metamorworks
Market Overview
Global markets tumbled lower during the second quarter, as rampant inflation, monetary policy tightening by central banks, conflict-related commodity volatility and COVID-19 disruptions spurred concerns of a recession and sent the MSCI EAFE Index declining 14.51%. Recessionary fears weighed disproportionately on small cap stocks in Europe, the U.K. and Asia, with the MSCI EAFE Small Cap Index declining 17.69% over the period as small cap companies tend to be more domestically focused businesses and thus highly sensitive to consumer confidence trends.
Value stocks were able to outperform during the first two months of the quarter due to the strength in energy and commodities, but this reversed strongly in June as investors embraced the bear market and sought safety in defensive sectors. Against this tumultuous backdrop, the ClearBridge International Small Cap Strategy outperformed its benchmark for the second quarter.
Surging inflationary pressures dominated the news cycle with the frenzy peaking in June surrounding the U.S. Federal Reserve’s rate hike decision, which investors feared would push the economy into recession. In Europe, the prolonged war in Ukraine continued to put significant strain on the region’s energy inventories. On the other side of the world, COVID-19 flare-ups continued across China, testing the government’s resolve toward its zero-COVID policies. Frequent shutdowns and quarantines have been large setbacks to China’s recovery as well as the normalization of global supply chains.
The main contributors to performance during the period were our holdings in the industrials sector, including the quarter’s top individual performer, Norwegian bulk shipping company Golden Ocean Group (GOGL). Golden Ocean and other dry bulk shipping companies held in the portfolio such as DS Norden (OTCPK:DPBSF) and Star Bulk Carriers (SBLK) have delivered some of our best returns over the past few years. The industry has benefited from robust demand for dry commodities, while skepticism around the sustainability of shipping rates has kept shipping fleet growth muted.
While we remain constructive around these industry dynamics, the share prices for all three bulk shipping companies hit our fair value targets during the quarter and we decided to exit the positions. We are, however, finding new and exciting long-term growth opportunities in industrials surrounding long-term global sustainability trends. For example, we initiated a new position in Befesa (OTCPK:BFSAF), which is headquartered in Luxembourg and is the world’s leader in steel and aluminum hazardous waste recycling.
Befesa is a great example of a circular economy enabler that stands to benefit from the market’s increasing emphasis on recycled materials. The company is already well entrenched in Western markets, and its recent expansion into China offers an enormous growth runway for years to come.
The portfolio maintains a significant underweighting to the information technology (IT) sector, which was also a beneficial contributor to performance. A substantial amount of the declines in global markets were driven by significant multiple compression among high-growth “blitzscaling” IT stocks, which we believe may be vulnerable to further derating as the tightening of monetary policy reduces their revenue growth rates. However, despite headwinds to the sector, we continue to find opportunities there.
For example, u-Blox (OTCPK:UBLXF) is a Swiss manufacturer of wireless positioning and connectivity modules that has been hampered over the last two years due to supply chain disruptions and semiconductor shortages. However, the improvement in semiconductor supply over the last few months has prompted a reversal in u-Blox’s business momentum and we believe our thesis is now finally playing out.
The materials sector proved to be the most challenging sector for the portfolio. Commodity demand has been relatively strong owing to its inflation-hedge nature. However, the continued aggressive rate hike posture from the Fed and deteriorating economic outlook resulted in a market selloff in commodity prices. These volatile periods can prove challenging for even the most skillful management teams to navigate.
Such was the case with Canadian gold miner Argonaut Gold (OTCPK:ARNGF), which faced significant capex overruns in developing a new key project in Magino, Ontario, and drove the company’s financing requirement beyond its funding capabilities. Argonaut’s decision to issue new equity was dilutive to its existing shareholders and, given its strained balance sheet, we exited the position.
Portfolio Positioning
Forecasting the future is an impossible exercise, but our process can identify attractively priced companies with strong balance sheets, solid cash flows and leading market positions that are best positioned for both cyclical and secular earnings growth. We believe this intentional “antifragile” design helps to make our process more effective in times of increased uncertainty and affords us the opportunity to improve the risk/reward potential of the portfolio over the subsequent phases of the market cycle.
“We believe this intentional “antifragile” design helps to make our process more effective.”
From a sector perspective, we continue to have high conviction within our overweight allocations to the industrials, energy, financials and materials sectors. The recent spike in recessionary fears has caused a dramatic selloff in these areas as investors follow the old playbook of selling cyclicals at the first inkling of economic challenge. Harbour Energy (OTCPK:PMOIF), the U.K.’s largest oil and gas exploration and production company, saw shares retreat sharply when the U.K. government enacted a windfall tax on oil and gas companies.
We were able to capitalize on the pullback to initiate a position in Harbour, which we believe can generate enough free cash flow over the next three years to eclipse its current market cap.
