ClearBridge Small Cap Strategy Q4 2023 Portfolio Manager Commentary

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By Albert Grosman and Brian Lund, CFA


Keeping Disciplined Amid Low-Quality Rally

Market Overview

Once upon a time, financial market prices were somewhat tethered to fundamental value. Sure, there were occasional bubbles or manias here or there, in tulips or regional shipping companies or internet stocks, but those were generally isolated to individual asset classes. Some purely speculative assets that generate no income and therefore are only worth what someone else will pay for them, i.e., gold or art or baseball cards, experienced price appreciation that couldn’t be ascribed to fundamental value but at least had some measure of utility. They were pretty or evocative or had unique metallurgical properties that attracted other buyers. Most of all, one could always count on the bond market, the most liquid and transparently valued market, to remain rational.

Those days seem to have ended. Now, in the time of high-speed, low-cost trading and immediate information dissemination, all markets appear to have devolved into speculation about what direction the next tick will be. The most absurd example of this phenomenon in the fourth quarter of 2023 was the 57% rise in bitcoin, a technology still in search of an application. It seems to have risen because there may be new, hopefully less fraudulent ways to trade the phantom “currency” through ETFs, which speculators believe will invite even more speculators to the party. Oh, the marvels of financial innovation.

More disturbing, however, was the behavior of the Treasury market in the fourth quarter. The yield on the benchmark 10-year U.S. Treasury bond (US10Y), one of the most liquid assets in the world, dropped 120 basis points (bps), almost 25%, from 5% to 3.8%. Was this move driven by fears of a weakening economy? Quite the opposite: GDP data for the third quarter was better than expected at 4.9% versus the 4.5% market consensus, payroll figures for October and November beat expectations, and U.S. stock markets boomed. No, the main driver was a press conference from Fed Chair Jerome Powell that perhaps signaled a more dovish monetary policy stance and the release of a new Fed dot-plot that showed it anticipates cutting rates in 2024. No actual cut occurred, and many Fed governors subsequently talked down the odds and magnitude of rate cuts, but markets went ahead and priced in 150 bps of cuts, anticipating a federal-funds rate of 4.0% by the end of 2024. The drop in 10-year yields ironically makes it less likely that the economy will suffer a downturn that would necessitate Fed rate cuts, but we’ll worry about that when Powell speaks after the next meeting.

In classic reflexive fashion, stock markets took the lower-rate ball and ran with it. Which stocks get the most leverage from lower rates? Why, those with the most value in the distant future! Among small caps, both the Russell 2000 Growth and Value indexes rose sharply, but the biggest winners were the quintile of stocks with the lowest return on equity and those with no earnings. Stocks with no earnings remain a historically high percentage of the Russell 2000 indexes (RTY): 31% of the companies in the Russell 2000 are expected to have negative earnings in 2023, including 34% of the Russell 2000 Growth and 31% of the Russell 2000 Value indexes. This large number of money-losing companies throws off historical P/E valuation for the indexes because those companies are excluded from the earnings calculation. While the Russell 2000 Growth and Value indexes appear to be only about 20% and 14%, respectively, above their long-term average on forward P/E, accounting for money losers would make that 35% and 29% above their long-term average.

Despite the chaos, a broadening of market leadership and a decline in yields helped to generate positive absolute returns for small cap stocks in the fourth quarter. However, the ClearBridge Small Cap Strategy underperformed its Russell 2000 Index benchmark as the lower-quality rally in the health care sector and idiosyncratic headwinds to our holdings in the consumer discretionary sector overcame positive contributions from our holdings in the industrials sector.

Stock selection in the health care sector was the primary detractor from relative performance in the fourth quarter. In a reversal from the third quarter, our limited exposure to biopharmaceuticals and portfolio tilt toward higher-quality medical service companies worked against us as investor optimism over an economic soft landing and the prospect of rate cuts in 2024 helped spur a lower-quality rally that sent biopharma stocks higher. Additionally, the prior quarter’s decline in biopharma stocks resulted in discounted valuations, leaving them positioned to rebound after several companies were acquired at premiums to their market price.

“The drop in yields ironically makes it less likely the economy will suffer a downturn that would necessitate rate cuts.”

One of our leading detractors was R1 RCM, a provider of revenue cycle management to hospitals and physician practices. Concerns about the pace of new contracts, leverage due to the company’s added debt load stemming from recent mergers and acquisitions, and concerns that the company’s most recent contract carries a lower take rate versus prior contracts weighed on shares. We continue to believe that the long-term contracted nature of the outsourced business, combined with the growth in its modular business, will provide a very strong base to grow from. As a result, we believe shares are undervalued relative to the cash flow potential of the contracted business.

Maravai Lifesciences (MRVI), which provides products to enable the development of drug therapies, diagnostics and novel vaccines, and to support research on human diseases, also faced challenges. The company has struggled to overcome persistent headwinds from both investor skepticism over the loss of its COVID-19 revenue and continued supply chain disruptions. We continue to believe the company’s intellectual property and investments in manufacturing capacity will, over the long term, produce sustainable profits, which are not incorporated in the current stock price.

Stock selection in the consumer discretionary sector also weighed on performance during the quarter. Outdoor sports and recreation product manufacturer Vista Outdoor (VSTO) sold off after the company announced its deal to sell its sporting products business for lower than what the market anticipated. We believe the final price is heavily discounted to the intrinsic value of the business and ultimately elected to exit the position in order to consolidate our exposure in higher-conviction holdings. Everi (EVRI), which provides casino games, cash access and customer relationship technologies to the gaming industry, also faced headwinds from a weaker than anticipated product cycle leading to lower third-quarter revenues. However, we believe these product cycle challenges are not atypical for the company periodically and are confident that management can successfully navigate the near-term environment to generate attractive long-term returns.

