ZWS - ClearBridge SMID Cap Growth Strategy Q1 2023 Portfolio Manager Commentary

2023-04-23 00:15:00 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 bank tsunami that broke in March resulted in further gyrations of interest rate and inflation expectations; the Strategy modestly underperformed its benchmark.
• While we did not own Silicon Valley Bank, we underappreciated the risk of rapid depositor exodus at other financial companies and moved swiftly to exit the positions we felt were the most at-risk.
• A stabilizing employment environment has benefited innovative growth names, easing labor churn and reducing costs of recruiting, training and integrating new talent.

By Brian Angerame, Aram Green, Matthew Lilling, & Jeffrey Russell

SMID Keeps Pace Amid Market Gyrations

Market Overview and Outlook

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 SMID Cap Growth Strategy modestly underperformed the Russell 2500 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.

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 Silicon Valley Bank (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 ( WAL ) 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.

"March came in like a lion, with a banking crisis precipitated by the increase of short-term interest rates."

Stock selection in the IT sector was the leading contributor to performance during the first quarter, as initial prospects of a potential Fed reversal later in the year helped bolster market optimism in higher growth assets. This included Monolithic Power Systems ( MPWR ), which manufactures and sells semiconductor-based power electronics for a wide variety of applications. The company’s fourth quarter earnings exceeded market expectations, which set it apart from many semiconductor names which have derated due to cyclical concerns. Additionally, the company’s exposure to China benefited from increased investor optimism over a reopening and rebound in the Chinese economy.

Another top performer was cloud-based marketing, sales, and customer service software platform HubSpot ( HUBS ), which delivered earnings that exceeded market expectations for the fourth quarter and raised its 2023 earnings guidance. Despite delays in the company’s sale cycle as customers brace for economic uncertainty, HubSpot has been able to capitalize on small and medium businesses’ desire for greater digital infrastructure, rapid integration and greater focus on customization and reporting. We believe that HubSpot’s transformation from a marketing automation company to a broader customer relationship management platform is well underway and that it is currently building a foundation to be a single source customer data and commerce platform over the long run. We are confident in the company’s execution, market strategy and long-term growth opportunities.

Health care continued to be a bright spot for performance in the first quarter, led by Penumbra ( PEN ). The company, which makes medical devices to remove clots from the brain, heart, lungs and peripheral circulation, has seen stronger than expected demand from hospitals for its peripheral clot removal products due to their ability to more quickly treat and discharge patients. Additionally, anticipation of new product introductions for stroke and vascular disease applications have met with good physician acceptance, based on limited introduction during recent months, powering the stock higher. We believe Penumbra’s enhanced technology will speed treatment times, help the company take share from competitors and potentially expand the number of interventionists that can offer clot removal.

Several portfolio holdings faced idiosyncratic headwinds which weighed on performance during the quarter. For example, National Vision ( EYE ) is an optical retailer offering eyeglasses and contact lenses as well as optometric services. The company had a major earnings reset for 2023 due to higher costs for remote optometric enablement in order to combat a chronic shortage of optometrists. Likewise Enphase Energy ( ENPH ), a semiconductor equipment company in the residential solar space, struggled during the quarter as as the costs of solar installations have moved higher in tandem with higher financing costs.

Portfolio Positioning

The last six months we have been able to use the elevated levels of volatility and market uncertainty to add high-quality growth stocks at compelling valuations. Fortunately, we maintain an extensive watchlist of companies we feel would be excellent additions to the portfolio under the right circumstances and move decisively to add them when they come under significant pressure. As a result, we added one new position and exited five existing holdings during the quarter.

We initiated a new position in Floor & Decor ( FND ), in the consumer discretionary sector, a multi-channel retail and commercial flooring distributor. The company is essentially a flooring version of Home Depot ( HD ) with similar service and cost leadership strategy, led by several members of senior management from Home Depot that guided that company through its rapid growth phase. Floor & Decor is set up for 15%-20% prospective store growth to 500 stores over the next decade and strong unit economics with new stores generating over 50% cash on cash returns in year three. Furthermore, there are favorable secular tailwinds as hard surface flooring is taking share from carpet and Floor & Decor has volume price advantages by purchasing products direct from suppliers.

We exited our position in Zurn Elkay Water Solutions ( ZWS ) in the industrials sector. The company designs and manufactures water system solutions that provide and enhance water quality, safety, control and conservation in non-residential buildings. We felt that the decline in non-residential construction, as well as the company’s lack of exposure to infrastructure, will prove a headwind to its near-term prospects. Additionally, we believe Zurn has lagged in capturing synergies from its acquisition of Elkay in mid-2022, and that meeting its current guidance will require them to incorporate synergies faster than they have demonstrated.

We also elected to sell our position in Petco Health & Wellness ( WOOF ), in the consumer discretionary sector, which offers pet consumables, supplies and services including veterinary care, grooming and training. We initially entered the position due to optimism surrounding the company’s strategy of transitioning its traditional retail establishments to holistic, one-stop destinations for pet products as well as onsite veterinary services, boarding, grooming and training. However, persistent inflationary and economic pressures have resulted in a slowing of customer acquisition, and the company’s shift away from higher margin supplies toward consumables has weighed on profitability.

We sold our investment in Western Alliance Bancorp, in the financials sector, after considerable debate. The company provides various banking products and related services primarily in Arizona, California, and Nevada. We underappreciated the risk of rapid depositor exodus at other financial companies in the wake of the collapse of SIVB, which became engulfed by depositor outflows. Although we believe that policy response was solid, with depositor protection and liquidity programs for similarly pressured institutions, our investment in Western Alliance Bancorp became substantially higher risk and more volatile than we had imagined.

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

During the first quarter, the ClearBridge SMID Cap Growth Strategy underperformed its Russell 2500 Growth benchmark. On an absolute basis, the Strategy had gains across six of the 10 sectors in which it was invested (out of 11 sectors total). The IT, industrials and health care sectors were the main contributors while the financials and energy sectors detracted.

In relative terms, overall sector allocation effects contributed to performance, but were offset by stock selection effects. Specifically, stock selection in IT, health care and energy sectors, an overweight to the IT sector and underweights to the energy and financials sectors drove results. Conversely, stock selection in the consumer discretionary, financials, materials, consumer staples and communication services sectors detracted from performance.

The leading contributors to absolute returns during the first quarter included Monolithic Power Systems, HubSpot, Penumbra, Wingstop ( WING ) and BJ’s Wholesale Club ( BJ ). Meanwhile, Western Alliance Bancorp, National Vision, Enphase Energy, Ultragenyx Pharmaceutical ( RARE ) and Matador Resources ( MTDR ) were the greatest detractors from absolute returns.

In addition to the transactions mentioned above, we exited positions in Horizon Therapeutics ( HZNP ) ahead of its acquisition by Amgen ( AMGN ), and Definitive Healthcare ( DH ), both in the health care sector.

Brian Angerame, Portfolio Manager

Aram Green, Managing Director, Portfolio Manager

Matthew Lilling, CFA, Portfolio Manager

Jeffrey Russell, CFA, Managing Director, Portfolio Manager

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