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By Aram Green | Jeffrey Russell
Annus Horribilis Ends on Positive Note
Market Overview
Toward the end of a year marked by a devastating fire at Windsor castle and tumult in the royal family, Queen Elizabeth famously noted, “1992 is not a year on which I shall look back with undiluted pleasure…it has turned out to be an `Annus Horribilis’.”
We feel similarly about 2022. Not much worked in a risk-off financial market environment. Equities succumbed to significantly higher interest rates, fixed income securities provided no refuge and cash lost real purchasing power. After years of TINA (there is no alternative), investors embraced TARA (there are reasonable alternatives).
The steady drumbeat of benchmark interest rate increases out of Washington was long overdue. The most unusual coalescence of pandemic, supply chain disruptions, fiscal stimulus, demographic changes and the assault on Ukraine led to a sharp spike of inflation, far above expectations of a year or two earlier. Those who recall the insidious impact of inflation from the 1970s aligned with the Fed’s desire to tighten monetary policy and tamp down structural inflation expectations.
Thus far, U.S. unemployment and inflation indices have remained stubbornly firm despite efforts to cool demand. While manufacturing activity as measured by the ISM Purchasing Managers Index (PMI) has softened, services indices have not. History shows that most Fed tightening cycles ultimately lead to recession, albeit with a time lag, and we believe investors have embraced that high likelihood for 2023.
Further compounding the influence of higher interest rates during 2022 were the accelerated trends for many businesses during the 2020/2021 pandemic surge that created “tough comps.” We underestimated the valuation impact (much more apparent in hindsight) on the stocks of higher growth companies, especially as managements had to “comp the comp” in 2022. Investor rotation towards perceived “value” stocks and the mid-year composition change of the Russell 2000 Growth Index benchmark proved additional hurdles to performance.
Performance Overview
Amid this backdrop the ClearBridge Small Cap Growth Strategy underperformed its benchmark for the year, a blow softened by outperformance in the fourth quarter. We are disappointed by any year’s underperformance; the Strategy usually outperforms during weak equity markets due to our preference for quality business franchises with financial stability.
The trend of higher interest rates during 2022 and a few other factors led to overwhelming outperformance by small cap value stocks over small cap growth stocks by 1,180 basis points, and the concomitant selling pressure on smaller growth stocks was palpable. In the fourth quarter, the benchmark Russell 2000 Growth Index gained 4.13% but still trailed the 8.42% advance for the Russell 2000 Value Index.
Healthcare was a performance drag for most of the year but proved a bright spot in the fourth quarter, led by companies tied to a rebound in medical procedures. Longtime holding Penumbra (PEN), a provider of medical devices to treat aneurysms, and Integra LifeSciences (IART), a supplier of surgical instruments and implants, were among the leading contributors. Additionally, ambulatory surgery center operator Surgery Partners (SGRY) saw its stock price bounce higher after being hurt for most of the year by staffing challenges and financial leverage. Underperformance was concentrated in Syneos Health (SYNH), a contract research organization with disappointing new order trends.
Industrials was another area of weakness through 2022 that saw improvement to close the year. Performance was led by H&E Equipment Services (HEES) and Aerojet Rocketdyne (AJRD), whose takeout offer from defense contractor L3Harris (LHX) validates our premise that the growth characteristics of smaller companies remain attractive to larger buyers.
Portfolio Positioning
Several of our companies had missteps, and many faced operating challenges, during the year. We sold 14 positions in 2022 (two due to takeover; 12 due to a variety of concerns) and made six new investments. A notable addition during the fourth quarter was HealthEquity (HQY), a cloud-based provider of health care benefits, information and payment services.
The positions liquidated were of relatively modest size, including fourth quarter exits from CareDx (CDNA) and Quanterix (QTRX) in the healthcare sector as well as Viant Technology (DSP) in IT. As a result, the annualized turnover in the Strategy remained below historic norms. Last year we had already begun repositioning the Strategy in lower capitalization investments, so there was little need for those actions this calendar year.
Outlook
As we peer over the hazy horizon into a new calendar year, it seems likely that the major inflation-fighting interest rate increases are behind us and inflation data will be better. Given the usual caveat that our investments are not based on any macro tilt, many measures have shown deceleration or outright declines (i.e. CRB commodity index, housing starts, e-commerce, PMIs, oil).
Several relevant trends heading into 2023 include:
- A sea change in how growing companies are changing spending behavior. Managements are moderating cash burn and refining investment spending as investor appetite for capital calls (secondaries) has declined and the cost of debt capital has risen. Some of the country’s most prolific corporate spenders have reined in costs in response to reduced revenue expectations.
- Labor pressures in selected industries are abating. This benefits our holdings, many of which had to fight to recruit talent and fend off talent raids. The “Great Resignation” is yesterday’s story (along with meme stocks, SPACs and crypto).
- Companies scrambled amid supply chain shortages and double-ordered, and now find themselves in a period of inventory reduction as well as moderating freight and other cost pressures. As inventory availability improves, capacity adjustments and job cuts follow – both of which are catnip for Fed watchers.
- The initial public offering market’s somnolence has been reflected in a roughly 95% decrease in IPO proceeds this year vs. 2021. The Renaissance IPO Index, a rolling three-year population of newly public companies weighted by float adjusted market cap, declined a stunning 56.95% this year.
The Fed remains focused on price stability through demand destruction. Many of the above trends are bullish for equities (ironically bad news for the job holder whose job is being eliminated is good news for inflation pressures.) We saw the first spark of recognition that rate increases are likely to plateau in 2023 with the October CPI report, which triggered a pretty violent upward stock price move.
There will doubtless be fits and starts along the way. Recall that the long-term global interdependence of trade is still fractured due to Russian actions. Nevertheless, barring further unforeseeable shocks, we believe the scenery is moving into place for a more favorable 2023 growth stock tableau as the year progresses.
The year past was a wretched one for financial markets, especially high growth equity assets. Small cap growth stocks notched their worst outcome since 2008. Keep in mind that the following five years brought a return of 2.7x in small cap growth stocks. We believe trends are in place for more favorable outcomes in the next few years.
Portfolio Highlights
The ClearBridge Small Cap Growth Strategy outperformed its benchmark in the fourth quarter. On an absolute basis, the Strategy posted gains in all nine sectors in which it was invested (out of 11 sectors total). The primary contributors to performance were in the industrials, information technology (IT) and energy sectors.
Relative to the benchmark, overall stock selection contributed to performance. In particular, stock selection in the health care, industrials, energy and communication services sectors and an overweight to the consumer staples sector drove results. Conversely, stock selection in consumer staples and an underweight to energy detracted from returns.
On an individual stock basis, the leading contributors were positions in H&E Equipment Services, Allegro MicroSystems (ALGM), Cactus (WHD), Lattice Semiconductor (LSCC) and Integra LifeSciences. The primary detractors were Omnicell (OMCL), Xometry (XMTR), Syneos Health (SYNH), Pacira Biosciences (PCRX) and Paycor (PYCR).
In addition to the transactions mentioned above, we gained shares of RXO, Inc. (RXO) in the industrials sector following its spinoff from portfolio holding GXO Logistics (GXO) and Biohaven Ltd. (BHVN) in a spinoff following the acquisition of portfolio holding Biohaven Pharmaceutical by Pfizer (PFE).
Aram Green Managing Director, Portfolio Manager
Jeffrey Russell, CFA Managing Director, Portfolio Manager
Past performance is no guarantee of future results.
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.
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