ClearBridge Aggressive Growth Strategy Commentary Q1 2022

Market Overview

Volatility continued to increase in the first quarter, both on a market-wide and individual stock basis, with Russia’s invasion of Ukraine adding to the existing risks of monetary tightening and rising inflation. The S&P 500 Index suffered a nearly 15% correction mid-quarter before recovering to finish down 4.60%. Growth stocks bore the brunt of the selling, with the benchmark Russell 3000 Growth Index falling 9.25% compared to a loss of 0.85% for the Russell 3000 Value Index. Small and mid cap growth stocks suffered even greater losses than their large cap peers, with the Russell 2500 Growth Index down 12.30%.

The Federal Reserve raised short-term interest rates 25 basis points in March, ending a period of unprecedented accommodation, and projected at least six more rate increases through year end. Yields were volatile, declining in a flight to safety during the early days of the invasion before resuming their climb, with the 10-year U.S. Treasury rising over 80 bps in aggregate to end the period at 2.3%. The spike in yields had the greatest impact on higher-multiple stocks, particularly those with limited earnings or free cash flow support. This was reflected in the underperformance of growth stocks, most acutely in the small and mid cap space.

The ClearBridge Aggressive Growth Strategy outperformed the benchmark Russell 3000 Growth Index during the quarter due to greater resilience of the steadily growing, highly free-cash-flow- generative and more moderately valued companies we target. We continue to see these types of durable compounders as the foundation of the portfolio, though we believe that complementary exposure to disruptors, which are generating rapid growth in revenues (20%+), as well as cyclical and improving growth companies, should position the Strategy to perform well in a variety of market and economic environments.

One of the key outcomes of our active repositioning over the last 15 months has been an increase in the portfolio’s overall growth rate, as measured by forward revenue and EPS growth, both on an absolute basis and compared to the benchmark. We have achieved this higher, long-term growth profile by taking a disciplined approach in rotating some of the portfolio into faster- growing disruptors. We have also worked to broaden out our industry exposures to further diversify the portfolio. The Strategy has a goal of protecting capital during turbulent periods and we are encouraged that we have been able to outperform during the market correction, while simultaneously improving our participation in strong growth rallies. We see this as an early testament to recent changes and our more formalized approach to portfolio construction, though we believe the performance of the Strategy should be measured over a longer time frame.

Portfolio Positioning

Short-term price inefficiencies created by recent market volatility have allowed us to ramp up our repositioning efforts over the last two quarters, laying the groundwork for six new positions. While our initial purchases are usually small, we have been patiently building our exposures by dollar cost averaging into market or security-specific weakness. During periods of market transition such as the current one, our experience has taught us that bearish investor sentiment often overlooks business fundamentals, creating opportunity for us as long-term investors. These efforts are evidenced in the increase in turnover over the past several quarters, though we expect portfolio turnover to settle out in the 10%–20% range over time.

We took advantage of a correction in higher-multiple stocks early in the first quarter to purchase shares of Unity Software (U), a leading platform to create, run and monetize 3D content. With about 1.6 million monthly active creators versus roughly 15 million potential content creators in gaming alone, we believe the company’s Create Engine is still underpenetrated relative to its core addressable market. We similarly see a long runway for growth in Unity’s Operate Solutions segment given its advertising network commands single-digit share of the $60 billion mobile app install ad market today. Furthermore, we believe Unity is well-positioned to expand its addressable market to include industries beyond gaming, on both the operate and create sides of their business. The company is not yet free cash flow positive but given strong net expansion rates and high gross margins, we see a path to improving profitability over time, with management notably targeting positive free cash flow this fiscal year.

Health care has always been a core foundation of the portfolio and we have been diversifying our health care exposure to include services and solutions beyond our traditional overweight to biopharmaceuticals and managed care. We first purchased Insulet (PODD) , a leading provider of insulin pumps for diabetes patients, in the fourth quarter of 2021, and we have aggressively added to the position since then. The company is currently the only meaningful manufacturer of patch pumps, the preferred form factor for many patients as compared to traditional tubed pumps. We believe Insulet has a long runway for growth given its large and underpenetrated market, which is only one-third penetrated in Type 1 diabetes and low-single-digit penetrated in the insulin- intensive Type 2 diabetes population. Additionally, we see the launch of the company’s next generation offering, Omnipod 5, which received FDA clearance in January, as an accelerant to growth. Insulet has strong gross margins and is profitable today, though we still see room for significant operating margin expansion ahead.

Doximity (DOCS), another new purchase, operates the largest professional social network for physicians. We believe Doximity is poised to gain share within its core addressable market for medical professional marketing, hiring and telehealth solutions. We also see significant opportunity for growth beyond this initial target market, driven by the potential for the company to add new member types, broaden its customer base, expand internationally and offer direct-to-consumer applications. Doximity has a profitable financial model, though we see room for further margin expansion ahead, particularly as growth matures.

Outlook

As we wrote last year when introducing the pyramid of growth, “We believe how the companies we own fit together in the portfolio is just as important in seeking to generate consistent, long-term results and helps to inform investor expectations and outcomes.” Performance during the quarter illustrated this balanced approach with leading contributions from such diverse businesses as long-time biotech holdings Vertex Pharmaceuticals (VRTX) and Ionis Pharmaceuticals (IONS), L3Harris Technologies (LHX) in the defense industry as well as a recent addition in the disruptor category, leading edge cybersecurity solutions provider CrowdStrike (CRWD).

While several smaller positions suffered sharp losses during risk- off periods of the first quarter, we remain confident in the fundamentals of their business models and were able to use short- term dislocations in the market to scale new holdings where appropriate. Fear and uncertainty may be dissipating from the extremes of the initial Russian invasion of Ukraine, but we expect volatility to continue going forward. This is the type of environment where we feel comfortable leaning on cash flow generators and owning businesses whose ability to compound growth, innovate and execute change, driving long-term value for shareholders, is underappreciated. The result is a Strategy that should over time be able to compound returns through a market cycle at a higher rate than the benchmark Russell 3000 Growth Index.

Portfolio Highlights

The ClearBridge Aggressive Growth Strategy outperformed its Russell 3000 Growth Index benchmark in the first quarter. On an absolute basis, the Strategy had losses across six of the seven sectors in which it was invested (out of 11 sectors total). The lone contributor to performance was the materials sector while the primary detractors were in the information technology (IT) and communication services sectors.

Relative to the benchmark, overall stock selection contributed to performance but was partially offset by negative sector allocation effects. In particular, stock selection in the communication services, health care and materials sectors and an overweight to health care drove positive results. Conversely, stock selection in the IT and consumer discretionary sectors and an overweight to communication services weighed on relative performance.

On an individual stock basis, positions in Vertex Pharmaceuticals, CrowdStrike, L3Harris Technologies, AbbVie (ABBV) and Ionis Pharmaceuticals were the leading contributors to absolute returns during the period. The primary detractors were TE Connectivity (TEL), Autodesk (ADSK), Facebook (FB), Seagate Technology (STX) and Etsy (ETSY).

In addition to the transactions mentioned above, we initiated a position in Airbnb (ABNB) in the consumer discretionary sector and closed positions in Cerence (CRNC) in the IT sector, Liberty SiriusXM (LSXMA) in the communication services sector, Medtronic (MDT) in the health care sector and Pentair (PNR) in the industrials sector.

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