Thinkhubstudio
By Brian Angerame, Aram Green, Matthew Lilling (CFA), Jeffrey Russell (CFA)
Backdrop Improving for Higher Growth Companies
Market Overview
Equities ended a tumultuous year on a positive note, grinding higher in the fourth quarter on better-than-expected corporate earnings and signs that inflation may have peaked. The Russell 2500 Index of small and mid-cap companies rose 7.43% for the quarter but finished down 18.37% in a year marked by a historic tightening of financial conditions. With the Federal Reserve raising interest rates by 425 basis points, long-duration growth stocks were impacted the most severely. The benchmark Russell 2500 Growth Index gained 4.72% for the quarter but underperformed the Russell 2500 Value Index (+9.21%), extending a streak that saw growth stocks fall 26.21% for the year, trailing value by 1,300 basis points.
Toward the end of a year marked by a devastating fire at Windsor castle and tumult in the royal family, Queen Elizabeth famously noted, “1992 is not a year on which I shall look back with undiluted pleasure…it has turned out to be an `Annus Horribilis’.”
We feel similarly about 2022. Not much worked in a risk-off financial market environment. Equities succumbed to significantly higher interest rates, fixed income securities provided no refuge and cash lost real purchasing power. After years of TINA (there is no alternative), investors embraced TARA (there are reasonable alternatives).
The steady drumbeat of benchmark interest rate increases out of Washington was long overdue. The most unusual coalescence of pandemic, supply chain disruptions, fiscal stimulus, demographic changes and the assault on Ukraine led to a sharp spike of inflation, far above expectations of a year or two earlier. Those who recall the insidious impact of inflation from the 1970s aligned with the Fed’s desire to tighten monetary policy and tamp down structural inflation expectations.
Thus far, U.S. unemployment and inflation indices have remained stubbornly firm despite efforts to cool demand. While manufacturing activity as measured by the ISM Purchasing Managers Index (PMI) has softened, services indices have not. History shows that most Fed tightening cycles ultimately lead to recession, albeit with a time lag, and we believe investors have embraced that high likelihood for 2023.
Further compounding the influence of higher interest rates during 2022 were the accelerated trends for many businesses during the 2020/2021 pandemic surge that created “tough comps.” We underestimated the valuation impact (much more apparent in hindsight) on the stocks of higher growth companies, especially as managements had to “comp the comp” in 2022. Investor rotation towards perceived “value” stocks and the mid-year composition change of the Russell 2500 Growth Index benchmark proved additional hurdles to performance.
Amid this backdrop, the ClearBridge SMID Cap Growth Strategy underperformed its benchmark for the year, a blow softened by meaningful outperformance in the fourth quarter. We are disappointed by any year’s underperformance; the Strategy usually outperforms during weak equity markets due to our preference for quality business franchises with financial stability.
“The year past was a wretched one for high growth equity assets. We believe trends are in place for more favorable outcomes in the next few years.”
Health care was a performance drag for most of the year but proved a bright spot in the fourth quarter. Horizon Therapeutics (HZNP), a biotechnology company developing treatments for rare, autoimmune and inflammatory diseases saw its shares rerate following the announcement of its acquisition by large cap pharmaceutical Pfizer (PFE), an example of the clinical potential of smaller cap biotechnology companies that present attractive growth opportunities for strategic acquirers. Insulet (PODD), meanwhile, a medical device manufacturer that develops insulin infusion systems for diabetes patients is increasing share in the market for patch pumps. Insulet beat earnings expectations handily and raised forward guidance due to strength in its U.S. Omnipod pump sales. It also announced EU approval of its Omnipod 5 pump which should launch in mid-2023. Integra LifeSciences (IART), a supplier of surgical instruments and implants, was boosted by a broad rebound in health care equipment providers after a difficult year as well as an increase in medical procedures as the economy and health care sector normalize from the restrictions of the COVID-19 pandemic.
Industrials was another area of weakness through 2022 that saw improvement to close the year. APi Group (APG), a provider of safety, specialty, and industrial services, saw its shares rise on better than expected revenue in its latest quarter. The rebound obviates the overblown investor pessimism surrounding increased leverage from its acquisition of Chubb Fire & Security, where synergies should continue to improve the company’s cash flow generation. Another solid contributor was Vertiv (VRT), a leader in power and thermal management and related tools and systems used by data centers, enterprise and industrials customers and communication carriers globally. Vertiv continues to demonstrate a recovery from supply chain disruptions, win investor approval of its new CEO’s focus on operational improvements and generate greater free cash flow which will continue to make it a strong, long-term holding.
Improved execution lifted results for several of our holdings in the consumer discretionary sector. Shares of discount retailer Burlington Stores (BURL) saw a recovery from a lackluster 2021 holiday season that was marred by logistics and inventory issues that spilled into the first half of the year. Burlington has shown improvement through better cost management and a sales rebound that has put its business model back on track. Five Below (FIVE), which operates as a specialty value retailer for products including apparel, accessories, novelty items, décor, cosmetics and accent furniture, exceeded expectations in the third quarter and raised its fourth quarter outlook, reflecting continued progress in store expansion and expansion of their higher priced product categories. The company’s position as a value retailer is enabling it to hold up well in a tepid environment for consumer discretionary spend.
Portfolio Positioning
We made moderate changes to the portfolio in the fourth quarter, culling several health care holdings facing near-term headwinds while selectively adding to our IT exposure at advantageous price points.
