Clearbridge Mid Cap Growth Strategy Q1 2022 Commentary

Market Overview

Mid cap growth stocks struggled in the back half of 2021 and into 2022 as the prospects of reduced fiscal stimulus and monetary tightening were at hand. Cost and price inflation had become imbedded in the U.S. economy; the Federal Reserve’s narrative of “transitory” inflation proved incorrect partially due to the persistence of supply chain interruptions from COVID-19. The Omicron spike proved a formidable challenge for business continuity and profitability.

Russia invaded Ukraine in late February, causing death, destruction, and a humanitarian crisis. Markets headed lower until late March, when speculation of a negotiated settlement began to rise. While the NATO allies did not put “boots on the ground” in Ukraine, the torrent of sanctions, penalties and disrupted trade flows has caused significant shocks to the “world economic order” of the past many decades. Oil was one of many essential commodities to skyrocket in price.

Mid cap growth stocks in the Russell Midcap Growth Index declined 12.58% as a result of the coalescence of these forces, entering “bear market territory” during the first quarter. The Russell Midcap index declined 5.68%, slightly underperforming the larger capitalization market. Value indices continued to outperform growth indices given the multiple compression from higher interest rates and economic deceleration. The underperformance gap for growth in the first quarter was a pronounced 1,080 basis points.

Innovation was out of vogue this quarter as investors had limited appetite for higher growth companies during this period of portfolio de-risking. The initial public offering market essentially ground to a halt after excessive supply in 2021.

On a sector basis, energy gained 37.42% and was the only sector in the black during a risk-off quarter. Other sectors that held up better than the benchmark included consumer staples (-4.11%), utilities (- 4.17%) – where we have no exposure and financials (-9.76%) and materials (-11.32%). Information technology (IT, -11.90%), industrials (-12.45%) and real estate (-13.15%) generally performed in line with the growth benchmark while communication services (- 25.57%), consumer discretionary (-16.41%) and health care (- 14.17%) underperformed for the quarter.

During this sharp downward move for growth equities, the ClearBridge Mid Cap Growth Strategy trailed its Russell Midcap Growth benchmark. Strategy holdings were buffeted by a variety of macro and industry-specific factors. These ranged from the deleterious effect of higher mortgage rates on housing-related stocks, such as building products supplier Azek (AZEK), to the war impacts on companies with significant European exposure like auto components supplier Aptiv (APTV). Additionally, the financing headwinds on the biotechnology sector weighed on health care companies that service the industry like life sciences tools supplier Mettler-Toledo (MTD). A handful of stellar stock performers during 2021 faced “tough comps” heading into 2022 and underperformed, such as consumer names Carvana (CVNA) and Etsy (ETSY) as well as marketing automation software provider HubSpot (HUBS) in IT.

More promising was the performance of several of the portfolio’s core compounding growth names. Pioneer Natural Resources (PXD), an oil and gas exploration and production company, offers a combination of a strong asset base, quality balance sheet and compelling free cash flow yield and is getting a lift from upward moves in commodity prices. Construction equipment leasing company United Rentals (URI) benefited from continued improvement of non-residential construction trends while restaurant supplier Performance Food Group (PFGC) and online travel agency Expedia (EXPE) saw gains from improved dining out and travel trends, respectively.

The Strategy also saw solid contributions from a handful of software companies. Palo Alto Networks (PANW) was boosted by rising demand for its information security products as cyberattacks have increased around the Russia-Ukraine conflict. Splunk (SPLK), a data analytics software company with a meaningful security presence, saw its share price climb after strong fourth quarter earnings which exceeded analyst expectations and the installation of a new, industry veteran CEO.

We made no new purchases during the first quarter, and eliminated three stocks, shifting exposures to higher conviction investments. We sold mobile gaming platform Zynga (ZNGA) after a takeout by rival game publisher Take-Two Interactive (TTWO). The action reflects the continued attractiveness of innovative business models to strategic acquirers and companies looking for new sources of growth.

We exited hair care products maker Olaplex (OLPX) in the consumer staples sector on concerns over what negative publicity for the company could mean for branding, and sales and payment processing technology provider Jack Henry & Associates (JKHY) to pursue more attractive opportunities.

Outlook

We have many more questions than answers about the long-term implications of the Russian invasion and subsequent sanctions.

There is much supposition how the war will be resolved, but only time will tell when investors begin to fully account for its impact and implications on economic growth. Companies have had to scramble to ensure continuity of supply, to rethink manufacturing and service economy footprints and adjust safe inventory levels, with war-related economic sanctions adding to the uncertainties sparked by the pandemic.

Rather than make projections on which of many macro scenarios may play out, we can do best by our investors by maintaining the quality bias of a concentrated portfolio that offers exposure to a variety of growth opportunities. We continually examine the durability and magnitude of growth and returns by assessing the opportunity set and competitive advantage of each holding.

The comeback for more growth-oriented stocks to end the quarter is encouraging and we believe the qualities we look for in portfolio companies, such as innovative, self-funding business models and superior management teams, should shine through as current macro and geopolitical risks and headwinds begin to dissipate.

Portfolio Highlights

During the first quarter, the ClearBridge Mid Cap Growth Strategy underperformed its Russell Midcap Growth benchmark. On an absolute basis, the Strategy had losses across nine of the 10 sectors in which it was invested during the quarter (out of 11 sectors total), with the IT, consumer discretionary and health care sectors the primary detractors, while the energy sector was the lone contributor.

In relative terms, overall stock selection detracted from performance. Specifically, stock selection in the consumer discretionary, IT, financials, health care and industrials sectors and an underweight to the energy sector hurt results. On the positive side, stock selection in the communication services sector contributed to relative performance.

The leading contributors to absolute returns during the first quarter included Pioneer Natural Resources, Palo Alto Networks, Splunk, Zynga and United Rentals. Meanwhile, Burlington Stores (BURL), Azek, Carvana, Mettler-Toledo and Aptiv were the greatest detractors from absolute returns.

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