Clearbridge Investments Mid Cap Strategy Q1 2022 Commentary

Market Overview and Outlook

Markets saw elevated levels of uncertainty and volatility during the quarter, putting pressure on mid cap stocks. The S&P 500 Index declined 4.60% for the period, while the benchmark Russell Midcap Index fell 5.68%. With macro catalysts limiting visibility into market performance, investors continued to favor value stocks over growth, with the Russell Midcap Value Index returning -1.82%, outperforming the Russell Midcap Growth Index by over 1,000 basis points.

Even the best run companies have struggled to navigate the global turmoil, inflation and supply chain disruptions seen during the quarter. Uncertainty over the medical and economic impact of the COVID-19 Omicron variant weighed on performance in the beginning of the period. However, these concerns pivoted to the impact of rising inflation, exacerbated by continued labor shortages, which caused consumer prices to experience the highest year-over-year increase in 40 years. To temper inflationary pressures, Fed policymakers raised rates for the first time since 2018 but Fed Chair Powell’s suggestion of a more aggressive hiking cycle introduced further policy uncertainty.

Russia’s invasion of Ukraine in February spurred further complications to global supply chain disruptions and increases in commodity and energy prices, contributing to higher global inflation. The conflict has increased the probability of a recession in Europe that could spread to other developed economies.

Ultimately, this rapid succession of large macro drivers has created a difficult environment to navigate.

From a sector standpoint, energy (+40.45%) was the best performer in the benchmark, followed distantly by consumer staples (+5.49%), utilities (+3.69%) and materials (+3.50%). The financials (-3.53%) and real estate (-4.55%) sectors lagged, but still outperformed the broader Russell Midcap Index. Consumer discretionary (-14.50%) was the worst performing sector in the benchmark, followed by information technology (IT, -11.16%), communication services (-10.13%), health care (-9.95%) and industrials (-9.69%).

Our underweight to the energy sector weighed on performance, as energy prices skyrocketed from inflationary pressures and the threat of reduced supply. We have a limited footprint within the sector but continue to look for companies that will generate strong, long-term returns such as Pioneer Natural Resources.

Pioneer is an oil and gas exploration and production company that offers a combination of a strong asset base, quality balance sheet and compelling free cash flow yield at current commodity prices. We believe Pioneer has strong underlying drivers that will generate attractive risk-adjusted returns beyond shorter-term fluctuations in energy prices.

The Strategy’s IT holdings were a positive contributor during the quarter. This included companies such as Aspen Technology (AZPN), a leader in asset optimization solutions and software for capital- intensive industrial industries. The increase in energy production provided a tailwind to the stock price, as the company’s software is utilized by many energy producers. Splunk (SPLK), a data analytics software company, saw its share price climb after strong fourth quarter earnings which exceeded analyst expectations and the installation of a new, industry veteran CEO. Splunk has strong momentum drivers in its cloud platform and heightened security imperatives that should provide a strong growth runway for the company over the next few years.

Portfolio Positioning

We continue to be active in refining our portfolio positioning and searching for the most attractive companies across the market.

While we recognize that macro catalysts will have some influence on sectors, our process and philosophy of looking for outstanding value through high-quality companies has not changed. We have a robust pipeline of potential candidates and stand at the ready to take action when we see opportunities to improve the portfolio’s risk-return profile.

We initiated a new position in Bloomin’ Brands (BLMN), in the consumer discretionary sector. The owner and operator of upscale casual dining brands, including Outback Steakhouse and Bonefish Grill, the company utilized the challenges of the COVID-19 pandemic to implement new productivity operations for its waitstaff and focus on improving corporate margins. As we transition from pandemic to endemic, the company should be able to meet the rebound in restaurant attendance with an improved cost structure and better operating leverage. We believe these long-term improvements and increased demand for dining are not reflected in the current share price.

We also initiated a new position in Workiva (WK) in the IT sector. The company provides cloud-based compliance and regulatory software that allows users to improve the productivity and efficiency of their reporting. It is the industry leader with over 50% market share for its reporting software and is making significant progress in expanding its geographical footprint outside the U.S. Workiva is also working to expand its product offerings into ESG reporting to meet the growing demand from U.S. companies and meet new EU regulations. As such, we see an attractive growth runway as a strong returns compounder over the foreseeable future.

We exited our position in Old Dominion Freight Lines (ODFL), in the industrial sector. While our opinion of the freight carrier’s business quality is unchanged, we believe the stock’s current price reflects less potential than some of the new opportunities we have been evaluating.

Outlook

This unprecedented, rapid succession of macro events has injected elevated uncertainty into the markets and shifted investors to favor undifferentiated, price-taking companies over higher-quality businesses with solid fundamentals. While navigating this cacophony of risks has proven challenging, we will leverage this opportunity to further refine our analysis with new data and continue to focus on investing in high-quality companies with attractive long-term value creation opportunities. We are confident in our current portfolio construction and believe our holdings will persevere through these short-term challenges and support long- term performance.

Portfolio Highlights

The ClearBridge Mid Cap Strategy underperformed its Russell Midcap Index during the first quarter. On an absolute basis, the Strategy had losses across eight of the 11 sectors in which it was invested during the quarter. The leading detractors were the industrials and consumer discretionary sectors, while the leading contributor was the energy sector.

On a relative basis, overall stock selection and sector allocation detracted from performance. Specifically, stock selection in the industrials, materials, consumer discretionary, health care, real estate and financials sectors and an underweight allocation to the energy sector weighed on returns. Conversely, stock selection in the IT sector contributed to returns.

On an individual stock basis, the biggest contributors to absolute returns in the quarter were Pioneer Natural Resources (PXD), Splunk, Performance Food Group (PFGC), Arch Capital (ACGL) and SolarEdge Technologies (SEDG). The largest detractors from absolute returns were Vertiv (VRT), Aptiv (APTV), Western Alliance Bancorp (WAL), Carvana (CVNA) and Black Knight (BKI).

In addition to the transactions listed above, we initiated a position in Coty (COTY) in the consumer staples sector, SailPoint Technologies (SAIL) in the IT sector, Six Flags Entertainment (SIX) in the consumer discretionary sector and Blue Owl Capital (OWL) in the financials sector. We also exited positions in Purple Innovation (PRPL), Carnival (CCL) and Lear (LEA) in the consumer discretionary sector.

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