EMO - ClearBridge SMID Cap Growth Strategy Q2 2023 Portfolio Manager Commentary

2023-07-30 02:40:00 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.
• Growth stocks generated positive returns as signs of economic resiliency, moderating inflation and better than anticipated corporate earnings helped to spur equity markets higher.
• The Strategy underperformed its benchmark, as a slowdown in software bookings and idiosyncratic headwinds to our consumer discretionary holdings weighed on performance.
• The debate over the timing of the next recession receives a lot of media attention, but we remain focused on finding mispriced growth companies with strong balance sheets in a volatile market.

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

SMID Growth Rises on Growing Optimism

Market Overview and Outlook

The growth rally expanded to SMID stocks in the second quarter, lifted by encouraging signs on 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 2500 Growth Index also joined the advance, rising 6.42% compared to a gain of 4.37% for the Russell 2500 Value Index. So far this year, SMID growth has outpaced value by over 750 basis points.

Additionally, markets received a boost from better-than-expected corporate earnings in the second quarter, as our portfolio companies continued to benefit from price increases as well as declining costs and slowing labor inflation. Much uncertainty still exists, but companies with the strongest balance sheets and cash flow generation should be able to continue investing in R&D and sales & marketing through uneven economic environments. This ongoing investment should result in share gains over weaker competitors.

The biggest drama for the markets right now involves the timing and severity of the next recession. Heading into the year, consensus held a recession in 2023 as a near certainty – now, not so much. Policymakers have made it clear that they anticipate further rate hikes, but the slowing of inflation has helped lend credence to the idea that a terminal risk-free rate may be within sight. As a result, investors are reclaiming the confidence to look beyond the recent spike in inflation and interest rate uncertainty to the return of a more “normal” economic expansion.

The ClearBridge SMID Growth Strategy trailed the benchmark during the second quarter. A combination of idiosyncratic individual stock moves 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.

Stock selection in the IT sector was the leading detractor from relative performance during the second quarter. Customer reticence to commit to incremental seats/contract duration or new products during the macro slowdown is understandable and predictably weighed on companies across the sector but was particularly detrimental to software providers such as Five9 ( FIVN ), which provides cloud-based software for call centers as well as Wix.com ( WIX ), which operates a cloud-based platform for website creation and applications. While we made the decision to exit Five9 during the quarter over concerns surrounding the possible headwind posed by AI development and integration, we continue to have high conviction in our IT companies.

"The biggest drama for the markets right now involves the timing and severity of the next recession."

Stock selection in the consumer discretionary sector also detracted in the second quarter. One of the largest detractors was Burlington Stores ( BURL ), an apparel and accessories retailer that offers a wide variety of products at discount prices. The market negatively reacted to the company’s first quarter earnings, which highlighted challenges the company faced as its core, lower-income consumer demographic continues to be impacted by inflationary pressures. Likewise, ETSY , the leading e-commerce marketplace for handcrafted items, was negatively impacted by a shift in consumer spending from goods to services, elevated year-over-year performance comparables and fear of slowing growth in the second half of 2023 or 2024.

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 and mid cap ETFs.

Our holdings in the industrials sector positively contributed to relative performance. Corporate earnings for the industrials sector have continued to exceed market expectations thanks in part to the diversity of industries and end markets for their products. Specifically, the portfolio benefited from its investments in XPO , our top individual performer, and Vertiv ( VRT ). XPO, which provides freight transportation services globally, saw its share price increase after the company announced it had hired an experienced industry veteran as its new president who is expected to implement new initiatives to help drive further margin expansion. Another strong contributor during the quarter was Vertiv, a leader in power and thermal management related tools and services used by data centers, enterprise and industrials companies and communication carriers globally. The company had a particularly strong quarter thanks to investors’ enthusiasm for AI-related technology. Deploying AI applications will necessitate substantial investment in new data centers and upgrading existing facilities. Combined with improved supply chain management and consequently a recovery in its free cash flow, Vertiv shares have recovered nicely in the first half of 2023.

The energy sector also contributed to relative performance, primarily driven by our investment in EQT . As North America’s leading natural gas provider, EQT had seen its share price slide as the lackluster reopening of China and a milder-than-expected winter in the northern hemisphere weighed on natural gas prices. However, as recessionary fears have given way to optimism and the prospect for greater energy demand, EQT’s share price has rebounded. While we continue to expect volatility in commodities prices, we believe that global energy demand, especially in Europe, along with the company’s leadership position in the natural gas market, make it a strong long-term compounder for the portfolio.

