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By Brian Angerame | Aram Green | Matthew Lilling | Jeffrey Russell
Growth Stocks Prepare for a Favorable Future
Market Overview
Equity markets capped off a tumultuous 2022 with positive returns in the fourth quarter, as stabilizing inflationary pressures and growing fears of a recession increased expectations for a slowing rate of interest rate increases from the Federal Reserve. The S&P 500 Index increased 7.56% over the three-month period, walking back its year-to-date decline to -18.11% while the Russell Midcap Index advanced 9.18%, shaving its annual loss to 17.32%. Despite their reputation as more cyclical in light of a looming recession, value stocks performed better than growth stocks, with the Russell Midcap Value Index returning 10.45% compared to the 6.90% return of the benchmark Russell Midcap Growth Index. In a year that proved especially difficult for longer duration stocks, growth ultimately ended the year underperforming value by over 1,400 basis points.
Signs of peaking inflation and evidence of slowing in the economy were a boost to investor optimism early in the quarter, in hopes that they would spur a change in the Fed’s policy of aggressive interest rate increases. However, while the Fed voted to end their streak of 75 basis point hikes in favor of a 50-basis point hike at their December meeting, Fed Chair Powell reiterated that the central bank still had more work to do in its fight against inflation. This dispelled the notion of a dovish policy pivot in the foreseeable future. These dashed hopes were replaced with concerns over corporate earnings and a growing possibility of recession, ultimately resulting in positive quarterly performance but little foresight into 2023.
Many of the macro factors that spurred market turbulence throughout the year persisted into the fourth quarter, including elevated inflationary pressures, supply chain issues and geopolitical tensions. Furthermore, the accelerated trends for many businesses during the 2020/2021 pandemic surge created “tough comps”, setting up companies to fail under anything but perfect execution. We underestimated how this would impact the valuations of higher growth companies, especially as managements had to “comp the comp” in 2022. Additionally, investor rotation during the quarter towards perceived “value” stocks proved yet another hurdle to performance.
“The trends of the pandemic created tough comps, setting up companies to fail under anything but perfect execution.
Stock selection within the IT sector was the main detractor from relative performance during the period. In addition to rate hikes compressing the multiples of longer-duration, high growth companies, recession concerns were also a headwind. IT companies which had proven resilient against customer budget reductions earlier in the year are starting to feel the impact of spending slowdowns as companies further scrutinize expenses in light of economic uncertainty. For example, Palo Alto Networks (PANW), which provides enterprise security solutions including next-generation firewalls and threat detection software, faced a challenging environment as customers delayed purchases and orders. However, we remain convinced of the company’s long-term growth prospects as an industry leader in a critical field and as digital attacks and ransomware continue to grow.
Paylocity (PCTY) also held up well against broad customer spending slowdowns earlier in the year but saw its share price weaken on broader macro headwinds during the quarter. The company’s cloud-based human capital management and payroll software solutions help businesses manage through broad labor shortages and provide solutions to retain talent. However, as excess slack in the labor market has begun to be absorbed, investments in human resources solutions have declined. Additionally, we believe Paylocity continues to have a compelling long-term growth runway as it attracts new customers and gains market share against large, mature competitors.
The health care sector also 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 took the opportunity to re-evaluate each of our health care holdings and reposition ourselves for greater opportunities. 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 trimmed 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. However, Catalent is responding by reshuffling internal assets to increase synergies and focus on its strong non-biologic franchises, such as its high-growth gummy vitamin business which we believe will be strong drivers of long-term returns.
Our review also highlighted many of the positive catalysts in our highest conviction holdings. Mettler-Toledo International (MTD), a multinational manufacturer of scales and analytical instruments for use in laboratory, industrial, and food retailing applications, was the portfolio’s top performer. The company’s exceptional management team continues to consistently deliver on its earnings targets, and we feel its sticky market share and pricing power will allow it to continue its strong growth trajectory. We also added to several of our high-conviction holdings like Doximity (DOCS), whose cloud-based digital platform for medical professionals continues to make strides in penetrating the digital advertising environment while increasing monetization of its telemedicine business offers a strong long-term revenue growth driver. We are confident these companies will be able to push past these near-term challenges and capitalize on them as opportunities to grow.
