JIE GAO/E+ via Getty Images
By Sean Bogda | Paul Ehrlichman | Safa Muhtaseb, CFA | Grace Su
Fortune Doesn’t Favor the Fearful
Market Overview
The third quarter began with a rally over hopes that a faltering U.S. economy could test the Federal Reserve’s resolve to fight inflation, but it proved short lived as strong employment and economic data caused the Fed and other central banks to ratchet up the pace of rate hikes. Markets declined as investors became increasingly convinced that monetary authorities would overshoot their desired outcome and drive global economies into a policy-engineered recession. The result was a global equity selloff, with the MSCI EAFE index returning -9.36% for the quarter. International small cap stocks, more sensitive to domestic consumer confidence trends, felt this decline more acutely, with the EAFE Small Cap Index returning -9.83%. Growth stocks outperformed their value counterparts during the quarter, with the MSCI EAFE Growth Index returning -8.50% versus the MSCI EAFE Value Index’s -10.21%. However, value still remains ahead of growth year to date by over 1,100 basis points.
Rather than driven by positive growth catalysts, the reversal in value leadership was largely impacted by a selloff in traditionally defensive sectors. These included real estate, consumer staples and telecommunications, a subsector within the communication services sector, which typically tend to attract capital amid growing concerns of an economic downturn. However, this dynamic was turned upside down due to the aggressive drumbeat of interest rate hikes of most central banks (with the exception of Japan). The rapid withdrawal of liquidity caused a spike in government bond yields, reducing the relative attractiveness of these bond proxy sectors. Despite these headwinds, the ClearBridge International Small Cap Strategy was able to outperform its benchmark during the quarter due in part to underexposure to these defensive sectors as well as an overweight to the more cyclical energy sector.
On a regional basis, the U.K. continued to be subjected to significant headwinds during the quarter. The country is currently experiencing a cost-of-living crisis resulting from the economic implications of Brexit, which have been further exacerbated by energy shortages tied to the war in Ukraine. In September, newly appointed Prime Minister Liz Truss further shocked the markets with a mini budget focused on providing unfunded tax cuts to spur economic growth. With many pundits questioning if the country had enough financial stability to successfully execute such policies, domestic capital markets – both bonds and stocks – sold off indiscriminately. Risk remained high in China as well, with the world’s second largest economy challenged by its troubled real estate market and zero-COVID policy.
A pair of semiconductor holdings bucked a tough environment for IT spending to drive relative performance. Swiss semiconductor manufacturer u-blox (OTCPK:UBLXF) saw its shares rally after delivering strong second-quarter results and raising its annual guidance for the second time this year, this at a time when many companies are walking back earnings projections. u-blox continues to deliver thanks to robust demand from its automotive and industrial customers for the company’s global positioning and wireless modules that power smart cars and internet of things technology. Similarly, Japanese semi equipment maker Optorun, which specializes in optical thin-film coatings, delivered improved results fueled by a recovery of sales in China and strong order momentum for its new Atomic Layer Deposition (ALD) tools. We sold the position during the quarter due to concerns about slowing demand in its core smartphone market, to consolidate our IT exposure in names with greater earnings visibility.
Macro headwinds hit hardest for consumer discretionary stocks. This was especially pronounced within the U.K. For example, Coats Group (OTCPK:CGGGF), a leading manufacturer of threads for the apparel and footwear industries, was one of the portfolio’s largest detractors during the period. The company was initially pressured by the need to secure financing to complete its acquisition of Texon, a leading footwear solutions provider, that would expand its market into sustainable threads. Recession fears only made things worse as investors dumped apparel stocks. However, we believe such pressures are unwarranted. Coats remains an industry leader and this acquisition represents a powerful shift towards sustainable sourcing. We believe the company will continue to be a long-term compounder in the portfolio, positioned to benefit from both its strong fundamentals as well as an eventual rebound in consumer spending.
The communication services sector also suffered as Spanish broadcaster Mediaset Espana Comunicacion (OTCPK:GETVF) was caught up in the selloff as its main revenue source, TV advertising, becomes more susceptible to reduced ad spending by clients. However, we believe this is yet another case of an overly dire macro outlook. The company is trading at exceptionally compelling valuations relative to its free cash flows and balance sheet, and we expect it to persevere through near-term challenges.
Portfolio Positioning
Although global equity markets remain uncertain, we are confident that our philosophy of investing in high-quality companies with sound balance sheets and strong market positioning will weather any economic storm. We have high conviction in our current portfolio companies but remain ready to tap opportunities from our extensive watchlist as markets evolve. We did just that in the third quarter, adding eight new positions and exiting six.
We added several names in the U.K. as the dire forecasts of recession until the middle of the decade have spurred extreme selloffs in some of the highest quality consumer franchises. We seized this opportunity to upgrade the quality of the portfolio, adding names like iconic British footwear manufacturer Dr. Martens (OTCPK:DOCMF), leading pet care operator Pets at Home (OTC:PAHGF) and housewares retailer Dunelm Group (OTCPK:DNLMY). Each are industry leaders with strong balance sheets and pricing power that we believe will allow them to leverage current events to further solidify their leadership and capture market share. As part of the upgrade to quality, we also exited names such as Marston’s (OTCPK:MARZF), a British pub operator which has suffered increased cost pressure on margins, and furniture manufacturer DFS Furniture (LON:DFS), which we felt had fewer means of offsetting weakness in demand than some of our other consumer-exposed companies.
