AZPN - ClearBridge Small Cap Growth Strategy Q2 2023 Portfolio Manager Commentary

2023-07-12 06:00:00 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.
• The Strategy underperformed during the quarter due to a combination of idiosyncratic individual stock moves, a lower-quality small-cap rally and Russell index rebalancing pressure.
• On an industry basis, significant moves in a biotech industry where we lack exposure and a slowdown in software bookings had significant impacts on performance.
• We have taken appropriate repositioning moves as necessary while reaffirming the long-term appeal of many of the short-term underperformers.
• We believe sticking to our investment discipline will lead to relative performance recovery and are encouraged by improvement in the last few weeks of the quarter.

By Aram Green & Jeffrey Russell

Staying Committed through Short-Term Turbulence

Market and Performance Overview

The growth rally expanded to smaller stocks in the second quarter, lifted by encouraging signs of inflation, a potential end in sight to interest rate increases, and rising enthusiasm over the potential benefits of generative AI. While the large-cap Russell 1000 Growth Index climbed 12.81% for the quarter, the benchmark Russell 2000 Growth Index also joined the advance, rising 7.05% compared to a gain of 3.18% for the Russell 2000 Value Index.

After slightly outperforming in the first quarter of 2023, the ClearBridge Small Cap Growth Strategy materially trailed the benchmark during the second quarter. A combination of idiosyncratic individual stock moves, a lower-quality small-cap rally, and Russell index rebalancing pressure exacerbated the underperformance. We have taken appropriate repositioning moves as necessary while reaffirming the long-term appeal of many of the short-term stock underperformers.

Relative performance was impacted by detractors across several industries, namely:

• Significant moves in small-cap biotechnology and medical technology stocks. The industry has been buoyed by takeover announcements (Prometheus Biosciences by Merck ( MRK )) as well as the hunt by large-cap biopharmaceuticals to fill product pipelines given patent expiries later this decade (Horizon/Amgen ( AMGN ) and Seattle Genetics/Pfizer ( PFE )). The Russell index rebalance created forced buying of these stocks (now over 10% of the Russell 2000 Growth Index) by passive vehicles and small-cap biotech rose 18.5% during the quarter. The Strategy owns virtually no pre-revenues small-cap biotech, preferring to focus on profitable scientific discovery enablers. Several medtech stocks (Integra LifeSciences ( IART ), Silk Road Medical ( SILK ), STAAR Surgical ( STAA )) were lower, due to company-specific reasons.
• Booking slowdowns for software stocks. These are among our largest and highest-growth, highest-confidence investments. Underperformers included Aspen Technology ( AZPN ), PagerDuty ( PD ), and Sprout Social ( SPT ). Customer reticence to commit to incremental seats/contract duration or new products during the macro slowdown is understandable, and we continue to hold substantial investments in this sector.
• A correction for semiconductor stocks after substantial first-quarter price moves. Both Allegro Microsystems ( ALGM ) and Monolithic Power ( MPWR ) rose ~50% in the first quarter. We believe these companies are share takers based on their innovative design wins and exposure to growth end markets. We have modestly trimmed Allegro recently due solely to position size.

Stock-specific guidance adjustments/business challenges have also skewed negatively. Several examples include BJ's Wholesale Club ( BJ ), Fox Factory ( FOXF ), Trupanion ( TRUP ), and Bloom Energy ( BE ).

1. Our long-standing investment in BJ's Wholesale Club in consumer staples was a detractor. Concerns over tough sales comparisons (partly from price deflation in certain categories plus consumer income pressures) led the stock lower. While we had trimmed the position earlier in the year, we continue to believe the company has a strong competitive position and consumer acceptance as evidenced by high membership renewal rates.
2. Fox Factory in the consumer discretionary sector has been a successful compounder since its 2013 IPO. The company was guided down due to an inventory glut in the high-performance bike segment to which it supplies components. We believe Fox continues to have very solid supply agreements with performance vehicle manufacturers and has no balance sheet concerns. We have maintained the investment.
3. Trupanion in the financials sector underwrites health care insurance for companion animals. Due to medical claims inflation running significantly higher than estimated (ascribed to vet practice wage pressures to attract/retain staff), the company's medical loss ratio was elevated beyond the 70% level of the past decade, pressuring capital adequacy and gating marketing resources. While we believe pricing actions (which lag costs) will eventually cover the higher costs, we have trimmed the position.
4. Bloom Energy in the industrials sector has been a recent execution disappointment. Orders/demand remain exceptionally vibrant for its advanced energy products, yet the capital required to scale the business has exceeded expectations. The stock was pressured on dilution from the recent convertible capital raise (for plant expansion and working capital.) We have kept our position, recognizing Bloom Energy remains a hyper-growth, higher-risk investment.

