We Are
By Brian Angerame | Matthew Lilling
Some Stocks Miss, Strong Catalysts Persist
Market Overview and Outlook
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 benchmark 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 Russell Midcap Growth Index. Value ultimately ended the year outperforming growth 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. The result continued to be more of the same; even the highest quality companies have struggled to find their footing, and fundamentals continue to be overshadowed by noise and negative sentiment. Although our portfolio is comprised of companies with strong balance sheets and economic resiliency, this disconnect of stock prices from fundamentals contributed to the ClearBridge Mid Cap Strategy’s underperformance versus its benchmark for the quarter.
“We took the quarter as an opportunity to re-evaluate each of our health care holdings, evicting those where we had lost confidence.”
From a sector standpoint, energy (+16.35%) was the top performer in the benchmark during the quarter. The health care (+14.08%), industrials (+12.52%), consumer discretionary (+12.46%), materials (+11.81%), utilities (+10.91%) and financials (+9.58) sectors also managed to outperform the Russell Midcap Index. Meanwhile communication services (-5.16%) was the worst and only negatively performing sector for the period, followed by information technology (IT, +2.49%), real estate (+3.88%) and consumer staples (+8.97%).
Health care was the leading detractor from Strategy performance during the period, as many of our companies continued to be plagued by the headwinds from the third quarter: extended sales cycles and a drop off in COVID-19 revenues. We took the quarter as an opportunity to re-evaluate each of our health care holdings, evicting those where we had lost confidence. For instance, we exited 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 the company through declining COVID-19 revenue, combined with supply chain disruptions and greater cyclicality than anticipated have extended longer than we anticipated, which has undermined our confidence.
However, our review also highlighted many of the positive catalysts in our highest conviction holdings. As a result, we added to several of our existing holdings like ICON, a leading contract research organization with strong, consistent performance and Avantor (AVTR), whose discounted share price does not reflect the growth in its bioproduction business and steady recurring revenues. We are confident these high-quality holdings will be able to push past these near-term challenges to be powerful, long-term compounders.
A negative macro environment also weighed on several of our industrials holdings. Resideo Technologies (REZI), which manufactures residential thermal and security solutions, has been hampered by supply chain disruptions and several products being destocked by distributors in addition to broader investor concerns over the impact of a recession on the housing market. However, we feel that Resideo possesses an exceptional management team with a strategic focus on cash flow generation, and as supply chain bottlenecks dissipate in the coming year the company will be able to improve margins. Likewise, electrical motors and power transmission manufacturer Regal Rexnord (RRX) announced an agreement to acquire Altra Industrial Motion (AIMC), leading to investor concerns over the timing and increase in leverage amid growing economic uncertainty. We believe the acquisition will allow the company to capture even greater market share in the powertrain industry and, given Regal Rexnord’s strong cash flow generation, it should be able to reduce its debt faster than the market anticipates.
The Strategy benefited from stock selection in the consumer staples sector, which saw increased demand due to shifts in consumer purchasing due to inflationary pressures and 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, as well as synergies from its acquisition of Core-Mark in 2021 that have strengthened its market share. COTY, a global beauty company made up of prestige fragrance and cosmetic businesses, also generated positive performance. Despite concerns of slowing consumer demand, the company continues to execute and exceed expectations through margin improvement, resilient Chinese demand and growing market share within mass market cosmetics in the U.S. We view Coty as exceptionally undervalued due to its historically high leverage but believe continued margin improvement and strong execution will improve its balance sheet and attractiveness to fundamentals-focused investors.
Portfolio Positioning
Despite the broad macro headwinds, we believe continuing to invest in businesses with strong company-specific catalysts is the best way to generate long-term appreciation. However, we also recognize that portfolio construction is an ongoing process. To that end, we continuously review our existing holdings against our extensive watchlist in order to ensure we are capturing the greatest opportunities. During the quarter, we added six new positions and exited six existing holdings.
We initiated a new position in ETSY, in the consumer discretionary sector, which operates online marketplaces and is a leading e-commerce destination for craft and artisan goods. The company has been making strong gains within the e-commerce industry, with opportunity to grow its footprint with male customers and capitalize on international opportunities. Improvement in search algorithms has better personalized the shopping experience, leading to improved sales conversion for its merchants. While the company has faced headwinds in overcoming the extraordinarily high comps of the COVID-19 pandemic, we see early signs the business is stabilizing. Combined with the company’s strong balance sheet and cash flow and lack of proprietary inventory, we see Etsy as better positioned to navigate a weakened economic environment than its peers.
We also added Houlihan Lokey (HLI), in the financials sector, an investment bank providing merger and acquisition, capital market, financial restructuring and valuation advisory services. While the prospects of a recession and higher interest rates have weighed on its capital markets and M&A businesses, Houlihan’s position as an industry leader within the financial restructuring industry provides excellent countercyclical exposure. Management’s ability to leverage key assets and personnel from its capital markets and M&A businesses during economic downturns provides a way to maintain its talent pool and provide downside protection as financial liquidity tightness continues to linger. We believe there will be a growing need for restructurings, which is currently not reflected in the company’s valuation.
We exited our position in Bloomin’ Brands (BLMN), in the consumer discretionary sector, which owns and operates casual and upscale restaurants including Outback Steakhouse. Although we have been pleased with the stock’s performance, we believe the company faces increased headwinds stemming from inflation in certain commodity prices. This, combined with the prospect of declining consumer spending entering a recession, resulted in our decision to capitalize on the stock’s positive performance and exit the position.
Outlook
Rather than dwell on 2022, 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, we are confident in our holdings of both high-quality growth companies and value stocks with visibility toward improvement. 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 Strategy underperformed its Russell Midcap Index during the fourth quarter. On an absolute basis, the Strategy had gains across 10 of the 11 sectors in which it was invested during the quarter. The leading contributors were the consumer staples, industrials and financials sectors, while the health care sector was the sole detractor.
On a relative basis, overall stock selection and sector allocation effects detracted from performance. Specifically, stock selection in the health care, industrials, energy and consumer discretionary sectors weighed on relative returns. Conversely, stock selection in the consumer staples, IT and communication services sectors contributed to returns.
On an individual stock basis, the biggest contributors to absolute returns in the quarter were Performance Food, Arch Capital (ACGL), Vertiv (VRT), APi and Horizon Therapeutics (HZNP). The largest detractors from absolute returns were Maravai LifeSciences (MRVI), Regal Rexnord, Catalent, Syneos Health (SYNH) and Resideo Technologies.
In addition to the transactions listed above, we also initiated new positions in Bentley Systems (BSY) in the IT sector, Five Below (FIVE) in the consumer discretionary sector, Advanced Drainage Systems (WMS) in the industrials sector and Baker Hughes (BKR) in the energy sector. We exited positions in Carvana (CVNA) in the consumer discretionary sector, Autodesk (ADSK) in the IT sector, BALL in the materials sector and Clarivate (CLVT) in the industrials sector.
Brian Angerame, Portfolio Manager
Matthew Lilling, CFA, Portfolio Manager
|
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.
Be the first to comment