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By Aram Green
Stay Close to Home for Growth
Market Overview
After a strong rally from June through mid-summer, equity markets rallied again following Fed Chairman Powell’s bluntly hawkish remarks in Jackson Hole. June market lows failed to be sustained and another hot inflation print in mid-September pushed markets to new cycle lows. Investor sentiment is struggling to see a period of increased inflation as rising rates and the end of a pandemic-induced consumer binge take a toll on global consumption.
The benchmark Russell 3000 Index ended 4.5% lower for the quarter and is down 24.6% year to date. In a departure from earlier in the year, growth stocks held up better than their value counterparts while smaller caps outperformed larger companies. The small- and mid-cap-focused Russell 2500 Growth Index fell 0.1% for the quarter while the Russell Midcap Growth Index was down 0.7%.
For the third quarter, the performance of some of these smaller-cap, growth-oriented businesses in the consumer discretionary and information technology (IT) sectors helped the ClearBridge Select Strategy outperform the benchmark. These include Latin America’s e-commerce marketplace MercadoLibre (MELI), which rebounded from June lows after notching another strong quarter of 40% growth with increased revenue levels, as well as retailer Crocs (CROX) slippers.
The development of the electric vehicle (EV) market is a secular innovation that we are targeting and here we see solid contributions from ON Semiconductor (ON), which designs semiconductor components for power management with end market in industrial and electronics that go into EVs, as well as leading EV manufacturer Tesla (TSLA).
WillScot (WSC), which belongs to the emerging portfolio opportunity segment that includes companies with specific drivers towards operational improvement, continued to execute its merger with Mobile Mini by driving sales that value in a more resilient business model and generating abundant free cash flow.
The vast majority of recent performance headwinds have been in healthcare. Main detractors Syneos Health (SYNH), Horizon Therapeutics (HZNP) and Surgery Partners (SGRY) were hurt by different issues. Syneos, a leading contract research organization, experienced a slowdown in new business wins from pharmaceutical customers; Horizon saw weaker sales trends for one of its key drugs, Tepezza for thyroid eye disease, while Surgery Partners sold on concerns that increased summer vacations for doctors will lead to lower patient procedures combined with a fair amount of leverage in its balance.
Our performance in healthcare has been disappointing because we believe this lower portion of the portfolio will be more defensive, with businesses more insulated from the macro issues plaguing the broader economy. We continue to own all three stocks because of relatively attractive valuations.
Portfolio Positioning
We made limited portfolio changes in the third quarter. The new purchases include embryonic positions in several fast growers — MongoDB (MDB) and Clear Secure (YOU) — whose valuations have come up sharply. MongoDB is a company we followed for years before its 2017 IPO. The stock looks very attractive trading at a third of its recent peak in November 2021. The database software company is growing fast and has a $50 billion and global market share.
Clear Secure uses its innovative biometrics technology to improve how consumers go through airport security. We believe that its subscription-based model, which contributes to better throughput through airports, should be more resilient to travel trends by slowing down with more growth drivers specifically to the company in the coming years, including new ways to monetize its unique identity systems. We trimmed our position in Expedia (EXPE) and moved those proceeds to Clear Secure.
We continued to trim some of Strategy’s consumer-facing areas through the sale of website tools provider Wix.com (WIX), gaming software developer Unity Software (U) and theme park operator Six Flags Entertainment (SIX) and a trim of discount retailer Burlington Stores (BURL). Meanwhile, we added to the software names Snowflake (SNOW), which is rapidly gaining share in cloud data management, and Everbridge (EVBG), an improving growth story under new management.
Outlook
It seems like every day brings another headline detailing a historic move or level in some key macro or industry statistic. All of this translates in the short term to more rate hikes, more pain ahead and more patience needed before investors feel comfortable buying risk assets. As a result, we believe this is an excellent time to add to high-conviction stocks whose businesses are likely to benefit from company-specific drivers and where valuations have already been compressed to a turbulent equity market.
We are at a point in the economic cycle characterized by a shrinking money supply, quantitative tightening and a pullback in risk taking. The US economy is holding up better than other regions and US multinationals, which take a large percentage of sales abroad, will see pressure from both lower international consumption as well as weaker translation of profit from foreign currency. With 40% of the S&P 500 Index’s earnings coming from international economies, we think there’s a strong case to be made for owning domestic secular growth and smaller cap companies.
Relative performance for Strategy was better in the third quarter compared to earlier in the year, but we still have a lot to gain after a difficult first half. We believe the portfolio is appropriately positioned for near-term volatility while keeping sight of the long-term goal of outperforming throughout the market cycle.
Portfolio Highlights
The ClearBridge Select Strategy outperformed its benchmark in the third quarter. On an absolute basis, the Strategy posted losses in eight of the 10 sectors in which it invested (out of a total of 11 sectors). The main contributors were the consumer discretionary sector while the main detractors were in the IT and health care sectors.
Relative to the benchmark, overall sector allocation contributed to performance but was partially offset by negative stock selection effects. In particular, an underweight in the communications services sector, the Strategy’s cash position as well as stock selection in the consumer discretionary, industrial and consumer staples sectors drove the results. In contrast, stock selection in the healthcare and financial sectors and an overweight in real estate weighed on performance.
On an individual stock basis, the top contributors were positions in WillScot Mobile Mini, MercadoLibre, Crocs, ON Semiconductor and Tesla. The main detractors are Syneos Health, ServiceNow (NOW), SBA Communications (SBAC), Match Group (MTCH) and Clarivate convertible preferred shares (CLVT.PA).
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Past performance is no guarantee of future results. Copyright © 2022 ClearBridge Investments. All opinions and data included in this commentary are as of the date of publication and are subject to change. The opinions and views expressed herein are those of the author and may differ from those of other portfolio managers or the company as a whole, and are not intended to be a prediction of future events, a guarantee of future results or investment advice. This information should not be used as the sole basis for making any investment decision. Statistics are obtained from sources believed to be reliable, but the accuracy and completeness of this information cannot be guaranteed. ClearBridge Investments, LLC or its information providers are not responsible for any damages or losses arising from any use of this information. Source of performance: Internal. Benchmark source: Russell Investments. The Frank Russell Company (“Russell”) is the originator and owner of the trademarks, service marks and copyrights associated with the Russell Indexes. Russell® is a trademark of the Frank Russell Company. Neither Russell nor its licensors accept any responsibility 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 the express written consent of Russell. Russell does not promote, sponsor or endorse the content of this communication. Source of performance: Internal. Benchmark source: Standard & Poor’s. |
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Editor’s Note: The summary bullets for this article were selected by the Seeking Alpha editors.