Further exacerbating underperformance has been a market preference for "early cycle" recovery names. Stocks geared to new home construction, for instance, have been among the strongest in recent weeks as investors anticipate the end of interest rate increases and a normalization of construction volumes. Another headwind to performance this quarter (and year to date) has been the outperformance of lower quality or "non-earners." This tends to coincide with periods of strong flows into small-cap ETFs.

Portfolio Positioning and Outlook

We have experienced prior periods of biotech exuberance as well as disappointments in individual stocks. We exited a few investments this quarter (Chegg ( CHGG ), Hain Celestial ( HAIN )) and made two new investments (Integral Ad Science ( IAS ) and BWX Technologies ( BWXT )). Ironically, some of the Strategy's best performers this quarter were "challenged" stocks in the preceding four to six quarters, such as Penumbra ( PEN ), Trex ( TREX ), and National Vision ( EYE ).

The Strategy has had three prior periods of significant underperformance. Those occurred during the second half of 2008, the first half of 2015, and most recently the fourth quarter of 2020 into early 2021. Needless to say, we're disappointed and frustrated during these periods of subpar performance. Yet the small-cap growth market (and the broader equity market) sometimes moves in mysterious ways during concentrated timeframes. We have found that sticking to our investment disciplines has led to relative performance recovery for our clients. We expect this period to be similar, as it was in the last few weeks of the second quarter.

We continue to exercise judgment and patience to ensure we have the 1) right balance of opportunity and risk in the Strategy, and 2) properly capitalized investments with substantial intermediate- to long-term growth opportunities.

Portfolio Highlights

The ClearBridge Small Cap Growth Strategy underperformed its benchmark in the second quarter. On an absolute basis, the Strategy posted gains across five of the nine sectors in which it was invested (out of 11 sectors total). The primary contributors to performance were the industrials and healthcare sectors, while the information technology ((IT)) sector was the main detractor.

Relative to the benchmark, overall stock selection detracted from performance. In particular, stock selection in the IT, health care, consumer staples, and financials sectors had the most negative impacts on results. On the positive side, underweights to the consumer discretionary and materials sectors and stock selection in materials contributed to performance.

On an individual stock basis, the leading absolute contributors were positions in Trex, Penumbra, Surgery Partners ( SGRY ), XPO ( XPO ), and American Equity Investment Life ( AEL ). The primary detractors were PagerDuty, BJ's Wholesale Club, Integra LifeSciences, Trupanion, and Sprout Social.

In addition to the transactions mentioned above, we exited positions in Sweetgreen and Figs in the consumer discretionary sector.

Aram Green, Portfolio Manager

Jeffrey Russell, CFA, Portfolio Manager

Past performance is no guarantee of future results. Copyright © 2023 ClearBridge Investments. All opinions and data included in this commentary are as of the publication date and are subject to change. The opinions and views expressed herein are of the author and may differ from other portfolio managers or the firm as a whole, and are not intended to be a forecast of future events, a guarantee of future results, or investment advice. This information should not be used as the sole basis to make any investment decision. The statistics have been obtained from sources believed to be reliable, but the accuracy and completeness of this information cannot be guaranteed. Neither ClearBridge Investments, LLC nor its information providers are responsible for any damages or losses arising from any use of this information

Performance source: Internal. Benchmark source: Russell Investments. Frank Russell Company ("Russell") is the source and owner of the trademarks, service marks, and copyrights related to the Russell Indexes. Russell® is a trademark of Frank Russell Company. Neither Russell nor its licensors accept any liability for any errors or omissions in the Russell Indexes and/or Russell ratings or underlying data and no party may rely on any Russell Indexes and/or Russell ratings and/or underlying data contained in this communication. No further distribution of Russell Data is permitted without Russell's express written consent. Russell does not promote, sponsor, or endorse the content of this communication.

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