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Market Overview
Despite the rally to end the first quarter, growth stocks suffered huge losses to start the year as a combination of forces worked against higher multiple market segments that led to performance by most COVID-19 pandemics and initial recovery. While the big cap S&P 500 Index ended 4.60% lower for the quarter and the marketwide Russell 3000 Index dropped 5.28%, the NASDAQ Composite which is very strong in growth dropped 9.10% while smaller capitalization growth index worsened further, with the Russell 2500 Growth Index down 12.30 %.
The round of outside growth and diversion to smaller companies began in the fourth quarter as the Federal Reserve began to heighten its money-restriction rhetoric and accelerated into the new year with a 40-year high inflation print. leading to the first interest rate increase of the cycle. Russia’s invasion of Ukraine in February put tremendous pressure on input costs for businesses around the world, most of which are passed on to consumers. This is causing inflation to rise beyond our expectations and likely means it will be higher and more durable. We expect the war and subsequent economic sanctions against Russia to put pressure on company margins and free cash flow throughout the year.
These macro effects on the growth of stocks were exacerbated by their overweight positioning in investors ’portfolios as well as the valuation extremes reached during the early fourth quarter rally. The ClearBridge Select Strategy was overweight growth and smaller cap stocks and endured the worst of the selling pressure facing these areas in the quarter. This resulted in poor performance against our main benchmark, the Russell 3000 Index, which holds both growth and value equities. Underperformance is less pronounced compared to the Russell 2500 Growth and Russell Midcap Growth indices.
The most important losses come in disruptive ones that account for a significant portion of the portfolio. Since most of the valuation of these fast -growing companies is based on cash flows expected in the future, they most directly carry the weight of valuation math when the denominator of discounted cash flow models – short -term interest rates – is increased significantly. Higher rates also increase the cost of borrowing, which can eventually weaken consumer demand. These risks have affected several disruptor that businesses are tied to e-commerce and consumer spending, including e-commerce enablement provider Shopify (SHOP), online used car platform Carvana (CVNA) and residential decking. maker Trex (TREX) all dropped more than 50% for the quarter while footwear retailer Crocs (CROX) dropped more than 40%.
The primary goal of the Strategy is to deliver returns that are different to passive portfolios and other active managers by focusing on stocks with company -specific drivers. These businesses tend to be more insulated from macro forces and are generally more resilient throughout the market cycle. However, stocks typically do not perform in more pro-cyclical and macro driven markets. While our long-term bias toward innovation and growth is detrimental to performance, our ownership of high-quality compounders and emerging opportunity stocks such as Performance Food Group (PFGC), L3Harris Technologies (LHX ) and CME Group (CME) helped offset some of the volatility of the first quarter. The stability of these companies reflects the balance we sought to achieve in the portfolio with our positioning actions during COVID-19.
Portfolio Positioning
Risk management supports this balance sheet goal and we are actively selling in the quarter. We cut our position in Pioneer Natural Resources (PXD) after gaining nearly 40% of the stock on rising oil prices and rotated some of that capital into the energy services space.
After many years of low activity, we believe that new energy exploration activity should increase, which will benefit stocks on the services and equipment side.
We also reduced our consumer exposure to manage increased uncertainty about retail spending during times of higher inflation and interest rates. These include the sale of apparel retailer American Eagle Outfitters (AEO), a trim of online car sales marketplace Carvana, and the replacement of long-standing investments with off-price retailer Ross Stores (ROST) for Burlington Stores (BURL) . We see Burlington as early in its maturation stage with a seasoned management team using a proven playbook. We also left Cricut (CRCT), a tool and software platform for handmade goods design, and pet supplies retailer Chewy (CHWY) after becoming more concerned about their user metrics. The online gaming platform Zynga (ZNGA) was sold before a strategic acquirer closed its acquisition at a huge premium.
In addition, volatility has provided opportunities to enter new positions at attractive prices. To those disturbing, this backdrop prompted our purchase of electric vehicle maker Tesla (TSLA) during a 25% correction in its components, as well as Sentinel One (S) in the information security space and Etsy ( ETSY), an online marketplace for handmade goods. We’ve also added two new consumer companies that we consider evolving opportunities, theme park operator Six Flags Entertainment (SIX) and fragrance maker Coty (COTY). Finally, more compelling valuations resulting from extensive selling pressure have allowed us to add to current software investments, including ServiceNow (NOW) and GitLab (GTLB).
Outlook
Private investments and initial public offerings offer another attractive source of new ideas for the Strategy but the current aversion to more risky, higher mass growth companies often freeze of activity in these markets. We typically see this during periods of market correction, as private markets typically take time to reach public markets. We remain active in negotiating with private and pre-IPO companies but until we see stability returning to equities, we expect limited issuance.
The return for more growth-focused stocks to end the quarter is encouraging and we believe the qualities we are looking for in portfolio companies (innovative self-funding businesses with a long runway for growth and operating levers company -specific) are evergreen characteristics. Although the market does not always value their stability (as we saw in the early days of COVID-19 in 2020), in the longer term we believe ownership of companies with such characteristics will be rewarded. While citing the recent variability of returns at some portfolio companies that we consider disruptive, we maintain confidence in the role of these higher growth names in a balanced portfolio that also includes healthy exposure to fluid. -continuous integration of businesses and evolving opportunities.
Portfolio Highlights
ClearBridge Select Strategy failed to meet its Russell 3000 Index benchmark in the first quarter. On an absolute basis, Strategy suffered losses in nine of the 10 sectors in which it invested in the quarter (out of a total of 11 sectors). The IT, consumer discretionary and industrial sectors are the major detractors in performance while the energy sector is a contributor.
In relative terms, overall stock selection is the main detractor to performance. In particular, stock selection in the IT, consumer discretionary and industrial sectors had the greatest negative impact on outcomes while selection in the healthcare and financial sectors also proved detrimental. On the positive side, stock selection in the communications services sector and an underweight in the sector contributed to the performance.
On an individual stock basis, the largest contributors to the full return in the first quarter were Pioneer Natural Resources (PXD), Zynga (ZNGA), Tesla (TSLA), Expedia Group (EXPE) and Performance Food Group (PFGC. ). The most important individual detractors are Shopify, Trex, DocuSign (DOCU), Vertiv Holdings (VRTV) and Crocs (CROX).
In addition to the transactions mentioned earlier, Strategy has closed positions in Twilio (TWLO), Dynatrace (DT), Yext (YEXT) and HashiCorp (HCP) in the IT sector, Rivian Automotive (RIVN) and Global-e Online ( GLBE) in the consumer discretionary sector, Uber (UBER) in the industrial sector and Altimeter Growth (AGCB) in the financial sector.
Editor’s Note: The summary bullets for this article were chosen by the editors of Seeking Alpha.