VRT - ClearBridge Select Strategy Q2 2023 Portfolio Manager Commentary

2023-07-19 09:15:00 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.
• The Strategy performed in line with the benchmark as solid results across most sectors was offset by weakness in consumer discretionary names.
• Despite being underweight mega cap growth stocks, the Strategy is well-positioned to participate in the robust growth of generative AI through our semiconductor and software holdings.
• We have been opportunistic in our recent positioning, patiently waiting for price dislocations to establish new positions across stocks in the durable compounder and evolving opportunity categories that enhance the balance of the portfolio.

By Aram Green

AI Accelerates Existing Growth Themes

Market Overview

Mega cap stocks remained in favor in the second quarter, with enthusiasm over generative AI extending their gains in a historically narrow market. The S&P 500 Index ( SP500 , SPX ) rose 8.74% while the small cap Russell 2000 advanced 5.21% as investors took cooling inflation to mean the Federal Reserve’s tightening cycle is nearing its conclusion. The benchmark Russell 3000 Index advanced 8.39% as growth stocks maintained their positive momentum. The Russell 3000 Growth Index advanced 12.47%, outperforming its value counterpart by 845 basis points, while the small and mid cap focused Russell 2500 Growth Index added 6.42%, 204 bps ahead of similar sized value stocks.

2023 has so far marked a return of leadership from the largest growth stocks in the market, a handful of companies in the information technology ((IT)), consumer discretionary and communication services sectors. Year-to-date, the five largest stocks in the benchmark have accounted for 53.3% of the total return of the Russell 3000 Index (Exhibit 1).

Exhibit 1: Mega Cap Performance Illustrates Concentrated Market

The ClearBridge Select Strategy has limited mega cap exposure, it is overweight Nvidia ( NVDA ) and also owns Apple ( AAPL ), but is meaningfully underweight this group overall versus the benchmark as we see better opportunities among companies in a lower market cap range. Yet, in addition to GPU chipmaker Nvidia, we own several companies that stand to benefit from the robust growth in generative AI.

These holdings play key roles in building out the necessary infrastructure for AI such as Marvell Technology ( MRVL ), a designer of chips for data centers that provide the compute power for large language models and Vertiv ( VRT ), which provides liquid cooling of data centers to optimize performance. Enterprise software makers HubSpot ( HUBS ), Adobe ( ADBE ), ServiceNow ( NOW ) and Gitlab ( GTLB ), meanwhile, are rolling out AI-enhanced versions of their key products to help customers leverage capabilities enabled by this emerging technology while information security software firms Fortinet ( FTNT ), SentinelOne ( S ) and Varonis ( VRNS ) are playing even greater roles in protecting data now vulnerable in more places including the cloud.

The Strategy has historically added alpha in momentum markets like the one experienced in the first half of the year. After outperforming in the first quarter thanks to strong contributions from our disruptor holdings, the Strategy performed in line with the benchmark in the second quarter.

Positive stock selection across a number of sectors was offset by weakness among our consumer discretionary holdings, most notably Burlington Stores ( BURL ), MercadoLibre ( MELI ), Crocs ( CROX ) and ETSY . Off-price apparel retailer Burlington is working to rebound from weaker consumer trends in March but has reiterated its fiscal year guidance in what should be a back-end loaded 2023 for revenue and earnings. Casual footwear retailer Crocs had very high expectations going into the second quarter and guided to a softer spring period due to tougher comparisons and stocking of inventory coming out of the pandemic. The company has also been ramping up spending for its seasonal promotional period in the summer, which has weighed on the shares. Etsy, which offers handcrafted goods on its online platforms, has been hurt by a slowdown from its habitual buyers and a normalization of consumer spending from goods to services. Latin America e-commerce platform MercadoLibre, meanwhile, was down modestly in a strong up market during the quarter.

Portfolio Positioning

The Strategy added four new positions during the quarter, maintaining a focus on balancing higher growth exposures with stocks in more cyclical areas or that we believe are mispriced by the market. We took advantage of price weakness due to increasing Medicare utilization trends to establish a position in UnitedHealth Group ( UNH ), a durable compounder that operates as a diversified health care company, offering managed care and pharmacy benefit services as well as operating-related technology and financial businesses. The company continues to offer consistent growth from a diversified, scaled base of health care insurance and services businesses.

