2023-10-22 11:35:00 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.
- Mid cap growth stocks declined during the quarter as the prospects for a higher-for-longer interest rate environment weighed on valuations.
- The Strategy underperformed its benchmark as challenges to our IT and consumer discretionary holdings outweighed positive contributions from our holdings in consumer staples and industrials.
- We continue to refine our positioning to balance a wide range of economic outcomes with companies driven by strong idiosyncratic drivers.
By Brian Angerame, Aram Green, Matthew Lilling, CFA, & Jeffrey Russell, CFA
Amid Growth Pressures, Mid Caps Deliver results.
market Overview
Equity markets proved challenging during the third quarter, as the potential for higher-for-longer interest rates chipped away at valuations and raised questions about an economic soft landing. As a result, value stocks supplanted growth stocks in market leadership, with the Russell Midcap Value Index returning -4.46% while the Russell Midcap Growth Index returned -5.22%.
Investor optimism was high entering the quarter as a string of better-then-anticipated corporate earnings results supported the possibility of an economic soft landing and fueled hopes that the Fed would reach its rate hike zenith, or even reduce rates, before the end of the year. However, a stubborn streak of inflationary data and continued economic resiliency pushed out rate cut expectations further into the future.
One of the things we are closely watching is consumer spending. Consumers have been irrepressible over the last two years in the face of higher rates and prices and, as 70% of the economy, have been significant contributors to the soft-landing narrative. However depleting savings, greater borrowing and higher mortgage rates have started to slow consumer behavior, and the resumption of student loan payments in the fourth quarter will not help. While we avoid making large macro bets, we continue to monitor these inputs for their impact on our companies and investment theses.
From a sector standpoint, energy (+15.26%) and financials (+2.50%) generated positive returns for the quarter, while IT (-3.18%) and industrials (-4.73%) lost ground but still outperformed the broader benchmark. Meanwhile, the health care (-12.62%), utilities (-12.61%), materials (-9.85%), communication services (-8.65%), consumer staples (-8.16%), real estate (-8.09%), and consumer discretionary (-5.57%) sectors underperformed the broader benchmark.
"Depleting savings, greater borrowing and higher mortgage rates have started to slow consumer behavior."
Stock selection in the IT sector was the main detractor during the quarter, as the prospect of a higher-for-longer rate environment weighed on longer-duration, higher growth stocks. Such was the case with Fortinet, our largest individual detractor, whose share price retreated after strong performance in the first half of the year. Extending sales cycles due to a softer macro environment and a period of customer digestion following several years of strong growth rates, unaided by several late quarter contract closings being pushed out, caused the company to miss second quarter revenue targets and lower its forward guidance. Despite the pullback, the company maintains solid revenue growth in an attractive end market and is projected to generate meaningful free cash flow over the next several years. Keysight Technologies ( KEYS ), which provides electronics test and measurement equipment and software to the communications and electronics industries, also saw a period of digestion by customers following several years of record bookings in addition to a sluggish Chinese economy weighing on demand for telecom orders and testing equipment. The company’s track record of expansion and improvement continues to point towards strong, long-term performance and we remain confident in its position as a preferred partner for developers as enterprises continue to increase their R&D budgets. Despite these challenges, there were also strong positive contributions from Splunk ( SPLK ) and AppLovin ( APP ). Splunk’s price rallied on the news of its acquisition by Cisco ( CSCO ), and investors applauded AppLovin’s new, AI-enabled platform which is improving productivity in its mobile games ad network.
In the consumer discretionary sector, Chipotle Mexican Grill ( CMG ) proved a detractor as investors were disappointed in management’s decision not to push additional menu pricing, which resulted in full year guidance falling short of expectations. However, we believe this is just a timing mismatch as their value proposition relative to peers leaves room for continued strong pricing power. Specialty value retailer Five Below ( FIVE ) also lowered its full year guidance after an unexpected uptick in theft weighed on its quarterly performance. However, management is taking loss mitigation initiatives. We believe this industry-wide problem can be overcome by the compelling growth and margin improvements the company is poised for over the next few years.
Positive performance in the consumer staples sector was primarily driven by Casey’s General Stores ( CASY ), which operates convenience stores and gas stations. The company continues to drive greater growth and improve internal performance through the expansion of its private label offerings, while a cooling labor market has helped alleviate wage pressures on margins. By deliberately focusing its geographic footprint on smaller communities, the company has high market share in the regions it serves as well as pricing power, which we believe will continue to be long-term earnings drivers.
Our holdings in the industrials sector also contributed during the quarter. XPO, which provides freight transportation services internationally, rallied on the news that industry competitor Yellow had filed for bankruptcy, resulting in market share gains for XPO . RBC Bearings also generated positive returns thanks to strong gross margin performance within the company’s aerospace and industrial segments. We believe these companies continue to have compelling long-term growth prospects and are positioned to be able to grow and capture additional market share regardless of the direction the economy takes over the near term.
