BRP - ClearBridge Small Cap Strategy Q1 2023 Portfolio Manager Commentary

2023-04-14 04:15:00 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 outperformed its benchmark in the first quarter, as a rebound in select small cap health care stocks and diversification across the financials sector overcame headwinds from the banking crisis.
• As the banking crisis began, we moved swiftly to exit the positions we felt were at the greatest risk from both shrinking deposit bases and higher deposit costs.
• We believe the best defense is to own companies with significant asset value that benefit from rising prices in cyclical sectors and limit exposure to banks and longer-duration businesses.

By Albert Grosman & Brian Lund

Diverse Financials Bolster Performance

Market Overview

The bank run that hit the markets in March may seem like it has ended, but it has only slowed down. While the banks that failed — Silicon Valley, Signature and Silvergate — all had unique profiles that caused depositors to flee suddenly, it caused the sector to ask an important question: why do I have cash earning 0%-2% in my bank account, when I can get 4%-5% in money markets and Treasury bills? The act of pulling deposits from banks forces lending restrictions, hurting the economy but slowing inflation. However, with the market now anticipating the Fed to shift and re-inject liquidity into the system, as it did in March, it creates a recipe for stagflation.

While the financial meltdown in 2008 and the pandemic in 2020-2021 certainly called for monetary easing, the Fed made little progress in the aftermath toward reducing liquidity. It has received criticism for getting a late start increasing rates in 2021-22, but perhaps more inexcusable was the failure to raise rates and enact quantitative tightening during the prolonged growth period from 2009 to 2019. In fact, it had only just begun to engage in quantitative tightening of its substantial holdings in Treasurys and mortgage-backed securities as part of its quantitative easing before it had to backtrack in March, with the money supply (M2) contracting for the first time in 50 years in 2022 (Exhibit 1).

Exhibit 1: M2 Shows Sign of Decline

Despite additional tightening via the federal-funds rate, which has remained below 2% for most of the last 15 years compared to its long-term average of 5% (Exhibit 2), the market seems to believe the Fed will quickly reverse course and ramp up liquidity at the first sign of trouble. Sadly, policymakers seem to encourage this view, with dot plots forecasting 2.5% “longer-term” rates despite short-term rates rarely having been that low prior to the Global Financial Crisis.

Exhibit 2: Rates Remain Low Despite Recent Raises

The tragedy is that the market’s expectation that the Fed will again restore unlimited liquidity at the first sign of trouble per se makes it less likely the Fed will be able to. Inflation remains a risk if the excess liquidity sits in the market, and monetary velocity can’t recover if banks are borrowing and lending near where five- to 30-year rates currently sit. The more long-term rates anticipate Fed easing, the more money flows out of the banking system and into short-term Treasury bills, waiting for a better entry into long-term assets. Bank lending must contract because of unfavorable spreads and low-cost deposit outflows, resulting in the probability of a recession rising, and the Fed’s reluctance to tighten liquidity causing inflation to run hotter. The combination makes dreaded stagflation more likely.

Despite generating positive returns for the quarter, the banking crisis combined with the higher probability of an economic recession meant that small cap stocks trailed the performance of their larger cap peers. The Russell 2000 Index returned 2.74% for the quarter, compared to the 7.46% return of the Russell 1000 Index. Investor optimism for most of the quarter also favored growth stocks over value stocks, with the Russell 2000 Growth index returning 6.07% compared to the -0.66% of the Russell 2000 Value Index.

Fortunately, our strong stock selection within the health care and consumer discretionary sectors, along with the diversification of our financials holdings across banks, payments and transaction companies and consumer credit, helped the Strategy outperform its Russell 2000 benchmark for the quarter.

The financials sector proved to be a positive relative contributor to performance, despite six of our top 10 worst-performing stocks being banks. We entered the quarter positioned in high-quality banks with strong balance sheets that we believed would be able to persevere through a potential recession. As the contagion began, we moved swiftly and decisively to exit the positions we felt were at the greatest risk from both the immediate shrink in deposit bases as well as the future hurdles of increasing loan growth as deposit costs rise. As a result, we exited National Bank and Veritex ( VBTX ) due to their elevated exposure to commercial real estate customers, who we expect will face higher rates and equity requirements when refinancing their existing loans.

However, the diversification of our financials in industries such as consumer finance and payments helped to overcome these detractors. For example, PROG, a provider of lease-purchase solutions to underserved and credit-challenged customers, was one of our top-performing holdings as the company’s profitability and cash flow for 2023 have already exceeded expectations. Additionally, its active share repurchase program exudes confidence in its current growth trajectory, and we believe it will gain market share as credit contracts and requirements for traditional lending sources increase.

"Markets cheering rate cuts to restore liquidity should consider whether that path leads to short-term relief or long-term illness."

