DOCS - ClearBridge Mid Cap Strategy Q3 2023 Portfolio Manager Commentary

2023-10-16 05:15:00 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 declined during the quarter as the prospects for a higher-for-longer interest rate environment weighed on valuations.
• The Strategy outperformed its benchmark as stock selection in the industrials and consumer staples sectors helped overcome headwinds to energy and our underweight in financials.
• We continue to refine our positioning to balance a wide range of economic outcomes with companies driven by strong idiosyncratic drivers.

By Brian Angerame & Matthew Lilling, CFA

Industrial Strength Bucks Market Weakness

Market Overview

Equity markets proved challenging during the third quarter, as the potential for higher-for-longer interest rates chipped away at valuations and raised questions about an economic soft landing. As a result, value stocks supplanted growth stocks in market leadership, with the Russell Midcap Value Index returning -4.46% while the Russell Midcap Growth Index returned -5.22%.

Investor optimism was high entering the quarter as a string of better-then-anticipated corporate earnings results supported the possibility of an economic soft landing and fueled hopes that the Fed would reach its rate hike zenith, or even reduce rates, before the end of the year. However, a stubborn streak of inflationary data, continued economic resiliency and surging Treasury yields pushed out rate cut expectations further into the future.

One of the things we are closely watching is consumer spending. Consumers have been resilient over the last two years in the face of higher rates and prices and, as 70% of the economy, have been significant contributors to the soft-landing narrative. However depleting savings, greater borrowing and higher mortgage rates have started to slow consumer behavior, and the resumption of student loan payments in the fourth quarter will not help. While we avoid making large macro bets, we continue to monitor these inputs for their impact on our companies and investment theses.

From a sector standpoint, energy (+13.17%) and financials (+1.29%) generated positive returns for the quarter, while IT (-4.04%) and industrials (-4.61%) detracted but still outperformed the broader benchmark. Meanwhile, the health care (-11.39%), communication services (-9.56%), consumer staples (-8.66%), real estate (-7.86%), utilities (-7.32%), consumer discretionary (-6.97%) and materials (-4.80%) sectors underperformed the benchmark.

Stock selection in the industrials sector was the leading contributor to outperformance during the quarter. Our industrials holdings continue to drive performance thanks to company-specific growth initiatives, economic resiliency, beneficial tailwinds from reshoring and strong backlog conversion. This was particularly true of our top performing stock during the quarter, Vertiv ( VRT ), a leader in power and thermal management tools and systems used by data centers. Vertiv saw strong data center demand and enthusiasm for AI-related technology. The company’s new management has executed well in keeping cost inflation under control while maintaining strong orders and backlog, resulting in improved margins and its best free cash flow generation to date. We believe Vertiv has even stronger long-term prospects as AI-related buildouts increase demand for the company’s liquid-cooling products and services. Environmental services and waste disposal company Clean Harbors ( CLH ) also supported results after posting quarterly earnings that exceeded analyst expectations thanks to strong pricing power.

"Industrials continue to drive performance thanks to company-specific drivers, economic resiliency, and tailwinds from reshoring."

The Strategy’s consumer staples holdings also fared well. One of our top performers was Casey’s General Stores ( CASY ), which operates convenience stores and gas stations. The company continues to drive greater growth and improve internal performance through the expansion of its private label offerings, while a cooling labor market has helped alleviate wage pressures on margins. By deliberately focusing its geographic footprint on smaller communities, the company has high market share in the regions it serves as well as pricing power, which we believe will continue to be long-term earnings drivers.

Stock selection in energy proved a headwind to relative performance. An underweight allocation to financials also weighed on performance, but we seized the opportunity during the quarter to add a new position in Raymond James ( RJF ), a high-quality leader in the wealth management industry. With a compelling valuation and solid growth in investment inflows, we believe the company can capitalize on any improvement in the capital markets.

Portfolio Positioning

Rather than making big macro bets on the economy and market direction, we continue to stick to our process and philosophy of constructing a portfolio of growth compounders as well as value stocks with compelling opportunities for improvement. We made several adjustments to the portfolio during the period, initiating five new positions and exiting three.

We initiated a new position in Noble ( NE ), a leading offshore drilling contractor for the oil and gas industry. Consolidation and underinvestment has significantly depleted the number of drilling ships available to meet the growing demand for offshore oil drilling, giving the company greater pricing power. Armed with a clean balance sheet and significant cash flow generation as day rates for its fleet rise, we believe the company will be a prime beneficiary of resurgent energy demand and investment in oil and gas drilling.

We also added Pinterest ( PINS ), in the communication services sector, which operates a social media platform where users can express their interests and discover ideas through images they “pin” to their pages. The platform and its loyal, growing user base are strong assets which the company has struggled to monetize. However, we believe the new CEO’s initiatives to improve advertisers’ return on investment and greater customer conversion are showing signs of early success. By making the platform more shoppable, we believe Pinterest can accelerate its growth and improve its cash flow generation.

We exited our position in Black Knight in the IT sector, which develops software for real estate and mortgage transactions, after the stock benefited from its announced acquisition by financial data service provider and exchange operator Intercontinental Exchange.

Outlook

The market continues to grapple with the direction of inflation and interest rates. In addition, investors no longer seem willing to ignore widening deficits as the Federal government continues its political debates over its fiscal budget, resulting in an approximately 70 bps increase in the 10-Year Treasury over the last few months. Our focus on strong balance sheets, cash flows and optimal capital deployment, as well as utilizing portfolio construction tools to reduce volatility and correlations, has left us well-positioned to balance this wide range of outcomes with companies driven by strong idiosyncratic narratives to compound and improve returns. Thankfully, we continue to find compelling opportunities as we explore the market for undervalued mid cap stocks.

Portfolio Highlights

The ClearBridge Mid Cap Strategy outperformed its Russell Midcap Index during the third quarter. On an absolute basis, the Strategy had gains across two of the 11 sectors in which it was invested during the quarter. The contributors were the financials and energy sectors, while the health care sector was the main detractor.

On a relative basis, overall stock selection effects positively contributed to performance. Specifically, stock selection in the industrials, consumer staples, financials and IT sectors benefited performance. Conversely, stock selection in the energy and materials sectors and an underweight allocation to the financials sector weighed on performance.

On an individual stock basis, the biggest contributors to absolute returns in the quarter were Vertiv, Black Knight, Pioneer Natural Resources ( PXD ), Casey’s General Stores and Aspen Technology ( AZPN ). The largest detractors from absolute returns were Doximity ( DOCS ), Keysight Technologies ( KEYS ), WillScot Mobile Mini ( WSC ), Endeavor ( EDR ) and ETSY .

In addition to the transactions listed above, we initiated new positions in Crown Holdings ( CCK ) in the materials sector and Everest Group ( EG ) in the financials sector. We exited positions in Paylocity ( PCTY ) in the industrials sector and Splunk ( SPLK ) in the IT 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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