AVTR - ClearBridge SMID Cap Growth Strategy Q3 2022 Portfolio Manager Commentary

Summary

• Having suffered through a sharp decline in earnings multiples, SMID cap growth stocks held up well in a volatile quarter marked by a sharp upward ratcheting of interest rates.
• The Strategy underperformed its benchmark, primarily due to weakness among health care holdings that support clinical research.
• The U.S. economy is holding up better than other regions and with U.S. multinationals facing foreign exchange headwinds, we believe there’s a strong case to be made for owning domestic secular growth and smaller cap companies.

By Brian Angerame | Aram Green | Matthew Lilling | Jeffrey Russell

Persevering Through Health Care Headwinds

Market Overview

After a strong rally from June through mid-summer, equity markets rolled over again following blunt hawkish remarks by Fed Chairman Powell at Jackson Hole. June market lows failed to hold and another hot inflation print in mid-September pushed markets to new cycle lows. Investor sentiment is struggling to see through a period of heightened inflation while rising rates and the end of the pandemic-induced consumer binge are producing a piercing effect on consumption globally.

The S&P 500 Index declined 4.88% over the three-month period, extending its decline to 23.87% year to date. With business visibility evaporating due to these macro headwinds, growth stocks showed greater resilience than value, with the benchmark Russell 2500 Growth Index giving back 0.12% compared to a decline of 4.50% for the Russell 2500 Value Index.

The upward ratcheting of interest rates has already slowed economic activity significantly. However, despite the fact that U.S. labor availability remains a challenge for many employers, we have begun to see indications that supply chain disruption pressures are ebbing and the positive effects of the dollar’s strength in helping cut the cost of imports.

Stock multiples had already declined sharply among small and mid cap growth stocks. We are now in the phase of the economic cycle where earnings expectations and growth rates are also declining. Profit margins have already been squeezed by a variety of elevated cost factors and, in some cases, taken step functions lower. While companies have implemented multiple price increases to help offset rising costs, there will inevitably be future “sticker shock” effects.

We have thoughtfully constructed the ClearBridge SMID Cap Growth Strategy to deliver consistency through trying macro conditions. However, the Strategy underperformed the benchmark for the quarter, dragged down by broad weakness among our traditionally defensive health care holdings.

With many biotechnology stocks reliant on the capital markets to help finance their operations, investor sentiment for health care companies supporting such customers declined, despite small changes in earnings trajectories for these companies. The portfolio’s worst performing stock during the quarter, Catalent ( CTLT ), develops and manufactures drugs, biologics, cell and gene therapies and consumer health products. The company saw its shares derate after it missed earnings expectations partially due to a drop-off in its COVID-focused biologics business. Catalent is responding by reshuffling internal assets to increase synergies and focus on its strong non-biologic franchises, such as its high-growth and high-quality gummy vitamin business.

Avantor ( AVTR ), a leading global provider of mission-critical products and services to customers in biopharma and health care among others, was hurt by FX impacts from a strong U.S. dollar, primarily due to forex strength, slightly higher COVID-19 headwinds, and revenues from a recently acquired property which have underachieved goals at the time of the acquisition. Shares of Ultragenyx Pharmaceutical ( RARE ), a biotechnology company developing gene therapies to treat rare diseases, were penalized by an earnings miss and investor displeasure for the company’s payment to take over control of a program for Angelman Syndrome.

One bright spot in health care was the rebound of Penumbra ( PEN ). The maker of specialty medical devices to treat stroke victims was lifted by management optimism over the launch of three new products in the next year, highlighted by its Thunderbolt and Lightning Bolt products for the treatment of stroke and arterial clots, respectively. Penumbra is also seeing solid growth across its peripheral businesses.

Stock selection was mostly positive across the rest of the portfolio, with strength among our information technology ((IT)) and consumer holdings. Wingstop ( WING ), which operates a national chain of fast casual restaurants featuring chicken wings and a heavy takeout business, was lifted by a number of growth drivers despite facing difficult COVID-19 inflated comps in the first half of 2022. Management is marketing a consumer value bundle, more fulsome national advertising year-round and an expanded menu while ingredient costs appear set to drop for wings. Bulk retailer BJ’s Wholesale Club ( BJ ) was lifted by second-quarter results that topped forecasts on better-than-expected same-store sales and expense controls. While BJ’s faced similar merchandise inflationary pressures as other retailers, the impact to its margins was offset by benefits in gasoline profitability and its lower mix of general merchandise.

Portfolio Positioning

Avalara ( AVLR ), in the IT sector, was also a significant contributor as the stock rerated following an acquisition offer from private equity firm Vista Equity Partners. We chose to exit the shares of the tax management software maker following the deal news. We also closed a position in survey software maker Momentive Global ( MNTV ), best known for its SurveyMonkey brand, due to disappointing business trends in its core survey business concurrent with its failed merger with Zendesk ( ZEN ).

To balance our higher growth holdings in areas like IT, we continue to add exposure in more cyclical areas. New buy Bloom Energy ( BE ) is a maker of fuel cells powered by natural gas that we have owned previously in our small cap growth portfolios. Its products provide a cost-effective, off-the-grid energy source, especially in states with high electricity prices. The company has rolled out its fuel cells in about half of the U.S. and should increase coverage as the production cost curve continues to decline.

New purchase Matador Resources ( MTDR ) is an independent oil and natural gas producer with primary acreage assets in the Delaware Basin of west Texas and southern New Mexico. Matador has high-quality acreage (as measured by well productivity,) as well as a history of very productive, lower risk acquisitions through transactions including acreage swaps for drilling and production efficiency. The result is a substantial portfolio, with an estimated 20 years’ worth of drilling opportunities.

Outlook

Markets are always forward looking. As recent comments out of the Federal Reserve suggest a steely determination to bend inflation expectations, the likelihood of a recession is already well appreciated by investors. The severity and duration of the slowdown/recession and the prospect of peak inflation rates will dictate, at least partly, equity market returns over the foreseeable few quarters. Valuations are now much more reasonable than at any time in the past few years and most sentiment indicators are bearish.

We are at a point in the economic cycle characterized by shrinking money supply, quantitative tightening and a pullback in risk taking. The U.S. economy is holding up better than other regions and U.S. multinationals, which derive a large percentage of sales overseas, will see pressure from both lower international consumption as well as weaker profit translation from foreign currency. With 40% of S&P 500 Index earnings coming from international economies, we think there’s a strong case to be made for owning domestic secular growth and smaller cap companies.

We continue to focus on constructing a concentrated portfolio of growth businesses, assessing the competitive advantages and managerial competence of each holding as we engage in derisking due diligence. We believe our emphasis on quality and durable growth stocks will benefit our clients as the macro headwinds begin to clear, and we thank you for your continued confidence amidst such challenging equity market conditions.

Portfolio Highlights

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

In relative terms, overall stock selection detracted from performance. Specifically, stock selection in the health care sector was the primary headwind to returns. Selection in the financials sector was also detrimental. On the positive side, stock selection in the consumer discretionary, IT and consumer staples sectors, an overweight to health care and an underweight to real estate contributed to relative performance.

The leading contributors to absolute returns during the third quarter included Penumbra, Wingstop, Avalara, BJ’s Wholesale Club and WillScot Mobile Mini ( WSC ). Meanwhile, Catalent, Avantor, Ultragenyx Pharmaceutical, Horizon Therapeutics ( HZNP ) and Omnicell ( OMCL ) were the greatest detractors from absolute returns.

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

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