ClearBridge SMID Cap Growth Strategy Q3 2023 Portfolio Manager Commentary

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

Market Overview and Outlook

The third quarter was marked by elevated macro influences on portfolio performance. While short-term risk-free rates inched higher, the 10-year U.S. Treasury yield increased 74 basis points, a notable headwind for SMID growth stocks. The benchmark Russell 2500 Growth Index declined 6.84% during the quarter, more than double the 3.13% decline of the large cap Russell 1000 Growth Index. Losses were widespread across the SMID growth market, with just three of the 11 sectors in the benchmark (energy, consumer staples and financials) managing gains for the quarter.

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, weighing on the valuations of longer-duration growth stocks.

Meanwhile, consumer spending began to show signs of cracks as macro risks rose. These concerns included 1) oil and gasoline prices increasing materially during the quarter, 2) the college student debt holiday ending September 1 and 3) the bolus of COVID consumer savings dwindling.

Despite these headwinds, the ClearBridge SMID Growth Strategy outperformed the benchmark during the third quarter as a combination of stock selection in the industrials and IT sectors, as well as an overweight to the consumer staples sector, helped to overcome macro headwinds that weighed on holdings in the consumer discretionary and health care sectors.

“Rather than making big macro bets, we continue to stick to our process and philosophy of constructing a portfolio of high-quality growth compounders.”

Our industrials holdings continue to drive performance thanks to company-specific growth initiatives, economic resiliency, beneficial tailwinds from reshoring and strong backlog conversion. This was particularly true of Vertiv (VRT), a leader in power and thermal management tools and systems used by data centers. The company saw strong data center demand and enthusiasm for AI-related technology. New management has executed well in keeping cost inflation under control while maintaining strong orders and backlog, resulting in improved margins and its best free cash flow generation to date. 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.

Stock selection in the IT sector also proved beneficial, as the pullback in the sector made smaller company valuations attractive to potential acquirers. This included web tracking and analytics company New Relic (NEWR), whose share price rallied on news that it had agreed to be acquired by a consortium of private equity sponsors, and real estate and mortgage software developer Black Knight, whose shares we sold on strength after the company announced its acquisition by Intercontinental Exchange (ICE).

Strong company-specific catalysts also helped to propel the share price of warehouse retailer BJ’s Wholesale Club. The stock price rose after BJ’s reported strong membership and omnichannel initiatives, helping to defuse disinflation fears and tough year-over-year comparisons.

However, growing concerns over the direction of the economy and consumer spending compounded stock-specific challenges that our consumer discretionary companies faced in the third quarter. For instance, specialty value retailer Five Below (FIVE) lowered its full year guidance after the company reported that 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 that the company is poised for over the next few years.

The early August revelation that the GLP-1 diabetes and obesity treatment semaglutide has potentially important cardiovascular benefits led to pervasive selling of a plethora of medical technology stocks. While the longer-term implication was most pointedly felt among diabetes stocks, which could suffer from reduced medical device utilization, reverberations were felt across the gamut of cardiovascular, orthopedic and surgery-related stocks. Directly influenced health care laggards in the portfolio included Insulet (PODD), while Penumbra (PEN, reversing gains from earlier in the year) and Omnicell (OMCL) were also notable detractors.

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 two new positions and exiting two existing holdings.

We 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 also initiated a new position in Novanta (NOVT), in the IT sector, which designs, manufactures, markets, and sells photonics, vision, and precision motion solutions for a wide variety of uses including laser scanning, life science and DNA sequencing, radio frequency identification and intelligent robotic end-of-arm technology among others. The company has broad exposure to several attractive secular growth applications with a benign competitive environment, as well as opportunities to improve margins as they optimize their manufacturing footprint.

We exited our position in Leslie’s (LESL), in the consumer discretionary sector, which markets and sells pool and spa supplies and related products and services. A combination of customer losses (following gains during the pandemic), extended destocking and weaker discretionary product sales resulted in lowering our expectations for long-term earnings, and we elected to exit the position in favor of more compelling opportunities elsewhere.

Outlook

Amidst artificial intelligence and GLP-1 obesity drug exuberance, 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 government shutdown fueling investors’ anxiety about widening deficits.

We navigate this wide range of macroeconomic outcomes with our usual focus on derisking 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, these characteristics serve as a competitive advantage amongst SMID companies given higher costs to fund investment.

Portfolio Highlights

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

In relative terms, overall sector allocation effects contributed to performance. Specifically, stock selection in the industrials, IT, consumer staples and financials sectors and an overweight to the consumer staples sector benefited performance. Conversely, stock selection in the consumer discretionary, health care and energy sectors and an underweight allocation to the financials sector weighed on performance.

The leading contributors to absolute returns during the third quarter included Vertiv, New Relic, BJ’s Wholesale, XPO and ChampionX (CHX). Meanwhile, Insulet, Penumbra, Monolithic Power Systems (MPWR), Shoals Technologies (SHLS) and Omnicell were the greatest detractors from absolute returns.

Brian Angerame, Portfolio Manager

Aram Green, Managing Director, Portfolio Manager

Matthew Lilling, CFA, Portfolio Manager

Jeffrey Russell, CFA, Managing Director, Portfolio Manager

Click to enlarge

Original Post

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