Portfolio Positioning

We continue to scour the market for opportunities to add high-quality growth and have built a substantial watchlist of companies we regularly review to see if prevailing market conditions merit their inclusion in the portfolio. During the quarter, we added six new positions and exited three.

We initiated a new position in Karuna Therapeutics ( KRTX ), in the health care sector, a biopharmaceutical company which creates and delivers transformative medicines for people living with psychiatric and neurological conditions. The company is preparing to launch a drug focused on schizophrenia in the second half of 2024, which is generating excitement from the physician community as the majority of drugs utilize a dopamine-related mechanism for this indication, unlike Karuna’s. Karuna also has trials underway to expand this neurology drug into other psychiatric indications with large total addressable markets.

Fox Factory ( FOXF ), in the consumer discretionary sector, engineers, manufactures and markets ride dynamics products including parts for high-performance bicycles, e-bikes and both on road and all-terrain vehicles. We capitalized on a dip in the stock price due to an inventory glut in the high-performance bike segment to establish a position. The company has been a successful compounder since its 2013 IPO, and we believe it continues to have solid supply agreements with performance vehicle manufacturers as well as a strong balance sheet.

We exited our position in Enphase Energy ( ENPH ), in the IT sector, which designs, manufactures and sells semiconductor equipment for the residential solar photovoltaic industry. New regulations within California, as well as improving supply chain dynamics in Europe, have placed additional pressure on the company. Facing concerns surrounding weaker U.S. residential demand, decelerating revenue growth trends and falling prices compressing margins, we elected to sell the position and redeploy our assets to other, higher-conviction holdings.

Outlook

All eyes continue to focus on the Federal Reserve’s pace of interest rate increases. Slowing inflation over the past two quarters contributed to a widely anticipated June meeting “skip.” With more certainty on the terminal risk-free rate, and a new fervor for AI, growth investors have gained the confidence to resume looking out multiple years through any potential near-term earnings malaise and into a more normal economic expansion, contributing to growth stock outperformance.

Despite growing investor optimism, there remains a significant degree of uncertainty in the market and economic outlook. As bottom-up, fundamental investors, we do not pretend to be able to predict the impact and outcomes of macro events and continue to take actions to optimize the risk/return tradeoff of our portfolio. We continue to focus investing in companies with balance sheet stability, free cash flow generation, sustainable competitive advantages and managerial competence that will generate attractive long-term returns over a full market cycle.

Portfolio Highlights

During the second quarter, the ClearBridge SMID Cap Growth Strategy underperformed its Russell 2500 Growth benchmark. On an absolute basis, the Strategy had gains across seven of the 10 sectors in which it was invested (out of 11 sectors total). The industrials, health care and energy sectors were the main contributors while the consumer discretionary and consumer staples sectors were the chief detractors.

In relative terms, overall stock selection effects detracted from performance while sector allocation effects contributed. Specifically, stock selection in the IT, consumer discretionary, consumer staples and health care sectors weighed on performance. Conversely, stock selection in the energy, industrials, communication services and materials sectors as well as an underweight to the financials sector benefited performance.

The leading contributors to absolute returns during the first quarter included XPO, Penumbra ( PEN ), TREX , Summit Materials ( SUM ) and HubSpot ( HUBS ). Meanwhile, BJ’s Wholesale Club ( BJ ), Integra LifeSciences ( IART ), Burlington Stores, Etsy and Five9 were the greatest detractors from absolute returns.

In addition to the transactions mentioned above, we initiated new positions in SiteOne Landscape Supply ( SITE ) and ATS in the industrials sector, Intra-Cellular Therapies ( ITCI ) in the health care sector and Shift4 Payments ( FOUR ) in the financials sector. We exited a position in Chegg ( CHGG ) in the consumer discretionary sector.

Brian Angerame, Portfolio Manager

Aram Green, Managing Director, Portfolio Manager

Matthew Lilling, CFA, Portfolio Manager

Jeffrey Russell, CFA, Managing Director, Portfolio Manager

Original Post

Editor's Note: The summary bullets for this article were chosen by Seeking Alpha editors.

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