The health care sector has proved challenging as many of our portfolio companies continued to be plagued by headwinds from the third quarter: extended sales cycles and a drop off in COVID-19 revenues. We exited our position in Avantor (AVTR), provider of mission-critical products and services to customers in the biopharma, healthcare, education and government industries, due to the company’s poor execution in integrating its acquisitions of Ritter GmbH and Masterflex while incurring higher leverage. We also closed our position in Catalent (CTLT), which develops and manufactures solutions for drugs, protein-based biologics, cell and gene therapies and consumer health products. The challenge of navigating through declining COVID-19 revenue, combined with supply chain disruptions and greater cyclicality, has extended longer than we anticipated.
Restrictive financial conditions have virtually closed the new issue market. We sold SVB Financial Group (SIVB), the holding company for Silicon Valley Bank, due to ongoing headwinds in the startup and venture capital industries due to tightening liquidity and rising interest rates that have virtually closed the window for financing. The company has also seen a deposit run off which was raising its financing costs.
On the buy side, we added Globant (GLOB), an IT services firm specializing in outsourced digital transformation and custom software development. With companies increasingly digitizing their operations, the cost of developing such systems internally has grown. Globant has been able to capitalize on this trend by acting as an outsourcing partner who can accomplish these tasks at lower cost and greater efficiency than their clients. As such, we believe Globant will continue to grow as more and more companies undergo digital transformations.
We also initiated a position in Bentley Systems (BSY), a maker of design and engineering software for engineering, construction and municipal and government customers. The company has accelerating end markets with innovative product development, strong pricing power and opportunities to expand their addressable markets by tailoring their product for small and medium businesses.
Outlook
As we peer over the hazy horizon into a new calendar year, it seems likely that the major inflation-fighting interest rate increases are behind us and inflation data will be better. Given the usual caveat that our investments are not based on any macro tilt, many measures have shown deceleration or outright declines (i.e. CRB commodity index, housing starts, e-commerce, PMIs, oil). Several relevant trends heading into 2023 include:
- A sea change in how growing companies are changing spending behavior. Managements are moderating cash burn and refining investment spending as investor appetite for capital calls (secondaries) has declined and the cost of debt capital has risen. Some of the country’s most prolific corporate spenders have reined in costs in response to reduced revenue expectations.
- Labor pressures in selected industries are abating. This benefits our holdings, many of which had to fight to recruit talent and fend off talent raids. The “Great Resignation” is yesterday’s story (along with meme stocks, SPACs and crypto).
- Companies scrambled amid supply chain shortages and double-ordered, and now find themselves in a period of inventory reduction as well as moderating freight and other cost pressures. As inventory availability improves, capacity adjustments and job cuts follow – both of which are catnip for Fed watchers.
- The initial public offering market’s somnolence has been reflected in a roughly 95% decrease in IPO proceeds this year vs. 2021. The Renaissance IPO Index, a rolling three-year population of newly public companies weighted by float adjusted market cap, declined a stunning 56.95% this year.
The Fed remains focused on price stability through demand destruction. Many of the above trends are bullish for equities (ironically bad news for the job holder whose job is being eliminated is good news for inflation pressures.) We saw the first spark of recognition that rate increases are likely to plateau in 2023 with the October CPI report, which triggered a pretty violent upward stock price move.
There will doubtless be fits and starts along the way. Recall that the long-term global interdependence of trade is still fractured due to Russian actions. Nevertheless, barring further unforeseeable shocks, we believe the scenery is moving into place for a more favorable 2023 growth stock tableau as the year progresses.
The year past was a wretched one for financial markets, especially high growth equity assets. Small and mid cap growth stocks notched their worst outcome in more than a decade. Keep in mind that the following five years brought above average returns in small and mid cap growth stocks. We believe trends are in place for more favorable outcomes in the next few years.
Portfolio Highlights
During the fourth quarter, the ClearBridge SMID Cap Growth Strategy outperformed its Russell 2500 Growth benchmark. On an absolute basis, the Strategy had gains across nine of the 10 sectors in which it was invested (out of 11 sectors total). The industrials, health care and consumer discretionary sectors were the main contributors while communication services was the lone detractor.
In relative terms, overall stock selection contributed to performance. Specifically, stock selection in the health care, consumer discretionary and industrials sectors and an overweight to the consumer staples sector drove results. Conversely, stock selection in the IT sector and an underweight to energy detracted from performance.
The leading contributors to absolute returns during the fourth quarter included Horizon Therapeutics, Performance Food Group (PFGC), Burlington Stores, ChampionX (CHX) and Insulet. Meanwhile, Catalent, Maravai LifeSciences (MRVI), Omnicell (OMCL), SentinelOne (S) and Paycor (PYCR) were the greatest detractors from absolute returns.
In addition to the transactions mentioned above, we closed a position in Farfetch (FTCH) in the consumer discretionary sector. We also gained shares of RXO in the industrials sector following its spinoff from existing holding XPO.
Brian Angerame, Portfolio Manager
Aram Green, Managing Director, Portfolio Manager
Matthew Lilling, CFA, Portfolio Manager
Jeffrey Russell, CFA, Managing Director, Portfolio Manager
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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 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. Performance source: Internal. Benchmark source: Standard & Poor’s. |
Editor’s Note: The summary bullets for this article were chosen by Seeking Alpha editors.
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