Portfolio Positioning
Rather than making big macro bets on the economy and market direction, we continue to stick to our process and philosophy of constructing a portfolio of high-quality growth compounders. We made several adjustments to the portfolio during the period, initiating four new positions and exiting two.
We initiated a new position in Ferguson ( FERG ), in the industrials sector, a leading distributor of plumbing, pipes-values-fittings, appliances, janitorial supplies and other products to plumbing and mechanical contractors. The company is an established market leader, commanding nine percent of the market in a highly fragmented industry. Ferguson has the opportunity to grow faster than the industry average through scale and technology advantages as well as accretive acquisitions. With the company having divested its European operations to focus on the North American market, we believe it is poised for significant valuation improvement.
We also added a new position in Shockwave Medical ( SWAV ), in the health care sector. The company’s innovative products help clear blockages inside arteries at a lower risk and higher efficiency than other, traditional solutions leading to more optimal outcomes for patients with coronary, vascular and heart valve diseases. We believe these innovations leave Shockwave poised for higher growth, improved margins and attractive free cash flow in a large, total addressable market.
We exited our position in Black Knight, in the IT sector, which develops software for real estate and mortgage transactions, after the stock benefited from its announced acquisition by financial data service provider and exchange operator Intercontinental Exchange ( ICE ).
Outlook
The market continues to grapple with the direction of inflation, interest rates and the next move by the Federal Reserve. Entering the quarter, the market was priced for a soft landing. Investor sentiment had improved as inflation and growth fears quelled - the Consumer Price Index cooled, and corporate earnings continued to come in better than expected. This narrative lost steam as the reality of “higher-for-longer” set in with stubbornly high inflation prints and political debates regarding a government shutdown fueling investors anxiety about widening deficits. The resultant 70 bps rise in the 10-year U.S. Treasury pressured equity market valuations and renewed growth concerns.
We navigate this wide range of macroeconomic outcomes with our usual focus on de-risking company fundamentals and constructing a portfolio across a spectrum of steady to hypergrowth investments. Our focus on strong balance sheets with the ability to self-fund will help our companies continue investing in their products and retain key employees should the economy falter. Should the economy remain steady, we believe our companies’ investment opportunities will continue unimpeded and drive compelling long-term returns over a full market cycle.
Portfolio Highlights
The ClearBridge Mid Cap Growth Strategy underperformed its Russell Midcap Growth Index 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 main contributors were the financials and energy sectors, while the health care and IT sectors were the main detractors.
On a relative basis, overall stock selection effects detracted from performance. Specifically, stock selection in the IT, consumer discretionary and energy sectors and an underweight to the financials sector weighed on performance. Conversely, stock selection in the consumer staples, industrials and financials sectors, an underweight to the health care sector and the Strategy’s cash position benefited performance.
On an individual stock basis, the biggest contributors to absolute returns in the quarter were Splunk, AppLovin, Tradeweb Markets ( TW ), Casey’s General Stores and XPO. The largest detractors from absolute returns were Fortinet ( FTNT ), Insulet ( PODD ), Chipotle Mexican Grill, Doximity ( DOCS ) and Mettler-Toledo International ( MTD ).
In addition to the transactions listed above, we initiated new positions in KKR in the financials sector and Teledyne Technologies ( TDY ) in the IT sector. We exited a position in Atlassian ( TEAM ) in the IT sector.
Brian Angerame, Portfolio Manager
Aram Green, Managing Director, Portfolio Manager
Matthew Lilling, CFA, Portfolio Manager
Jeffrey Russell, CFA, Managing Director, Portfolio Manager
Past performance is no guarantee of future results. Copyright © 2023 ClearBridge Investments. All opinions and data included in this commentary are as of the publication date and are subject to change. The opinions and views expressed herein are of the author and may differ from other portfolio managers or the firm as a whole, and are not intended to be a forecast of future events, a guarantee of future results or investment advice. This information should not be used as the sole basis to make any investment decision. The statistics have been obtained from sources believed to be reliable, but the accuracy and completeness of this information cannot be guaranteed. Neither ClearBridge Investments, LLC nor its information providers are responsible for any damages or losses arising from any use of this information. Performance source: Internal. Benchmark source: Russell Investments. Frank Russell Company (“Russell”) is the source and owner of the trademarks, service marks and copyrights related to the Russell Indexes. Russell® is a trademark of Frank Russell Company. Neither Russell nor its licensors accept any liability for any errors or omissions in the Russell Indexes and/or Russell ratings or underlying data and no party may rely on any Russell Indexes and/or Russell ratings and/or underlying data contained in this communication. No further distribution of Russell Data is permitted without Russell’s express written consent. Russell does not promote, sponsor or endorse the content of this communication. |
Editor's Note: The summary bullets for this article were chosen by Seeking Alpha editors.
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ClearBridge Mid Cap Growth Strategy Q3 2023 Portfolio Manager Commentary