WBS - ClearBridge Small Cap Value Strategy Q3 2023 Portfolio Manager Commentary

2023-10-26 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 third quarter was a mirror image of the second, as last quarter’s winners became losers due to growing uncertainty over the economy and interest rates.
• The Strategy outperformed its benchmark, as contributions from communication services stocks and an underweight to health care offset macro headwinds in materials.
• Market visibility is decreasing alongside the prospect of an economic soft landing, increasing the need for strong due diligence and active management.

By Albert Grosman & Brian Lund, CFA

Despite Market Pressures, Small Value Shows Resilience

Market Overview

The third quarter was a mirror image of the second quarter for small cap stocks. The Russell 2000 Index ( RTY ) was down more than 5% after being up more than 5% in the second quarter; companies with the lowest returns on equity or no earnings were down the most after being last quarter’s leaders; and value outperformed growth by about the same amount that growth had outperformed value previously.

Where the outlook seemed to be for lower future interest rates in the second quarter, the third quarter crushed that optimism. The 10- and 30-year government bond rates both rose to the highest levels since before the Global Financial Crisis of 2008. Russell 2000 energy stocks substantially outperformed on rising crude prices, and financials bounced back from their weak first-half performance by rising slightly, while health care, information technology ((IT)), and rate-sensitive utilities and real estate sectors underperformed.

We don’t expect these trends to continue. The market is exhibiting a great deal of uncertainty, not just about the outlook for the economy and interest rates, but what that outlook would mean for stocks. We know that the cost of capital has risen, but is that good or bad for, say, IT stocks that have long-duration cash flows but cash on the balance sheet? Is it good or bad for financials that need the yield curve to uninvert so that long rates are higher than short rates and make lending more profitable, but have large holdings in Treasurys and mortgage-backed securities that are losing value as rates rise?

The answer is: it depends. This collision of highly unusual macro events — the yield curve deeply and persistently inverted; unemployment at historical lows and not responding to Fed tightening; the economy remaining strong while consumer sentiment declines — make sector-investing playbooks useless. Instead, we focus on the fundamental factors that will matter to individual businesses based on their unique circumstances rather than historical generalizations.

• The cost of debt is higher now than it has been in 15 years. Although corporate bond spreads are relatively narrow, even in high yield, the average cost of debt on balance sheets is well below the cost to refinance that debt. Companies with variable rate debt have already seen a big increase in cost, but there is a lot more debt to roll at higher prices, and tight liquidity at banks means that the cost to renew their debt may also take another leg up. Companies, in any sector, that must roll debt (including mortgages and leases) will likely see higher costs.
• Equity capital is increasingly expensive. Although the equity risk premium seems to be relatively low and market valuations high despite rising debt yields, the IPO and secondary equity markets are historically weak. Companies that need access to equity capital should expect to pay a much higher price for it than they have in the past decade.
• The cost to replace fixed assets is high. Although material inflation has come down, the cost of land, labor and financing is much higher than it was a few years ago. Companies that have underinvested in their physical plants or are going through a major upgrade are at a disadvantage against companies that own and operate established fixed assets.
• Profitable small cap stocks trade at a much lower valuation than large cap peers. The Russell 2000’s P/E relative to the Russell 1000 is now lower than at any time since the Internet Bubble burst in 2000 and in the bottom decile of the last 50 years.

Exhibit 1: Forward P/E Back to 2016 Levels

• Almost half the companies in the Russell 2000 are not profitable. About 47% of the companies in the Russell 2000 had negative trailing-12-month EBITDA at the end of the third quarter of 2023, a relic of the enormously speculative IPO market in 2020-2021. It has never been more important to pick stocks carefully from among index components as it is now, especially considering fragile macroeconomic conditions.

Amid this background, the ClearBridge Small Cap Value Strategy outperformed its Russell 2000 Value Index benchmark for the third quarter, as strong performance from our communication services and consumer discretionary holdings and a health care underweight helped to overcome headwinds from our materials holdings.

In the communication services sector, Gambling.com ( GAMB ) was our top individual performer. A leading provider of digital marketing services to the global online gambling industry, the company saw its stock price rise after announcing second-quarter earnings that exceeded analysts’ expectations and raising its full-year guidance, and as the football sports betting season began. Gambling.com has rapidly reached profitability in its North America lead-generation business for sports betting sites, which continues to offer compelling growth opportunities as more U.S. states legalize online gambling, while its mature European business continues to see growth from improved search engine optimization. Ultimately, we believe the company’s low marketing and capital expenditures, combined with the attractive opportunities from growth in online sports wagers, will make Gambling.com a strong long-term compounder for the portfolio.