The portfolio benefited from stock selection within consumer staples due to increased demand from shifts in consumer purchasing resulting from inflationary pressures and growing recession fears. Performance Food Group (PFGC), a food supplier to restaurants and convenience stores, continues to benefit from a recovery of consumer demand for dining following the COVID-19 pandemic. Additionally, the new synergies from its acquisition of Core-Mark in 2021 have strengthened and continue to grow the company’s market share within the convenience store channel. We also benefited from a number of strong company-specific drivers within the consumer discretionary sector including Burlington Stores (BURL), an apparel and accessories retailer that offers a wide variety of products at discount prices. Burlington has rectified many of the supply chain issues which reduced its inventory earlier in the year and is now well stocked to cater to greater consumer demand. Additionally, discount retailers such as Burlington tend to have high new consumer retention rates, which we feel will increase the company’s customer base and drive growth beyond near-term economic uncertainty.
Portfolio Positioning
Although growth stocks continue to face broad, macro-driven headwinds to performance, we remain confident that our rigorous investment selection process and focus on flexible portfolio management will allow us to take advantage of emerging opportunities in the coming year. We maintain an extensive watchlist of high-quality, high-growth companies that may merit inclusion into the portfolio and take action when we decide they will improve the portfolio. As a result, we both initiated and exited two positions.
We established a new position in Baker Hughes (BKR), in the energy sector, which provides technological support and services to energy and industrial companies including oilfield services, oilfield equipment, turbomachinery and process solutions and digital solutions. We believe management’s focus on capital discipline has helped streamline their strategic focus and placed greater emphasis on improving cash generation and returns. Additionally, Baker Hughes’ overwhelming market share in the gas turbine and compression business creates a long-term growth runway due to the global buildout of renewable energy projects and rising liquefied natural gas capital expenditures.
We also 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 exited our position in online automotive retailer Carvana (CVNA), in the consumer discretionary sector. After being one of the portfolio’s top performers over the last few years, Carvana has struggled due to a cyclical downtrend in used car volumes and prices as well as investor concern about the company’s ability to fund future growth. We felt the combination of growing macro uncertainty combined with weakening fundamentals justified finally closing the position.
Outlook
We look forward to 2023 as potentially the year that the market’s hyperfocus on macro catalysts fades away and fundamentals matter more. Although near-term market visibility remains limited, are confident in our holdings of high-quality, innovative growth companies and see this as an opportunity for them to capitalize on new opportunities. We remain focused on building a portfolio designed to generate attractive, long-term returns over a full market cycle, and know that investing in companies with strong balance sheets and economic resiliency at compelling valuations is the key to achieving our goal.
Portfolio Highlights
The ClearBridge Mid Cap Growth Strategy underperformed the Russell Midcap Growth Index during the fourth quarter. On an absolute basis, the Strategy had gains across six of the 10 sectors in which it was invested during the quarter (out of 11 sectors total). The leading contributors were the industrials, health care and consumer discretionary sectors, while the primary detractor was the IT sector.
On a relative basis, overall stock selection detracted from performance. Specifically, stock selection in the IT, health care, energy, financials and real estate sectors weighed on returns. Conversely, stock selection in the consumer staples, consumer discretionary and communication services sectors and an underweight to communication services contributed to returns.
On an individual stock basis, the biggest contributors to absolute returns in the quarter were Mettler-Toledo International, Burlington Stores, United Rentals (URI), Performance Food and Five Below (FIVE). The largest detractors from absolute returns were Catalent, Paylocity, Advanced Drainage Systems (WMS), Palo Alto Networks and Syneos Health (SYNH).
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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