to capitalize on the growing demand for these services across various industries.

  • Exited: Black Knight (BKI) – Sold our position on strength as BKI recently rallied after announcing plans to divest two divisions (Empower and Optimal Blue), which significantly increased the odds of the pending acquisition of BKI by Intercontinental Exchange (ICE).

  • Initiated: Casella Waste Systems (CWST) – CWST is the 5th largest waste company in the U.S., and it’s the #1 player in the dense Northeast. CWST is vertically integrated and has significant rural market exposure (~70%) versus its peers. The Northeast hasn’t approved a new landfill permit in 30 years, so the scarcity value of landfills combined with CWST’s vertical integration has given it significant pricing power. We’re attracted to CWST’s leading position in a stable business with high degree of recurring revenue. It has low leverage and is family owned. Plus, as a smaller player in a consolidating industry, CWST could possibly be acquired by a large player in the future.

  • Increased: AerCap (AER) – Added to existing holding based on confidence in long term outlook for the business and attractive valuation (less than 1x book value).

  • Increased: Cable One (CABO) – Added on weakness. We believe CABO remains well positioned for broadband growth in less competitive rural markets.


Looking Ahead

As we head into the final months of 2023, the macro outlook remains increasingly uncertain. Potential positives include a strong labor market, rising wages, and lower inflation. Potential negatives include higher interest rates, elevated energy prices, tighter bank lending standards, and the drawdown of savings accumulated by consumers during the pandemic. While the odds of a recession over the next 12-18 months remain elevated, there are signs that suggest a soft landing may be possible. Predicting the future direction of the economy is always challenging, but we remain positive on the U.S. economy’s longer-term outlook.

In terms of the equity market, we recognize the difficulty in determining what investors have priced into stocks at a specific point in the economic cycle. Valuations based on near term earnings are somewhat elevated in the context of higher interest rates and a possible recession. Moreover, we still have a top-heavy market with narrow leadership in the richly valued Magnificent 7. Narrow markets tend to be fragile markets, and we continue to expect greater volatility in the months ahead. We believe that equity returns in the near term may be muted, with shareholder yield (dividends, share repurchase, debt reduction) comprising a significant percentage of the total return from equities. The companies in London Company portfolios generate sustainably high returns on capital, with low leverage ratios, at reasonable valuations relative to the broader market, and possess attractive shareholder yields. We believe these attributes provide us with a compelling advantage in a fragile market environment with elevated uncertainty.

Annualized Returns 

As of 9/30/2023

SMID Cap - 3Q2023 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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