LHX - ClearBridge Small Cap Growth Strategy Q1 2023 Portfolio Manager Commentary

2023-04-14 03:45:00 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.
• A focus on sturdy business models and management teams enabled the Strategy to outperform in a quarter marked by a banking crisis that rattled confidence in smaller cap stocks.
• Despite fears that the dislocation at Silicon Valley Bank might restrict or blunt the growth of innovation, and financing of technology and health care investments, our portfolio companies are not unduly dependent on external capital and maintain appropriate levels of financial leverage.
• The Fed’s campaign to cool the labor market is having positive impacts on small cap growth businesses, including better talent management with less churn and lower recruiting costs. An earlier peak for interest rates should also support growth stocks.

By Aram Green & Jeffrey Russell

Keeping Pace as March Came in Like a Lion

Market Overview

At year-end, we had hoped to soon be past the macro/news domination of stock prices. However, the first quarter was marked by a banking deposit tsunami that broke with astonishing rapidity in March and resulted in further gyrations of future interest rate and inflation expectations. Through this tumult, the ClearBridge Small Cap Growth Strategy modestly outperformed the Russell 2000 Growth Index benchmark.

January began with a rally most unloved by strategists and many investors. While there are some indications of easing negativity, this remains a generally disdained equity market given the prospect of further interest rate increases and likely earnings shortfalls stemming from the economic slowdown. However, we believe there continue to be overlooked positives in the market, such as materially improved supply chain frictions (“parts and labor”) and slowing inflation (as evidenced by commodity prices substantially lower versus a year ago).

Recent data shows that employment remains stubbornly high, much to the frustration of the Federal Reserve. However, many of our companies, particularly in the information technology ((IT)) sector, remark that sales, engineering and other key talent have shifted from “the Great Resignation” to a much more stable “buyer’s market.” That trend does not show up in short-term earnings estimates, yet managing a growth business is immeasurably easier with lower labor churn given the costs of recruiting, training and integrating new talent.

"Many of our IT companies remark that sales and engineering talent has moved from “the Great Resignation” to a much more stable buyer’s market."

Unemployment unexpectedly dropped in January and long-term Treasury yields backed up quickly in February, testing the market’s mettle. Yet as the old proverb suggests, March came in like a lion, with a banking crisis precipitated by the increase of short-term interest rates. This, combined with generally poor asset/liability duration matching across the industry and the ability of depositors to instantaneously move money with a mouse click, proved toxic and contagious.

The financial failure and depositor run at SVB Financial (SIVB) was stunning. While the Strategy did not own SIVB, we underappreciated the risk of rapid depositor exodus at other financial companies, which became engulfed by depositor outflows. Policy response was solid, with depositor protection and liquidity programs for similarly pressured institutions, yet our investment in Western Alliance Bancorp became substantially higher risk and more volatile than we had imagined. After considerable debate, we sold the investment.

The near-term, second order effect of SIVB’s failure was the selling of selected technology and health care investments perceived to be a part of the SIVB “ecosystem.” The inference was that the dislocation at SIVB might restrict or blunt the growth of innovation and financing in Silicon Valley. While that may be true for a number of pre-public businesses in deficit mode, we suspect those business had already begun to ration cash given the more austere financing environment of the past year. The companies in which the Strategy has invested are not unduly dependent on external financing in the near term; we continue to believe the financial leverage of some of our investments is appropriate to the underlying business stability.

Portfolio Positioning

We initiated three new investments during the quarter in Definitive Healthcare ( DH ), Element Solutions ( ESI ) and Livent ( LTHM ):

• Definitive Healthcare is a highly profitable data and analytics supplier to health care providers and manufacturers. Definitive’s analytics are “commercial intelligence,” assisting salespeople to find the right prospects and decision makers.
• ESI is a high-value specialty materials manufacturer, targeting primarily the contract manufacturing electronics industry and metal plating for automotive applications. ESI works closely with end clients to configure custom materials characteristics and the company’s products are frequently in design specifications of contract manufacturers.
• Livent mines lithium compounds which, once further processed by customers, are a key element in batteries for electric vehicles and other advanced applications. Demand for lithium is expected to grow materially over the next decade as the use of electric vehicles supplants internal combustion engines.

In addition to exiting Western Alliance ( WAL ), we sold smaller positions in truck brokerage firm RXO , content marketing visibility software maker SEMrush ( SEMR ) and collaboration software developer Smartsheet ( SMAR ).

Outlook

The broader implications of the March banking crunch are still unfolding, but several longer-lasting elements seem clear:

• The costs and regulation of regional banking will increase, making the industry ultimately “safer” but with constrained returns.
• Financially-focused businesses with limited credit exposure or depositor flight risk will become more appealing to investors.
• The Fed’s inflation fight becomes even tougher given systemic fragility.
• Interest rates may peak sooner, favoring the visibility of growth stocks over value stocks. Parenthetically, the mega-tech laggards of 2022 became the rotational “safe bet” as the quarter ended.
• Transaction multiples will be pressured and acquisitions will be more difficult to effect if borrowing is necessary to consummate a deal or to drive transaction economics.

Portfolio Highlights

The ClearBridge Small Cap Growth Strategy outperformed its benchmark in the first quarter. On an absolute basis, the Strategy posted gains across six of the nine sectors in which it was invested (out of 11 sectors total). The primary contributors to performance were in the IT and health care sectors while the main detractors included the financials and energy sectors.

Relative to the benchmark, overall sector allocation contributed to performance. In particular, an overweight to IT, an underweight to energy and stock selection in the health care and IT sectors drove results. Conversely, stock selection in the consumer discretionary, financials and industrials sectors and an underweight to consumer discretionary detracted from returns.

On an individual stock basis, the leading contributors were positions in Allegro MicroSystems ( ALGM ), Lattice Semiconductor ( LSCC ), Penumbra ( PEN ), Fox Factory ( FOXF ) and Monolithic Power Systems ( MPWR ). The primary detractors were National Vision Holdings ( EYE ), Western Alliance Bancorp, Silk Road Medical ( SILK ), Chegg ( CHGG ) and Xometry ( XMTR ).

In addition to the transactions mentioned above, we sold Aerojet Rocketdyne ( AJRD ) ahead of its pending acquisition by L3Harris Technologies ( LHX ).

Aram Green, Portfolio Manager

Jeffrey Russell, CFA, Portfolio Manager

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