“Our intention remains to gradually rebalance the portfolio to the East as we identify compelling new investments.”
Overall, the portfolio remains tilted toward cyclical sectors, with overweight allocations to industrials, energy, materials, and financials. We continue to believe these “real economy” sectors have suffered from a decade of underinvestment and will be key beneficiaries of transformational trends related to decarbonization, vehicle electrification, supply chain automation, and infrastructural renewal. To this end, we initiated a position in Eneti (NETI), a Monaco-based owner and operator of offshore wind turbine installation vessels, which should benefit from the strong and growing backlog of offshore wind projects as part of the overall global energy transition.
Conversely, we maintain an underweight to defensive and long-duration sectors such as real estate, technology, communication services, consumer staples and utilities. Our sense is that we are in the early stages of the rate normalization process, which is a key variable driving performance for these sectors.
Geographically, the portfolio maintains its overweight to emerging markets, North America, and the U.K., funded mainly by underweights in Japan and Asia. Although we are taking time to assess the macro and market outcomes, our intention remains to gradually rebalance the portfolio more to the East as we identify compelling new investments. One of those companies is JAC Recruitment (TYO:2124), Japan’s third largest employment introduction agency, which we added during the quarter. JAC stands to benefit from tightening in the labor market, particularly in mid-career jobs which are seeing increased demand and wage hikes as Japan continues its reopening process.
Outlook
Going into the winter months, we expect the abundance of challenges on both the economic and geopolitical fronts will continue to drive increases in investor uncertainty. However, from a different angle, this deep-market correction has also created some incredible opportunities to invest in high-quality businesses that will power the portfolio over the full market cycle.
During times of such uncertainty, our reaction has always been to trust our investment philosophy and process, which has been finely calibrated in an effort to increase effectiveness alongside increases in pessimism. The beautiful simplicity of a philosophy built around owning high-quality franchises at significant discounts allows us to capitalize on opportunities capable of generating long-term outperformance.
Portfolio Highlights
The ClearBridge International Small Cap Strategy outperformed its MSCI EAFE Small Cap benchmark during the third quarter. On an absolute basis, the Strategy had losses across all 11 sectors in which it was invested. The industrials and consumer discretionary sectors were the main detractors during the quarter.
On a relative basis, overall sector allocation contributed to performance but was partially offset by negative stock selection. Specifically, stock selection in the real estate, IT and financials sectors, an overweight allocation to the energy sector and underweight allocation to the real estate sector aided performance. Conversely, stock selection in the consumer discretionary, industrials, energy and communication services sectors weighed on returns.
On a regional basis, stock selection in Europe Ex U.K., an overweight to emerging markets and North America and underweight to Europe Ex U.K. contributed to performance. Stock selection in emerging markets and North America, an underweight to Japan and Asia Ex Japan and overweight to the U.K. weighed on performance.
On an individual stock basis, Ero Copper (ERO), Yellow Cake (OTCQX:YLLXF), u-blox, JHSF Participacoes (BVMF:JHSF3) and Cargotec Oyj (OTCPK:CYJBF) were the leading contributors to absolute returns during the quarter. The largest detractors were Mediaset Espana Comunicacion, Chorus Aviation (OTCPK:CHRRF), Coats Group, Galliford Try (LON:GFRD) and Pason Systems (OTCPK:PSYTF).
During the quarter, in addition to the transactions mentioned above, the Strategy initiated positions in AMADA (OTCPK:AMDLY) in the industrials sector, Arcos Dorados (ARCO) in the consumer discretionary sector and First Pacific (OTCPK:FPAFY) in the consumer staples sector. The Strategy exited positions in Banca Sistema (BIT:BST) in the financials sector, Cementir (OTCPK:CMTHF) in the materials sector and Tassal (OTCPK:TSLLF) in the consumer staples sector.
|
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: Morgan Stanley Capital International. Neither ClearBridge Investments, LLC nor its information providers are responsible for any damages or losses arising from any use of this information. Performance is preliminary and subject to change. Neither MSCI nor any other party involved in or related to compiling, computing or creating the MSCI data makes any express or implied warranties or representations with respect to such data (or the results to be obtained by the use thereof), and all such parties hereby expressly disclaim all warranties of originality, accuracy, completeness, merchantability or fitness for a particular purpose with respect to any of such data. Without limiting any of the foregoing, in no event shall MSCI, any of its affiliates or any third party involved in or related to compiling, computing or creating the data have any liability for any direct, indirect, special, punitive, consequential or any other damages (including lost profits) even if notified of the possibility of such damages. No further distribution or dissemination of the MSCI data is permitted without MSCI’s express written consent. Further distribution is prohibited. |
Editor’s Note: The summary bullets for this article were chosen by Seeking Alpha editors.
Be the first to comment