Stock selection in the industrials sector was the leading contributor to performance during the period, largely driven by the performance of cargo container purchaser, leaser and reseller Textainer (TGH), one of our top portfolio holdings. Our analysis indicated the company’s share price was tremendously discounted to its fair business value. We believe this was validated after the company announced it agreed to be acquired at a premium to its share price by infrastructure fund Stonepeak early in the quarter. As we did not foresee other market participants making a better offer for the company, we elected to sell the position and capture the premium.

Portfolio Positioning

We continued to be highly active in the fourth quarter, adding several new positions with strong balance sheets, compelling earnings drivers and attractive valuations, while also exiting positions where we felt our investment thesis weakening. Ultimately, we added 10 new positions and exited six.

Our largest new position is SkyWest (SKYW), in the industrials sector, which operates a regional airline in the U.S. The company derives most of its revenue from fixed-price contracts with major airlines, including Delta (DAL), United (UAL), and Alaska (ALK), to operate short routes to secondary cities. On these flights, SkyWest takes no fuel, load, or price risk, which leaves it exceptionally well-positioned in the event of a recession. It also operates a portion of its fleet at-risk but has reduced this earnings source since the COVID-19 pandemic due to a pilot shortage. As that shortage ends, we believe SkyWest will earn substantially higher profits.

We also added consumer staples company Oddity (ODD), which builds and scales digital-first brands to disrupt beauty and wellness industries. Oddity quickly became one of our top performers during the quarter after it appreciated sharply following a strong earnings report and growing market conviction that its next-generation products will succeed. We believe Oddity is undervalued relative to the potential long-term cash flows to be generated by its existing two brands. In addition, there is further potential value in future brands and categories that Oddity is investing in.

We made several new additions in the health care sector during the period, capitalizing on compelling entry prices at the beginning of the quarter. These included Verona Pharma (VRNA), a biopharmaceutical company focused on the development and treatment of respiratory diseases with unmet medical needs. The company’s current drug candidate, ensifentrine, represents the first novel mode of action for treating chronic obstructive pulmonary disease (COPD) in over a decade; its FDA approval decision date is currently scheduled for drug trials in mid-2024. We believe the current data on the drug is extremely promising, giving it a high likelihood of approval, and leaves it poised to quickly capture a significant proportion of the $10 billion COPD market. Additionally, the company’s strong cash position leaves it well-positioned to continue operations through its initial product launch without the need for further capital injections.

We also added AMN Healthcare Services, which provides health care workforce solutions and staffing services to hospitals and health care facilities. We believe the company’s current stock price represents a compelling investment opportunity as it overestimates a level of cyclical decline in staffing, particularly when compared to the normalization of health care service demand, the relatively high age distribution of existing health care providers and the company’s exciting new initiatives in areas such as language services.

Outlook

Markets pulled forward a lot of good news in the fourth quarter and, as much as these markets demonstrate conviction in coming rate cuts and a continuing strong economy, the uncertainty is palpable in these wild swings. A light breeze in the opposite direction may well convince bond markets that the Fed is more likely to cut 50 or 75 bps in 2024, not the current market expectation. Under such a scenario, we would expect speculative assets like profitless companies to react with a harsh selloff. As a result, we will continue to invest based on bottom-up fundamental views of companies’ intrinsic value under a wide range of scenarios, rather than play guessing games with our investors’ hard-earned money.

Portfolio Highlights

The ClearBridge Small Cap Strategy underperformed its Russell 2000 Index benchmark during the fourth quarter. On an absolute basis, the Strategy had gains across nine of the 11 sectors in which it was invested during the quarter. The leading contributors were the industrials and financial sectors, while the energy and health care sectors were the detractors.

On a relative basis, overall stock selection and sector allocation effects detracted from performance. Specifically, stock selection in the health care, consumer discretionary, IT, real estate, energy, financials and communication services sectors and an overweight allocation to the energy sector weighed on performance. Conversely, stock selection in the industrials and consumer staples sectors proved beneficial.

On an individual stock basis, the biggest contributors to absolute returns in the quarter were Textainer, Century Communities (CCS), Bank OZK, Photronics (PLAB) and Oddity. The largest detractors were SMART Global (SGH), R1 RCM, Vista Outdoor, Atlas Energy Solutions (AESI) and Maravai Lifesciences.

In addition to the transactions listed above, we initiated new positions in Forward Air (FWRD) and Wabash National (WNC) in the industrials sector, Academy Sports and Outdoors (ASO) in the consumer discretionary sector, Replimune (REPL) in the health care sector, Vivid Seats (SEAT) in the communication services sector and Alexander & Baldwin (ALEX) in the real estate sector. We exited positions in CARA Therapeutics, CareMax (CMAX) and Omnicell (OMCL) in the health care sector. We exited our position in Crane (CR), which manufactures and sells engineered industrial products, after the stock attained our valuation target during the period. During the period, existing portfolio holding NCR was renamed NCR Voyix (VYX) and spun-off NCR Atleos (NATL), both of whose shares we retained in the portfolio.

Albert Grosman, Managing Director, Portfolio Manager

Brian Lund, 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.


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

Editor’s Note: This article discusses one or more securities that do not trade on a major U.S. exchange. Please be aware of the risks associated with these stocks.

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