ARGNF - ClearBridge Mid Cap Strategy Q2 2023 Portfolio Manager Commentary

2023-07-16 07:00:00 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.
• Mid cap stocks generated positive returns as signs of economic resiliency, moderating inflation and better than anticipated corporate earnings helped to spur equity markets higher.
• The Strategy outperformed its benchmark as strong performance in the industrials and energy sectors helped offset idiosyncratic headwinds from stocks in the consumer discretionary sector.
• The debate over the timing of the next recession is fascinating, but we remain focused on finding mispriced mid cap assets in a volatile market.

By Brian Angerame & Matthew Lilling

Mid Caps Rally as Investor Confidence Returns

Market Overview

The second quarter proved to be generally positive for mid cap stocks as signs of economic resiliency, moderating inflation and better than anticipated corporate earnings helped to spur equity markets higher. Mid cap stocks generated positive returns during the three-month period, with the Russell Mid Cap Index returning 4.76%, but trailed the performance of large cap peers due to a surge in investor demand for large tech companies at the forefront of artificial intelligence ((AI)) development. The prospect of a potential end to interest rate hikes also helped to propel growth over value stocks, with the Russell Midcap Growth Index returning 6.23% compared to the 3.86% return of the Russell Midcap Value Index.

Emerging from the shadow of March’s banking crisis, the period saw an increase in investor optimism as recessionary fears were offset by hopes of an economic soft landing. Despite interest rates reaching a 16-year high in May, both the labor market and consumer spending continue to show signs of resiliency. Additionally, markets received a boost from better-than-expected corporate earnings in the second quarter, as our portfolio companies continued to benefit from price increases as well as declining costs and slowing labor inflation. While the market still has plenty to worry about, many companies that implemented measures to shore up their balance sheets and improve cash flow generation over the past two years are finally being rewarded for their efforts.

The biggest drama for the markets right now involves the timing and severity of the next recession. Heading into 2023, consensus held a recession in 2023 as a near certainty – now, not so much. Policymakers have made it clear that they anticipate further rate hikes, but the slowing of inflation has helped lend credence to the idea that a terminal risk-free rate may be within sight. As a result, investors are reclaiming the confidence to look beyond the recent spike in inflation and interest rate uncertainty to the return of a more “normal” economic expansion, or dare we say it – a soft landing.

From a sector standpoint, the industrials (+11.07%), consumer discretionary (+7.36) and information technology (IT,+7.30%) sectors were the top performers for the quarter. The real estate (+3.90%), communication services (+3.23%), financials (+2.94), materials (+1.03%), health care (+0.72%) and consumer staples (+0.61%) sectors generated positive returns but trailed the broader benchmark’s performance. Conversely, utilities (-2.11%) was the sole detractor for the period.

Stock selection in the health care sector was the leading contributor to outperformance during the quarter. As capital markets funding activity in biotech stocks have begun to slowly build off a low base, a key health care R&D industry headwind is fading. This aided our top performing health care stock during the quarter, ICON ( ICLR ), which manages clinical research studies and provides lab services to pharmaceutical companies. ICON continues to deliver strong, consistent performance and saw its backlog increase during the quarter as they continue to execute strong bookings growth.

"Companies that implemented measures to shore up their balance sheets and improve cash flow are finally being rewarded for their efforts."

Our holdings in the industrials sector also contributed positively to the portfolio’s outperformance during the period. Corporate earnings for the industrials sector have continued to exceed market expectations thanks in part to the diversity of industries and end markets for their products. Specifically, the portfolio benefited from its investments in Vertiv ( VRT ), the top individual performing holding, and CoStar ( CSGP ). Vertiv, which produces power and thermal management tools and systems used by data centers, had a particularly strong quarter thanks to investors’ enthusiasm for AI-related technology. Deploying AI applications will necessitate substantial investment in new data centers and upgrading existing facilities. Combined with improved supply chain management and consequently a recovery in its free cash flow, Vertiv shares recovered nicely in the first half of 2023. CoStar, which provides information, analytics and online marketplace services to the commercial real estate market, also saw its stock price rebound during the quarter. With the downturn in the commercial real estate market leading to a more competitive landscape for real estate brokers, CoStar’s data and marketplace services have proven to be a countercyclical tailwind. 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.

