iQoncept
Double, Double Toil and Trouble
Market Overview
The three witches of Shakespeare’s Macbeth famously chant “double, double toil and trouble; fire burn, and cauldron bubble” as they mix an odious potion to summon dark forces. The toxic ingredients of the witches’ brew (eye of newt and toe of frog, wool of bat and tongue of dog, etc.) coalesce for “a charm of powerful trouble, like a hell-broth boil and bubble.”
The witches, and their Elizabethan incantation, are apt metaphors for the macro forces depressing U.S. equity markets. Rising risk-free yields, overlaid on the dislocations from the pandemic (supply chain and labor shortage) and the horrific attack on Ukraine (energy and commodity prices) proved to be too much weight for equities. Stock multiples have sharply corrected from elevated levels during a period when many companies have been challenged by faltering demand and/or difficulties fulfilling customer requests.
Entering 2022, we believed the prospects of reduced fiscal stimulus and monetary tightening were likely to lead to choppy markets. Yet the pernicious and accelerating inflation trend has forced the hands of central banks globally, resulting in a rising probability of contraction within the bubbling economic cauldron.
The U.S. Federal Reserve turned more aggressive after the May Consumer Price Index release and short-term interest rates are headed higher. The yield of the 10-year U.S. Treasury note has more than doubled since the turn of the year, pressuring valuations across the spectrum of growth stocks as well as influencing fixed income instruments and credit spreads.
“Innovation remained out of vogue as investors had limited appetite for higher growth companies through economic stress and portfolio de-risking.”
Profit margins have been squeezed (from labor and commodity costs) and in some cases taken step functions lower. While companies have implemented multiple price increases, there are sticker shock effects yet to be counted. We’ve already seen, for instance, a softening of the red hot residential real estate market in response to higher mortgage costs for borrowers. Some retailers are struggling as consumer wallets are thinned by higher prices.
Small cap growth stocks in the Russell 2000 Growth Index declined 19.25% in the second quarter as a result of the coalescence of these forces, firmly entering “bear market territory.” The Russell 2000 index declined 17.20%, slightly underperforming the larger capitalization market. Growth indices continued to underperform value indices given the multiple compression from higher interest rates and unfolding economic deceleration.
Innovation remained out of vogue again as investors had limited appetite for higher growth companies during this period of economic stress and portfolio derisking. The initial public offering market essentially remained shut after 2021’s excessive supply, with IPO proceeds down approximately 95%.
Against this tumultuous backdrop for small cap growth stocks, the defensive sectors of consumer staples (-2.23%) and utilities (-8.57%) held up best. The commodity sectors of energy (-16.53%) and materials (-16.70%) also outperformed as higher oil and natural gas prices and the announcement of long-term supply agreements to help Europe wean itself from Russian gas sources offered support, while industrials (-16.78%) also beat the benchmark. Financials (-18.66%) and health care (-19.24%) performed in line with the Russell 2000 Growth Index while the consumer discretionary (-21.11%), information technology (IT, -23.13%), real estate (-24.48%) and communication services (-25.98%) underperformed.
During weak markets the Strategy typically holds up better than the index, and thus we are dissatisfied that the Strategy modestly underperformed its Russell 2000 Growth benchmark by declining 20.5%. Despite this result, we maintain optimism in our portfolio’s construction. Some of the more cyclical sectors which benefited from higher interest rates and commodity price increases were relative outperformers (financials, materials) while price declines were most pronounced among some of our long-term holdings in health care with bright growth prospects (such as Surgery Partners (SGRY), Penumbra (PEN) and Progyny (PGNY), all of which are retained in the Strategy). Our health care holdings faced technical selling pressure due to the recently concluded Russell index rebalances, which saw health care decline as a weight in most smaller growth indices; more cyclical sectors were rebalanced higher.
Portfolio Positioning
After an active first quarter, we made relatively few changes this quarter. We favor the business prospects and competitive position of the Strategy’s holdings and believe managements are capably positioning their businesses for more austere times while continuing to invest for sustainable growth.
We added Wingstop (WING), a restaurant franchisor with over 1,700 locations. Wingstop has a number of growth drivers despite facing difficult COVID-19 inflated comps in the first half of 2022. Management is marketing a consumer value bundle, more fulsome national advertising year-round and an expanded menu while ingredient costs appear set to drop for wings. We also took advantage of price declines to add to a number of our existing positions.
We exited cloud communications software maker Bandwidth (BAND) as price concessions to a large customer compromised profitability and a security breach last year constrained growth. Additionally, we trimmed our position in Biohaven Pharmaceutical (BHVN), which accepted a takeover offer from large cap pharmaceutical maker Pfizer (PFE).
Outlook
Calendar 2022 is half over and has had one of the poorest starts on record, with significant risk having been wrung out of financial markets evidenced by major value destruction in speculative assets such as crypto, meme stocks, de-SPACs, etc.
Markets are discounting mechanisms and the likelihood of a significant slowdown and/or recession is now well-known and appreciated. Realtime data such as purchase manager indices and consumer surveys already point to a sharp slowdown. Unanswerable is whether we are in another “Volcker” moment, where crushingly high nominal interest rates and a deep recession are needed to bend the curve of prices and inflation expectations. The severity and duration of the slowdown/recession and the prospect of peak inflation rates will, at least partly, dictate near-term equity market expectations.
The negatives (Macbeth’s “witches’ brew”) are well-known. On the positive side, valuations are much more reasonable than at any time in the past 24 months, there is a mountain of capital to be deployed by private equity sponsors and SPACs, U.S. wholesale financial institutions have much more robust capital cushions than in 2008/2009 and investor sentiment seems massively bearish.
Macro headlines have dominated financial markets over the past six months. We have stuck to our long-standing playbook of focusing on a concentrated portfolio of growth businesses as well as assessing the competitive advantages and managerial competence of each holding during our derisking due diligence. As macro forces begin to recede as primary influence, we firmly believe our emphasis on quality and durable growth stocks will benefit clients.
We thank you for your continued confidence during these challenging market conditions.
Portfolio Highlights
During the second quarter, the ClearBridge Small Cap Growth Strategy underperformed its Russell 2000 Growth benchmark. On an absolute basis, the Strategy had losses across the nine sectors in which it was invested (out of 11 sectors total), with the IT, health care, industrials and consumer discretionary sectors the primary detractors.
In relative terms, overall stock selection detracted from performance but was partially offset by positive sector allocation effects. Specifically, stock selection in the health care, consumer discretionary and IT sectors was the primary headwind to returns. Selection in the industrials, energy and consumer staples sectors was also detrimental. On the positive side, an overweight to consumer staples as well as stock selection in financials and communication services contributed to relative performance.
The leading contributors to absolute returns during the second quarter included Biohaven Pharmaceutical, Grocery Outlet (GO), PJT Partners (PJT), Certara (CERT) and Calavo Growers (CVGW). Meanwhile, Surgery Partners, Penumbra, National Vision Holdings (EYE), Varonis Systems (VRNS) and Progyny were the greatest detractors from absolute returns.
Editor’s Note: The summary bullets for this article were chosen by Seeking Alpha editors.
Be the first to comment