In the consumer discretionary sector, Vista Outdoor ( VSTO ), which makes a wide range of products serving the outdoor sports and recreation markets, topped analysts’ expectations for second-quarter earnings and was further lifted on optimism about the spinoff of its outdoor products business in the fourth quarter. Retail gas station and convenience store operator Murphy USA ( MUSA ) benefited from rising fuel margins thanks to the combination of rising oil and gas prices and its low-cost operating discipline. As investors grew more uncertain about the future, the company saw increased demand for its lower-cost convenience store merchandise. We believe the company’s more defensive nature will remain a tailwind in an increasingly uncertain economy.

"The current collision of highly unusual macro events makes sector-investing playbooks useless."

The Strategy also benefited from its underweight allocation to the health care sector, the worst performer in the benchmark, and our limited exposure to biopharmaceuticals. These companies tend to be very reliant on capital markets throughout the development and trial stages for their products, resulting in longer-duration cash flows and valuations more susceptible to discount rates. Within health care, we have purposely tilted our exposure toward medical service companies, which have stronger balance sheets, positive cash flows and are less reliant on capital markets.

Stock selection in the materials sector weighed on relative performance for the period. Eagle Materials ( EXP ), which manufactures and sells heavy construction materials and light building materials, was the main detractor in the sector, pulling back after a strong showing in the first half of the year over investor concerns about a possible recession and signs of slowing in construction data. However, we believe Eagle’s second-quarter earnings showed strength and the company is well-positioned to weather any economic downturn due to strong pricing power in its cement business and its cost advantages over peers in its wallboard business.

Portfolio Positioning

We were quite active in the third quarter, adding six new positions and exiting five, as we continued to target companies with strong balance sheets and long-term earnings drivers at discounted valuations.

We made a number of moves within financials to favor banks with rising net interest margins, higher capitalization ratios and lower-risk securities portfolios. As a result, we exited positions in WesBanco ( WSBC ), Simmons First National ( SFNC ) and Webster Financial ( WBS ) in favor of several new additions, including Home BancShares ( HOMB ). A full-service financial firm offering commercial and retail banking as well as financial services to businesses, real estate developers and investors under Centennial Bank, Home BancShares operates bank branches in Arkansas, Florida, Alabama, Texas and New York. We believe Home BancShares increases our exposure to banks with relatively high net interest margins and lower interest-rate risk in their securities portfolios and we believe the company’s long history of excellent credit underwriting should serve it well if the economy tips toward a recession.

We also added Oxford Industries ( OXM ), in the consumer discretionary sector, which is an apparel company operating lifestyle brands including Tommy Bahama and Lilly Pulitzer. The company’s management team has been able to consistently improve Oxford’s operating margins and sales growth over the past few years, and we believe its current stock price represents an attractive value opportunity at relatively low risk for a strong portfolio of brands within the apparel industry.

We exited our position in auto parts manufacturer Stoneridge ( SRI ), which makes engineered and electronic components, modules and systems for motorcycle and agricultural vehicles. Our investment case was based largely on the incremental value to be created by the company’s new products. However, we determined that the risk-reward for the stock became less attractive due to the increasing likelihood of a strike by the United Auto Workers as the third quarter progressed. The potential impact of the strike on the company’s maturing debt in 2024 only added to our concerns, so we elected to exit the position in favor of better opportunities.

Portfolio Highlights

The ClearBridge Small Cap Value Strategy outperformed its Russell 2000 Value Index benchmark during the third quarter. On an absolute basis, the Strategy had gains across three of the 11 sectors in which it was invested during the quarter. The leading contributors were the energy and communication services sectors, while the IT and industrials sectors were the largest detractors.

On a relative basis, sector allocation effects positively contributed to performance. Specifically, a health care underweight and stock selection in the communication services and consumer discretionary sectors positively contributed to relative returns. Conversely, stock selection in the materials sector weighed on relative performance.

On an individual stock basis, the biggest contributors to absolute returns in the quarter were Gambling.com, HF Sinclair ( DINO ), CNX Resources, Vista Outdoor and Western Alliance Bancorp. The largest detractors were Euronet Worldwide ( EEFT ), Photronics ( PLAB ), SMART Global ( SGH ), NorthWestern ( NWE ) and Eagle Materials.

In addition to the transactions listed above, we initiated new positions in Independent Bank ( IBTX ), National Bank ( NBHC ) and S&T Bancorp ( STBA ) in the financials sector and ONE Gas ( OGS ) in the utilities sector. We exited a position in Black Hills ( BKH ) in the utilities sector.

Albert Grosman, Managing Director, Portfolio Manager

Brian Lund, CFA, Managing Director, Portfolio Manager

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