New addition Ashland ( ASH ), in the materials sector, is an evolving opportunity that we have been researching for over a year. We waited for inflation and pricing issues to play out, and then took advantage of recent destocking of inventory that pressured the stock to establish a position. The company has a new management team and has sold off the commoditized areas of its specialty additives and ingredients business to focus on higher value add and higher priced offerings in life science and cosmetics. This restructuring should result in higher margins, higher returns and a bigger capital return story.

Discount retailer Five Below ( FIVE ), similar to Burlington, sold off on fears around consumer spending and potentially negative impacts from the restart of student loan repayments. The stock sold off heading into first quarter earnings, creating a compelling entry point. Earnings were a clearing event and the stock has rebounded since then. Five Below recently introduced an above $5 price point section and we believe premiumization and store expansion should allow the company to maintain its characteristics as a durable compounder.

The sale of rideshare provider LYFT was motivated by an evolving opportunity not working out in a timely and effective manner. We initially purchased Lyft when rideshare volumes were still depressed due to COVID-19. While Lyft was a clear #2 behind UBER in domestic rideshare, we believed it was a cleaner way to play the U.S. recovery due to the focused nature of its business. However, poor execution and the uneven nature of the U.S. recovery, with West Coast markets where Lyft has historically had greater exposure lagging due to a lack of return to office work, further weakened its market position. In March, Lyft announced co-founder Logan Green would step down as CEO with David Risher, a former Amazon executive, taking his place. While Risher has laid out ambitions to drive Lyft’s market share higher, we believe doing so will require more than a few quarters fix. Furthermore, while the company has looked for areas to right size their cost base, we see necessary investments in price, service levels and product differentiation to drive this turnaround, further pushing out the path to improved profitability.

Other activity during the quarter included repurchasing data software company Confluent ( CFLT ) and exiting cloud-based data warehouse provider Snowflake ( SNOW ) and biotechnology firm Moderna ( MRNA ). We had purchased Snowflake opportunistically and sold it on strength to manage the growth profile of the portfolio. Moderna was a small position we had established on positive expectations for its clinical trial for a triple vaccine covering COVID, RSV and the flu. Trial results were disappointing and, with COVID trends weakening, we sold out.

Outlook

We are encouraged by improving market breadth as the second quarter ended, with small caps outperforming large caps. As market participation expands, the Strategy owns a number of companies capable of generating organic growth and expanding early mover leadership positions in the emerging secular growth trend signaled by the rapid adoption of AI.

The growing implementation of AI applications should further enhance the growth potential for several themes that permeate the portfolio and are guiding current and future positioning. These include data and analytics, where we see a lot of growth runway in companies like Confluent, which allows companies to see their data in real-time across all platforms. As mentioned above, information security will continue to play a larger role as the explosion of data and analysis creates more vulnerable endpoints to protect. The compute power of generative AI should also enhance the predictive and more targeted nature of retail offerings from e-commerce providers like merchant enablement provider Shopify.

Portfolio Highlights

The ClearBridge Select Strategy performed in line with its benchmark during the second quarter. On an absolute basis, the Strategy posted gains across eight of the 10 sectors in which it was invested (out of 11 sectors total). The primary contributors were the IT and industrials sectors, while the consumer discretionary sector was the main detractor.

Relative to the benchmark, overall stock selection contributed to performance but was offset by negative sector allocation. In particular, stock selection in the industrials, consumer staples, health care, materials, energy and financials sectors and an underweight to financials were the primary drivers of results. Conversely, stock selection in the consumer discretionary sector was the chief detractor. Stock selection in the real estate sector, an overweight to consumer staples and the Strategy’s cash position also hurt performance.

On an individual stock basis, the leading contributors were positions in Nvidia, ServiceNow, Apple, Surgery Partners ( SGRY ) and Copart ( CPRT ). The primary detractors were Burlington Stores, MercadoLibre, SBA Communications ( SBAC ), Insulet ( PODD ) and Crocs.

In addition to the transactions mentioned above, we exited a position in Atkore ( ATKR ) in the industrials sector.

Aram Green, Managing Director, Portfolio Manager

Original Post

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

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