Many of our high-quality health care companies who found themselves punished in the fourth quarter rebounded on further clarity and an easing of concerns over hospital and health providers’ capital spending. R1 RCM ( RCM ), a provider of revenue cycle management to hospitals and physician practices, was the fourth quarter’s top detractor. The initiatives the company has undertaken to ensure success in client deployments appear to be working, its new CEO has found acceptance with investors, and R1 RCM’s acquisition of Cloudmed appears to be bearing fruit in cross-selling opportunities and accelerating revenue growth. We believe these strong drivers, along with the company’s large book of long-term contracts, will help propel R1 RCM’s cash flow and earnings power amid the growing demand to improve health care collections.

Moderating inflationary indicators and economic resiliency helped spur investor hopes of a shallow recession to the benefit of our consumer discretionary holdings. Century Communities ( CCS ), an entry-level, single-family homebuilder, benefited from stabilizing mortgage rates and muted inflation in input costs, which helped it exceed the market’s expectations for fourth-quarter earnings. Although more restrictive credit and economic conditions may soften housing demand in 2023, we have high conviction about the company’s multiyear growth runway as demand for housing continues to significantly outpace available supply. We believe Century can capitalize on this and continue to swell its book value over the next several years.

Stock-specific catalysts weighed on our selection in the information technology ((IT)) sector. BigCommerce ( BIGC ), which we added during the quarter, operates a software-as-a-service infrastructure platform for online retail and business-to-business transactions. Its shares were under pressure after lackluster fourth-quarter earnings and a slower than expected revenue outlook for 2023. However, the company’s platform offers customers tremendous flexibility to design and customize their e-commerce operations, and this niche approach has allowed it to capture market share from established industry leaders. Ultimately, we believe the market has drastically underestimated BigCommerce’s ability to achieve greater economies of scale as well as its significant opportunities for long-term growth and margin improvement.

Portfolio Positioning

In a period of elevated market uncertainty, we made a number of changes to the portfolio during the quarter, largely reflecting idiosyncratic drivers.

We initiated a position in Prestige Consumer Healthcare ( PBH ), which makes over-the-counter health and personal care products such as baby ointments, throat lozenges and feminine hygiene products. We believe there is a significant gap between the company’s current market price and its long-term value, based on its growth runway from product expansion in key brands and solid corporate margins.

We added Valaris ( VAL ), in the energy sector, which provides offshore drilling services to the international oil and gas industry through its fleet of drillships, semisubmersible rigs and jackup rigs. The demand for drillships has grown sharply in recent years, and we believe it will continue to grow compounded by limited capacity and few new equipment orders. As a result, the company should realize strong pricing power to propel its revenue and earnings with little need for additional capital spending. We believe the current market price does not reflect this lack of capacity in offshore drilling, and Valaris should be a strong, long-term compounder for the portfolio.

We also exited BRP Group ( BRP ), an insurance company that reached our fair value target during the quarter, and for which we believe the depressed demand for commercial insurance and rising interest rates will prove to be a headwind.

Outlook

At some point, the Fed will have to break the back of inflation that springs from 15 years of easy-money policies. Markets cheering rate cuts to restore liquidity should consider whether that path leads to short-term relief or long-term illness. We believe the best defense against the potential for stagflation is to own companies with significant asset value that benefit from rising consumer prices. As a result, we remain concerned about banks and asset-light, long-duration businesses in areas such as health care and technology, while favoring those in the materials, energy, consumer discretionary and consumer staples sectors, as well as certain industrial industries.

Portfolio Highlights

The ClearBridge Small Cap Strategy outperformed its Russell 2000 Index benchmark during the first quarter. On an absolute basis, the Strategy had gains in eight out of 11 sectors in which it was invested during the quarter. The leading contributors were the consumer discretionary and industrials sectors, while the financials and energy sectors were the main detractors.

On a relative basis, overall sector allocation effects positively contributed to performance, while stock selection detracted. Specifically, an underweight to the health care sector and stock selection in the health care, consumer discretionary, financials and materials sectors contributed to relative returns. Conversely, stock selection in the IT, energy and utilities sectors detracted.

On an individual stock basis, the biggest contributors to absolute returns in the quarter were Integral Ad Science ( IAS ), Lantheus ( LNTH ), Century Communities ( CCS ), R1 RCM and PROG. The largest detractors were Veritex, Western Alliance Bancorp ( WAL ), Helmerich & Payne ( HP ), Sterling Check ( STER ) and Bank OZK ( OZK ).

In addition to the transactions listed above, we initiated a position in Prosperity Bancshares ( PB ) in the financials sector and Atlas Energy Solutions ( AESI ) in the energy sector. We exited positions in Semtech ( SMTC ) in the IT sector and Oportun Financial ( OPRT ) in the financials sector.

Albert Grosman, Managing Director, Portfolio Manager

Brian Lund, CFA, Managing Director, Portfolio Manager

Original Post

For further details see: