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QTD SMID Cap – 2Q2024 vs. R2500

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Market Observations & Portfolio Commentary

SMID Cap – 2Q2024 vs. R2500

 

Market Update

U.S. stocks posted mixed results during 2Q24. The broader market, measured by the Russell 3000 Index, rose 3.2% with gains concentrated in large companies with ties to spending on artificial intelligence. The S&P 500 reached new all-time highs during the quarter, but market breadth (a measure of how many stocks are participating in the rally) sharply declined once again. The Russell 2000 Small Cap Index was down 3.3%. Economic data released during the quarter reflected decelerating growth, some weakening in the labor market, and lower inflation, which collectively support the notion of rate cuts beginning in the next few months. Corporate earnings were solid, but there were signs of greater caution from consumers. Investors continued to favor Large Cap, Growth and Momentum factors, consistent with trends in recent quarters. Value and Yield factors continued to face headwinds, while Quality & Volatility had a mixed impact.

 

Key Performance Takeaways

  • The London Company Small-Mid Cap portfolio fell 5.7% (5.9% net) during the quarter vs. a 4.3% decrease in the Russell 2500 Index. Both sector allocation and stock selection were headwinds to relative performance.

  • The SMID portfolio came up short of our 75-80% downside capture expectations in 2Q. Our focus on high Quality and low Volatility factors faced headwinds in a market favoring Momentum and Growth. Having no exposure to Utilities, the best performing sector, and weakness in some of the portfolio’s Consumer Staples, Healthcare, and Materials holdings were additional obstacles. For the year, the portfolio is outperforming its benchmark and exceeding our 85-90% upside capture expectations.

 

Top 3 Contributors to Relative Performance 

  • Churchill Downs (CHDN) – CHDN outperformed in 2Q as recent results exceeded expectations, and the 150th Kentucky Derby delivered growth above expectations as well. Additionally, in our view the value creation from recent acquisitions is becoming clearer to the market. We continue to view CHDN as a high quality business run by a management team with a track record of astute capital allocation and a strong pipeline of opportunities for continued growth.

  • Murphy USA (MUSA) – Investors were cautious about the fuel market environment after MUSA’s 1Q report showed margin pressure in the face of steep fuel price increases. That trend reversed in 2Q with fuel prices falling ~15% peak to trough, leading to MUSA’s outperformance. While there is a level of short-term volatility in MUSA’s results due to fuel price fluctuations, we prefer to assess the business with a view to the long term. We continue to believe that the business is structurally improving and management’s favorable capital allocation policies should yield attractive shareholder returns.

  • AerCap (AER) – AER continues to benefit from tight supply/demand conditions in the commercial aircraft market. However, we would note this is not unique to AER – companies with exposure to commercial aircraft supply chains/life cycle are generally outperforming. As a result, AER has been selling their older aircrafts at nice gains on book, only to turn around and use those proceeds to buy shares at below book value. Our conviction on AER is founded on its market strength and the stellar management team.

 

Top 3 Detractors from Relative Performance 

  • Lamb Weston (LW) – LW underperformed the broader market in 2Q due to headwinds from its recent ERP rollout, and a reduction in near-term guidance. Investors have overcapacity concerns as volumes at QSRs have slowed. Price elasticity has remained low given the stability in fry attachment rates. Despite the short-term issues, we believe that this is one of the more attractive consumer staple companies with a clean balance sheet and industry-leading growth. We remain attracted to LW’s market share, pricing power, and industry tailwinds.

  • Trex Company (TREX) – TREX underperformed in 2Q despite continued solid execution, as sentiment turned cautious on building products and decking specifically. TREX had a very strong run coming off 2022 lows and outperformed by a wide margin in Q1 of this year. Our view of the long-term prospects for the business is unchanged, but we trimmed the position in 1Q and 2Q of this year due to valuation concerns.

  • NewMarket (NEU) – NEU underperformed after reporting declining revenue in its latest quarter reflecting lower selling prices. The company also added debt after acquiring AMPAC.  

 

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 Consumer Staples (a better performing sector)

  • What Hurt: Underweight Utilities (a better performing sector) & overweight Consumer Discretionary (a weaker performing sector)

 

Trades During the Quarter

  • Exited: Hasbro (HAS) – Sold remaining position on strength. Sale reflects the challenging environment facing toy manufacturers.