Among these sectors we see distinct differences from prior cycles. In industrials and materials, companies have exercised more capital discipline in markets characterized by low levels of spare capacity and depleted global inventories. In energy and commodities, low global stockpiles have helped to bolster prices for the foreseeable future as the infrastructure needed to increase available production and capacity to meet growing global demand requires significant time and capital investment.
In financials, the layers of regulation and stress testing required since the Global Financial Crisis of 2008 means that bank balance sheets remain very conservatively capitalized and likely able to withstand even severe recessionary scenarios.
In contrast, we are underweight traditional defensive sectors such as real estate, utilities and consumer staples. The retreat to safe-haven sectors over growing recession fears has resulted in these stocks rising to historically high valuation premiums. Such was the case with our holding in Spanish real estate developer Metrovacesa (OTC:MRVCF), which was subject to an existing shareholder trying to accumulate and consolidate substantial ownership within the company.
Although we feel the company is undervalued relative to its extensive land bank, the dwindling liquidity as this investor snapped up shares proved too risky for our assessment, and we exited the position. We also remain wary of old leadership growth stocks and maintain low exposure to technology and communication services. We view many of these companies as being pandemic beneficiaries resulting from significant pull-forward of demand and valuations which, despite the derating, remain unattractive relative to other sectors.
From a geographic perspective, political fragility continues to plague Europe and the U.K. Market selloffs across the region have created many deep value opportunities but have also created significant risks. While the adoption of rational and efficient energy policies could serve to further unite Europe and ease uncertainty, the risk of a deep recession remains very real. As such, we currently do not anticipate making any significant changes to our overall allocations to the region.
However, our process continues to highlight several opportunities within Asia, Japan and emerging markets and we expect the portfolio’s exposure to these regions to increase. For example, we recently added Samsonite (OTCPK:SMSOF), a Hong Kong–based global leader and the world’s largest luggage manufacturer. We believe Samsonite is a direct beneficiary of the vigorous recovery in travel activity and, although near-term sales will constitute only 80% of the company’s pre-pandemic levels, we believe it has a multiyear runway for sales growth and will be an excellent long-term compounder of returns.
Outlook
Highly emotional and volatile times highlight the importance of a disciplined investment process. Rather than trying to make precise forecasts about if or when a recession will occur, our focus remains on finding companies with strong profitability, high free cash flows, generous dividends and solid balance sheets exposed to long-term investment themes.
Additionally, global themes, such as the global energy transition, production automation, food security and decarbonization are all secular growth industries that should see high levels of investment regardless of the interest rate backdrop or geopolitical tensions. We remain committed to the goal of building a resilient portfolio with high upside optionality that will generate long-term returns for our investors.
Portfolio Highlights
The ClearBridge International Small Cap Strategy outperformed its MSCI EAFE Small Cap benchmark during the second quarter. On an absolute basis, the Strategy had losses across all 11 sectors in which it was invested. The industrials and materials sectors were the main detractors during the quarter, while the consumer staples and utilities sectors were the top performers.
On a relative basis, overall sector allocation effects contributed to performance but were partially offset by a negative contribution from security selection. Specifically, stock selection in the industrials, IT and real estate sectors, an overweight to the energy sector and underweight allocations to the IT and real estate sectors aided performance. Conversely, stock selection in the materials, energy, consumer discretionary, health care and financials sectors and an underweight to the consumer staples sector weighed on returns.
On a regional basis, stock selection in Europe Ex U.K., an overweight to emerging markets and underweight allocations to Asia Ex Japan and Europe Ex U.K. contributed to performance. Stock selection in the U.K., Japan and emerging markets, an underweight to Japan and overweight to North America weighed on performance.
On an individual stock basis, Golden Ocean Group, Tassal (OTCPK:TSLLF), Beijing Capital International Airport (OTCPK:BJCHF), D/S Norden and QinetiQ (OTCPK:QNTQF) were the leading contributors to absolute returns during the quarter. The largest detractors were Marston’s (OTCPK:MARZF), Sims (OTCPK:SMSMY), Tethys Oil (OTCPK:TTHYF), Ero Copper (ERO) and AMG Advanced Metallurgical Group (OTCPK:AMVMF).
During the quarter, in addition to the transactions mentioned above, the Strategy initiated positions in Fagron (OTC:ARSUF) in the health care sector, and BELLSYSTEM24 (OTCPK:BLSYF) in the IT sector. The Strategy exited positions in West China Cement (OTCPK:WCHNF) and Greatview Aseptic Packaging (OTCPK:GRVWF) in the materials sector, Humm (OTCPK:HUMGF) in the financials sector, Elior (OTC:ELROF) in the consumer discretionary sector and Inwido in the industrials sector.
Editor’s Note: The summary bullets for this article were chosen by Seeking Alpha editors.
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