DH - ClearBridge Mid Cap Strategy Q1 2023 Portfolio Manager Commentary

2023-04-14 23:00:00 ET

Summary

• ClearBridge is a leading global asset manager committed to active management. Research-based stock selection guides our investment approach, with our strategies reflecting the highest-conviction ideas of our portfolio managers.
• Equity markets generated positive returns in the first quarter, as hopes of a milder recession bolstered market optimism, before a banking crisis dampened performance.
• The Strategy underperformed its benchmark as the share prices of fundamentally-sound companies were hurt by fears of bank contagion and recession.
• We remained very active in repositioning the portfolio, using elevated levels of volatility to leverage our watchlist of high-quality growth and value companies, adding eight new positions while exiting seven holdings.

By Brian Angerame & Matthew Lilling

Bank Crisis Curtails Mid Cap Performance

Market Overview and Outlook

Equity markets generated positive returns in the first quarter, as the perception of a softer economic landing bolstered investor sentiment before a March banking crisis dampened performance. The S&P 500 Index ( SP500 ) increased 7.50% over the three-month period, while the benchmark Russell Midcap Index advanced 4.06%. Signs of economic resiliency and hopes of an end to Fed rate hikes helped growth stocks outperform value stocks for the period, with the Russell Midcap Growth Index returning 9.14% versus 1.32% for the Russell Midcap Value Index.

Stocks rallied early in the quarter, as the combination of slowing inflation indicators and a resilient economy spurred optimism over an end to the Fed’s rate hikes and stabilizing long-term interest rate expectations. However, in March, markets became fixated on the banking system as the collapse of Silicon Valley Bank (SVB), the 16th largest U.S. bank, and Signature Bank ( SBNY ) a couple of days later, sparked a crisis of confidence across small and midsized regional banks. Although contagion concerns had largely eased by the end of the quarter, the crisis intensified investor fears of a severe recession.

Macro factors continue to play an outsized role in market performance. As a result, good companies with strong balance sheets and economic resiliency have found their share prices subjected to fickle investor sentiment rather than fundamental valuations. This tumultuous environment and divergence between fundamental valuation and market price resulted in the ClearBridge Mid Cap Strategy underperforming its benchmark for the quarter.

From a sector standpoint, communication services (+15.42%) was the top performer in the benchmark during the quarter. The IT (+14.46%), consumer discretionary (+8.21%), industrials (+7.72%) and materials (+4.10%) sectors also managed to outperform the Russell Midcap Index. Meanwhile the energy (-7.89%), financials (-6.33%) and utilities (-1.71%) sectors all posted negative returns, followed by the real estate (+0.54%), consumer staples (+3.32%) and health care (+3.44%) sectors.

"The collapse of SVB had a ripple effect across the system, creating a panic that weighed on even the most fundamentally-sound banks."

Stock selection in the financials sector was the leading detractor during the period. Entering the quarter, we deliberately chose to be underweight the sector and were invested in high-quality banks with sticky customer bases and minimal credit risk which would allow them to persevere even if the U.S. were to enter a recession. For example, First Republic Bank ( FRC ), focused on providing best-in-class service to high-net-worth clientele, had a strong loan portfolio with a history of minimal credit write-offs. Likewise, we had similarly high conviction in Western Alliance Bancorp ( WAL ) due to the diversity of its depositors. However, the collapse of SVB had a substantial and rapid ripple effect across the entire banking system, creating a panic that weighed on even the most fundamentally-sound banks. Depositors, aided by the ability to shift deposits instantaneously and overnight, transferred money from mid-sized banks to large ones and created a vicious cycle of dwindling liquidity.

In the face of such an unquantifiable risk and diminished earnings prospects from greater capital requirements, we moved swiftly to exit these two positions in the early stages of the contagion. We also reviewed other holdings we felt could be adversely impacted by a higher probability of recession and reduced credit availability, and sold our holding in Starwood Property Trust ( STWD ), the largest commercial mortgage REIT in the U.S. While we remain underweight to regional banks, the turmoil also created compelling entry prices into high-quality super-regionals likely to be long-term beneficiaries of this deposit reshuffling. This motivated us to add new positions in PNC Financial Services ( PNC ) and U.S. Bancorp ( USB ), both of which have strong brands, diverse geographical and funding footprints and smaller expense growth than their regional peers.

