Market Observations & Portfolio Commentary

SMID Cap – 3Q2024 vs. Russell 2500

 

Market Update

U.S. equities traded higher during Q3 with most of the major indices posting mid-single digit gains. The quarter was marked by significant market shifts, including inflation cooling, employment weakening, volatility spiking, and a larger-than-expected Federal Reserve rate cut, yet the stock market ended on a high note. The broader market, measured by the Russell 3000 Index, rose 6.2%. There was a notable rotation to small cap and value styles away from large cap growth. This fostered broader market participation, with a wider range of sectors participating, especially the rate sensitive areas. Looking at market factors, Yield and most Value factors posted the strongest returns while most of the Growth, Volatility, and Momentum factors presented headwinds. Quality factors had a mixed impact.

 

Key Performance Takeaways

• The London Company Small-Mid Cap portfolio returned 2.2% (2.0% net) during the quarter vs. a 8.8% increase in the Russell 2500 Index. Both sector allocation and stock selection were headwinds to relative performance.

• The SMID portfolio trailed its benchmark and came up short of our 85-90% upside capture expectations during 3Q. The portfolio didn’t fully benefit from the rotation away from mega-cap growth stocks. The areas of the market that rallied the most were lower-quality, highly leveraged companies, which stand to benefit the most from rate reprieve. Our focus on balance sheet strength, which typically benefits us, became a temporary headwind. Another challenge was being underweight rate-sensitive sectors (e.g. Real Estate, Comm. Services & Utilities), which were the best-performing sectors down-cap. Lastly, idiosyncratic weaknesses in a few holdings were a drag on performance in a robust return environment. While the short-term report card hasn’t been as favorable this year as the prior two, the longer term performance remains strong.

 

Top 3 Contributors to Relative Performance 

• Waters Corporation (WAT) – Shares of WAT rallied during 3Q as demand trends improved while results in China were better than expected. WAT continues to launch new products into higher growth verticals, which should lead to revenue growth and longer-term margin expansion. On the capital allocation front, management comments suggest a likely resumption of share buybacks in the future, and the contribution from the Wyatt acquisition has been better than expected.

• Zebra Technologies Corporation (ZBRA) – ZBRA reported strong operating results, reflecting better-than-expected customer demand and strong execution. While management is not calling for an inflection in customer sentiment yet, expectations were low going into the quarter, so the stock rallied. While we have no clear visibility on the timing of a rebound, we think the company is well-positioned to strengthen its market position and rapidly increase margins coming out of the current tepid demand environment. We continue to have confidence in the quality of the business and competence of management.

• Armstrong World Industries, Inc. (AWI) – Shares of AWI have been strong over the last two years. AWI maintains leading market share in ceiling tiles at 55% (competes with USG and CertainTeed). The company serves a diverse group of end markets. Sales in the most recent quarter rose over 12%. Long-term contracts with distributors and warranties on the installed base (which require contractors to use original manufacturers) are advantages that should help AWI in the future.

 

Top 3 Detractors from Relative Performance 

• Entegris, Inc. (ENTG) – ENTG lagged the broader market during 3Q due to a more gradual recovery for trailing edge nodes, slower wafer starts, and delayed manufacturing capex spending. The near-term market conditions and different recovery rates throughout the industry have led to a more cautious outlook for the remainder of the year. That said, its solutions for advanced technology and incremental wafer content gains should propel a faster recovery next year. ENTG is one of the most diversified players in the semi-materials industry with its size and scale. We remain attracted to the industry’s high barriers to entry, limited competitors, and high switching costs.

• Lamb Weston Holdings, Inc. (LW) – LW underperformed this quarter due to the residual effect from its ERP (Enterprise Resource Planning) rollout issues, market share losses, and limited visibility on a recovery in demand. The broad-based volume slowdown and higher fixed-cost nature of the business have muted margins. Management has taken action to fix what it can control by taking out costs, increasing productivity, and removing less efficient capacity. We remain attracted to LW’s market share, flexible balance sheet, and long-term industry tailwinds.

• White Mountains Insurance Group Ltd. (WTM) – Shares of WTM underperformed the market during 3Q. The company generates much of its income from P&C insurance, and the stock tends to track growth in book value over time. Separately, WTM has a good track record of creating value via capital allocation (buying and selling businesses) decisions, so transactions like the sale of NSM and also movements in its underlying investments (e.g. MAX) can meaningfully impact shares. We remain confident in management’s ability to deliver outsized growth in book value per share over time through prudent capital allocation.

 

Sector Influence

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

• What Helped: Underweight Energy & Information Technology (two weaker performing sectors)

• What Hurt: Underweight Financials (a better performing sector) & overweight Cons. Staples (a weaker performing sector)

 

Trades During the Quarter

• There were no trades during the quarter.

 

Looking Ahead

Stocks enter 4Q in good form, but challenges remain. The market appears priced for near perfection, with expectations of a soft landing and healthy earnings growth driving the S&P 500 to a lofty valuation that leaves little room for error. The Fed’s recent rate cut may sow the seeds for a cyclical recovery, but whether the economic impact arrives in time to avoid a downturn is uncertain. Lower rates tend to support market sentiment and multiples in the short term, but it can take up to two years for policy changes to impact economic and earnings data. Meanwhile, rates remain in restrictive territory. Therefore, the impact of restrictive policy may continue to affect the economy in the months ahead. While we believe that the odds of a near term recession are low, we note the difficulty in navigating a soft landing. 

In terms of the equity market, valuations based on near term earnings are elevated in the context of moderate GDP growth. We believe that equity returns in the near term may be modest, with shareholder yield (dividends, share repurchase, debt reduction) comprising a significant percentage of the total return from equities. Moreover, as a large corporate debt maturity wall approaches, balance sheet strength will likely become a differentiator and an advantage for investors focused on fundamentals. We believe our focus on quality, diversification, and valuation will continue to reinforce our margin of safety, positioning our portfolios for success in this uncertain climate.

 

We believe our focus on quality, diversification, and valuation will continue to reinforce our margin of safety, positioning our portfolios for success in this uncertain climate.

 

Annualized Returns 

As of 9/30/2024

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