ClearBridge Mid Cap Strategy Portfolio Manager Commentary Q2 2022

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Persevering In Uncertainty Requires High Conviction

Market Overview and Outlook

Equity markets saw widespread declines during the second quarter as slowing economic growth and aggressive interest rate rises to combat surges in inflation weighed on equity valuations. The S&P 500 Index declined 16.10%, contributing to a 19.96% decline for the first half of 2022, the worst start to the year since 1970. Investors continued their flight to value over growth stocks, with the Russell Midcap Value Index returning -14.68%, outperforming the Russell Midcap Growth Index by over 600 basis points for the quarter and by over 1,400 basis points year to date.

Disruptions in global supply chains stemming from COVID-19 lockdowns in China, the Russian invasion of Ukraine, a tight labor market and undersupplies of global commodities contributed to persistent increases in inflation during the first half of the year. In response, the Fed turned more hawkish, raising interest rates by 50 basis points in May and 75 basis points in June — the most aggressive single hike since 1994. These increases resulted in significant compression of equity multiples across the market and stoked fears of a recession. The uncertainty over the pace and number of rate rises also pushed the 10-year Treasury yield above 3.00% for the first time since 2018.

Against this tumultuous backdrop, even the highest-quality companies faced continued challenges, and the Strategy underperformed its benchmark in the quarter. Concerns over companies’ abilities to sustain their growth rate and margins permeated nearly every sector of the market. As a result, the second quarter largely favored price-taking companies with undifferentiated products in sectors such as energy and consumer staples.

“The second quarter largely favored price-taking companies with undifferentiated products.”

From a sector standpoint, utilities (-5.55%) was the best performer in the benchmark, followed by energy (-6.31%) and consumer staples (-7.96%). The health care (-14.92%), financials (-15.76%), industrials ( 16.19%) and real estate (-16.36%) sectors lagged, but still outperformed the broader Russell Midcap Index. Communication services (-26.78%) was the worst-performing sector in the benchmark, followed by information technology (IT, -23.45%), consumer discretionary (-20.04%) and materials (-16.95%).

The Strategy’s consumer discretionary holdings weighed on performance during the quarter, as rising interest rates and a shift in consumer spending toward staples and services made overcoming comparisons with 2021 earnings more challenging. Our sector exposure is focused on high-quality share-takers such as online used car retailer Carvana (CVNA). After being one of the portfolio’s top performers over the last few years, Carvana has struggled of late due to low used car inventory levels and investor concern about the company’s ability to fund future growth. However, we see Carvana as a consistent earnings compounder that continues to steadily gain share. We took advantage of derating in the stock price to add to our position.

The Strategy’s IT holdings were a positive relative contributor during the quarter, as declining valuations made several companies compelling acquisition targets. This included SailPoint Technologies (SAIL), a leader in enterprise level identity, governance and administration security software, and Black Knight (BKI), a mortgage-lending software and analytics firm. Both companies received offers to be acquired at healthy premiums, and we subsequently closed our position in SailPoint.

Portfolio Positioning

We have a high degree of confidence in our existing portfolio holdings and do not feel the need to make drastic changes to play defense. We continue to adhere to our philosophy of constructing our portfolio from a combination of both high-quality growth companies and value stocks, favoring companies that exhibit strong pricing power, diversified and differentiated product lines and that are run by experienced and efficient management teams. To that end, we maintain a robust pipeline of potential portfolio candidates that we can and have added to opportunistically as we adapt to changes in market conditions.

We took advantage of short-term earnings weakness to initiate a new position in Doximity (DOCS), in the health care sector. The company operates a cloud-based digital platform for medical professionals, enabling them to collaborate with colleagues, coordinate patient care and conduct virtual patient visits. As the health care system accelerates its integration of digital technology, we believe Doximity is uniquely positioned to capitalize on these long-term sector drivers, as well as continue to improve the margins of its subscription-based business model.

We also added to our existing holding Six Flags Entertainment (SIX), in the consumer discretionary sector. Six Flags’ management effectively used its downtime during the COVID-19 pandemic to shift the company’s focus to the premiumization of its theme parks and improvements in overall guest experiences. In addition to benefiting from the economy’s reopening, Six Flags offers a cost-effective regional, day-trip experience than many budget-conscious consumers are choosing over destinations that require costly airfare or lodging. Ultimately, we believe these initiatives will drive further improvements in the company’s share price.

We exited our position in Chewy (CHWY), in the consumer discretionary sector. While we continue to have a favorable opinion of the online pet products retailer, we decided to consolidate our exposure to the pet industry within our existing holding Petco Health & Wellness (WOOF), which is transforming its stores into omnichannel locations offering services such as grooming, short-term pet boarding and veterinary clinics in addition to traditional retail products such as pet toys and food. We used the proceeds from the sale to add to positions we believe offer greater upside potential.

Outlook

The rapid succession of macro events impacting the market has made short-term visibility extremely challenging. The lingering global pandemic, supply chain disruption, inflation and war in Ukraine continue to cloud our view. However, the recent rerating of valuations and expectations, in addition to signs of peaking inflation in many areas of the economy, hint to us the worst may be over for U.S. equities. As has been the case so often in the past, these tumultuous market swoons have provided opportunity to take advantage of attractive price levels in many high-quality companies with strong fundamentals and exceptional management teams. This is what we are most focused on for now.

Portfolio Highlights

The ClearBridge Mid Cap Strategy underperformed its Russell Midcap Index during the second quarter. On an absolute basis, the Strategy had losses across all 11 sectors in which it was invested during the quarter. The leading detractors were the industrials and consumer discretionary sectors, while the more defensive utilities sector was the top contributor.

On a relative basis, overall stock selection detracted from performance, but was partially offset by a positive contribution from sector allocation. Specifically, stock selection in the consumer discretionary and industrials sectors and an underweight allocation to the energy sector weighed on relative returns. Conversely, stock selection in the IT, materials and financials sectors as well as an overweight allocation to the consumer staples sector and the Strategy’s cash position contributed to returns.

On an individual stock basis, the biggest contributors to absolute returns in the quarter were SailPoint Technologies, Black Knight, Definitive Healthcare (DH), Ashland Global (ASH) and Americold Realty Trust (COLD). The largest detractors from absolute returns were Carvana, Expedia (EXPE), Workiva (WK), Marvell Technology (MRVL) and Vertiv (VRT).

In addition to the transactions listed above, we also exited positions in Service Corporation (SCI) in the consumer discretionary sector and DocuSign (DOCU) in the IT sector.


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

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