Stock selection in the industrials sector was a significant contributor to the Strategy’s returns, as many of the companies that struggled in the fourth quarter rebounded on solid earnings. ATS, which provides automation services for manufacturers around the world, saw its share price rise due to its increased orders of equipment to manufacture electric vehicle (EV) batteries. We recognized the opportunities that the EV battery market represented for the company when we made our initial investment and feel that it will continue to be a long-term driver of returns. Another top performing holding, APi Group ( APG ), offers safety solutions for industrial services such as fire protection, air conditioning and infrastructure maintenance. The stock rebounded from a decline in the fourth quarter as investors gained greater visibility into its contract revenues and the company issued higher than expected guidance for 2023. We believe that APi’s internal initiatives continue to drive fundamental improvements, keeping it on track to meet forecasts.

Our investments in the consumer staples sector also generated positive relative returns for the period and included the top individual performer, COTY . The global beauty and fragrance company continues to strongly deliver on both its short-term targets as well as its strategic mission to improve its brand profile. Coty has several strong growth drivers, including its strong market share within a reopening Chinese market and further penetration of its mass market cosmetics business. The company’s continued success should allow it to reduce debt, which should act as a share price catalyst.

Portfolio Positioning

We have remained very active over the last six months, using the elevated levels of volatility to add high-quality growth and value stocks at compelling valuations. We maintain an extensive watchlist of companies that would be excellent additions to the portfolio under the right circumstances and move decisively when they come under significant pressure. As a result, we added eight new positions and exited seven existing holdings during the quarter.

We initiated a new position in Paylocity ( PCTY ), in the IT sector, which provides cloud-based human capital management and payroll software solutions. While the Fed’s rate increases have started to weigh on the economy, we believe Paylocity should benefit from rate increases by earning higher returns on client’s payroll deposits. Additionally, Paylocity maintains a compelling long-term growth runway as it attracts new customers and gains market share against large, mature industry incumbents.

We also added CoStar ( CSGP ), in the industrials sector, which provides information, analytics and online marketplace services to the commercial real estate market under brands including its flagship Apartments.com . As the provider of a robust, real estate tech platform, CoStar is poised to capitalize on a downturn in commercial real estate by being the primary leasing and listing source for real estate brokers looking for greater visibility. Additionally, the company is leveraging its expertise and economies of scale to build a similar database and listing source for the residential housing market, Homes.com , which could prove to be a substantial, long-term growth driver. The company is well-positioned as a counter-cyclical alternative to the rest of the commercial real estate industry.

We exited our position in ON Semiconductor, in the IT sector, which designs, manufactures and markets semiconductor components. The company has been a strong performer in the portfolio, and we have been gradually trimming the position to capture gains and manage the position size during its stock run-up. However, we believe that the expectations around the company’s silicon carbide business will be challenging to exceed, complicated further by the need to delicately balance increasing capacity without oversaturating demand, Ultimately, we decided to close the position in favor of other opportunities.

Outlook

The first quarter proved a tumultuous one, as macro factors and fears of a banking crisis proved to be the primary drivers of market performance. Rather than try to chase short-term shifts, we have high conviction that combining active management with an investment process centered on high-quality companies will generate attractive returns over a full market cycle. As such, we will continue to see these gyrations as opportunities to improve our portfolio and focus on investing in companies with strong balance sheets, attractive cash flows and earnings visibility.

Portfolio Highlights

The ClearBridge Mid Cap Strategy underperformed its Russell Midcap Index during the first quarter. On an absolute basis, the Strategy had gains across six of the 11 sectors in which it was invested during the quarter. The leading contributors were the industrials and IT sectors, while the financials sector was the main detractor.

On a relative basis, overall stock selection detracted from performance while sector allocation effects positively contributed. Specifically, stock selection in the financials, IT, consumer discretionary, health care, communication services, real estate and materials sectors weighed on relative returns. Conversely, stock selection in the industrials and consumer staples sectors, an overweight to the IT sector and underweight allocation to the financials sector contributed to returns.

On an individual stock basis, the biggest contributors to absolute returns in the quarter were Coty, ATS, APi, Aptiv ( APTV ) and Regal Rexnord ( RRX ). The largest detractors from absolute returns were First Republic Bank, Western Alliance Bancorp, Alexandria Real Estate Equities ( ARE ), Pioneer Natural Resources ( PXD ) and Hartford Financial Services ( HIG ).

In addition to the transactions listed above, we also initiated new positions in Atkore ( ATKR ) and Clean Harbors ( CLH ) in the industrials sector and Teleflex ( TFX ) and IDEXX Laboratories ( IDXX ) in the health care sector. We exited positions in Zurn Elkay Water Solutions ( ZWS ) in the industrials sector, Petco Health & Wellness ( WOOF ) in the consumer discretionary sector and Definitive Healthcare ( DH ) in the health care sector.

Brian Angerame, Portfolio Manager

Matthew Lilling, CFA, Portfolio Manager

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