Energy also proved to be a strong contributor to quarterly performance, primarily driven by our investment in [[EQT]]. As North America’s leading natural gas provider, EQT had seen its share price slide as the lackluster reopening of China and a milder-than-expected winter in the northern hemisphere weighed on natural gas prices. However, as recessionary fears have given way to optimism and the prospect for greater energy demand, EQT’s share price has rebounded. While we continue to expect volatility in commodities prices, we believe that global energy demand, especially in Europe, along with the company’s leadership position in the natural gas market, make it a strong long-term compounder for the portfolio.

Stock selection in the consumer discretionary sector proved to be the largest detractor from performance. Aptiv ( APTV ) and [[ETSY]] faced elevated year-over-year performance comparables and fear of slowing growth in the second half of 2023 or 2024. Aptiv, which is a Tier 1 automotive parts supplier to global auto manufacturers, saw its share price struggle after management said margin improvement may take longer than anticipated. We believe the market’s response to the announcement overshadowed improvements the company has made to its supply chain and production levels. Likewise, Etsy, the leading e-commerce marketplace for handcrafted items, was hurt by a shift in consumer spending from goods to services.

Portfolio Positioning

We continue to scour the market for opportunities to add high-quality growth and value stocks with visible paths to improvement. As a result, we have built a substantial watchlist of companies we regularly review to see if the prevailing market conditions merit their inclusion in the portfolio. During the quarter, we added six new positions and exited four holdings.

We initiated a new position in [[CAE]], in the industrials sector, which provides aerospace flight simulation training to commercial and military pilots. Although total air miles remain below pre-COVID levels, we believe current pilot shortages are indicative of the need for airlines to make substantial investment into pilot training and development programs over the next decade. As the industry leader in professional aerospace flight simulation, CAE is well-positioned to capitalize this need through its ability to train new pilots as well as the recurring revenue streams generated through refresher and cross-training programs.

We also added Service Corporation International ( SCI ), in the consumer discretionary sector, which offers funeral and cemetery products and services. Although we have previously owned SCI in the portfolio, we exited the position last year over concerns about its ability to maintain growth in the wake of the COVID-19 pandemic, and valuation considerations. However, with COVID-related increases in deaths well understood by the market, and a more compelling valuation, we repurchased the stock. We believe the company will continue to be a strong performer due to its steady earnings growth and ability to scale its products and services to gain greater market share.

We exited our position in Syneos Health ( SYNH ), which is a clinical research organization providing clinical trial services. The company’s share price has faced sustained pressure over the last few quarters due to many company-specific factors and was taken out during the quarter by private equity investors.

Outlook

Despite growing investor optimism, there remains a significant degree of uncertainty in the market and economic outlook. As bottom-up, fundamental investors, we do not pretend to be able to predict the impact and outcomes of macro events and continue to take actions to optimize the risk/return tradeoff of our portfolio. We continue to focus investing in companies with balance sheet stability, free cash flow generation, sustainable competitive advantages and managerial competence that will generate attractive long-term returns over a full market cycle.

Portfolio Highlights

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

On a relative basis, overall stock selection and sector allocation effects positively contributed to performance. Specifically, stock selection in the health care, industrials, energy, communication services, financials and consumer staples sectors as well as an overweight allocation to the industrials sector benefited performance. Conversely, stock selection in the consumer discretionary, materials and IT sectors weighed on performance.

On an individual stock basis, the biggest contributors to absolute returns in the quarter were Vertiv, Marvell Technology ( MRVL ), Live Nation Entertainment ( LYV ), ICON and Bentley Systems ( BSY ). The largest detractors from absolute returns were Ashland ( ASH ), Etsy, Aspen Technology ( AZPN ), Aptiv and Everbridge ( EVBG ).

In addition to the transactions listed above, we also initiated new positions in Steris ( STE ) and Argenx ( ARGX ) in the health care sector, Eastman Chemical ( EMN ) in the materials sector and [[ATS]] in the industrials sector. We exited positions in SolarEdge Technologies ( SEDG ) in the IT sector, RBC Bearings ( RBC ) in the industrials sector and Horizon Therapeutics ( HZNP ) in the health care sector.

Brian Angerame, Portfolio Manager

Matthew Lilling, CFA, Portfolio Manager

Original Post

Editor's Note: The summary bullets for this article were chosen by Seeking Alpha editors.

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