  • Exited: Endava (DAVA) – Our holding period for DAVA was much shorter than expected. We purchased the shares in late 2023, but sold reflecting a change in capital allocation after DAVA announced a large acquisition that we believe is outside of their core competency.

  • Exited: MBIA (MBI) – Sold MBI after a long holding period. MBI no longer writes municipal bond insurance and has been in run-off mode in recent years.

  • Reduced: Deckers Outdoors (DECK), Trex (TREX), NewMarket (NEU), & AerCap (AER) – Trims reflect some portfolio rebalancing on strength. We maintain a positive view on each of the underlying companies, but felt it was prudent to reduce the position size.

  • Initiated: Bruker (BRKR) – BRKR designs and manufactures advanced scientific instruments as well as analytical and diagnostic solutions for a number of differentiated end markets in the life sciences arena. Its solutions enable its customers to explore life and materials at microscopic, molecular, and cellular levels. With a global presence and a focus on life sciences, it benefits from long-term drivers like proteomics research. BRKR derives its competitive moat from its highly innovative instruments that push the cutting edge of science, enabling strong pricing power and market leadership. BRKR’s management team has an excellent track record of capital allocation and delivering on their promises that help create shareholder value. Over time, BRKR has reduced its reliance on government/academic customers, diversified away from Europe, increased growth, and expanded margins meaningfully. BRKR also possesses many characteristics we look for in a company, including a strong balance sheet, high ROIC (>20%), improving margin (close to 20%), and high inside ownership. BRKR is also owned in our Mid Cap portfolio.

  • Initiated: Qualys (QLYS) – QLYS provides cybersecurity and compliance solutions, which enable its clients to identify, prioritize, and remediate risks to information technology infrastructures. QLYS also offers solutions through a software-as-a-service model, primarily with renewable annual subscriptions. QLYS should continue to benefit from the long-term secular tailwinds that drive sustainable growth in cybersecurity. QLYS’s products are critical but also low-cost relative to a company’s overall security budget, helping ensure high retention rates and recession resistance. We believe QLYS is among the best managed in the industry. Many past decisions have positioned QLYS ahead of peers in terms of product quality, structurally higher margins, and competitive moat. QLYS generates high operating margins with growing cash flow generation and has a very strong balance sheet. QLYS is also owned in our Small Cap portfolio.

 

Looking Ahead

Conditions are trending in a positive direction for the Fed to begin reducing rates. Inflation is still higher than the Fed’s target, but it has continued to drift lower. The labor market remains strong, but there have been some signs of weakening. Together with signs of weakness in some recent economic data, we could see the Fed shift to a less restrictive policy and reduce rates before year-end. While the odds of a recession in the near term have declined, risks remain. Longer term, we remain positive regarding the U.S. economy and expect real annualized GDP growth in the 1.5-2% range driven by growth in the labor force and improving productivity.

In terms of equities, we note that narrow, top-heavy markets are fragile markets. The odds of a recession have come down, but our cautious posture persists due to high valuations, market concentration, looming debt challenges, and the lengthiest inversion of the yield curve in history. Continued multiple expansion in a higher rate environment is unlikely. We suspect the S&P 500 will eventually track earnings, so we would expect more volatility, especially in stocks where a lot of growth is already priced in. We believe returns in the near term may be modest, with shareholder yield (dividends, share repurchase, debt reduction) comprising a significant percentage of the total return. In our view, this uncertain economic backdrop warrants an investment approach that prioritizes consistency and stability—not excessive wagers. Owning great businesses at reasonable prices and allowing them to compound is still a winning, long-term strategy.

 

Annualized Returns 

As of 6/30/2024

SMID Cap - 2Q2024 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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Disclosure Notes

 

The London Company’s performances are size weighted and annualized based on calculations for the period ending June 30, 2024. 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.

 

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 GIPS® Report 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.

 

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 London Company 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. Prior to April 1, 2024 returns are calculated gross of withholding taxes on foreign dividends and interest. Starting April 1, 2024, performance is calculated net or gross of foreign withholding taxes on dividends and interest income dependent on custodian data. Dividends are reinvested. The accounts represented in the composite reflect actual London Company fees paid on the particular account which may be different from the fee normally offered to other clients. 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. An investment in a London Company strategy is subject to risks, including the loss of principal. Referenced strategies may not be suitable for all investors. The appropriateness of a particular strategy will depend on individual circumstances and objectives. In making an investment decision, individuals should utilize other information sources and the advice of their investment advisor.

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