everythingpossible
By Albert Grosman | Brian Lund
Value Finds Favor as Recessions Concerns Loom
Market Overview
Anchoring and recency bias are powerful forces in the human brain. We tend to think our recent experience is the “normal” state of things, so any deviation from it is aberrant and temporary. In reality, “normal” states usually arise from a set of conditions that, once changed, create a new environment that is more likely to produce different outcomes. The stock market is now shifting from one state to another, creating confusion among investors. People tend to think bad news is only temporary and that we will get back to the way things used to be as soon as it’s over. Unfortunately, that’s usually not the case.
The market has seen three major phase shifts this century. First was the bursting of the Dot-Com Bubble in 2000-2002, followed by the Global Financial Crisis (GFC) in 2007-2009 and now we find ourselves in the aftermath of the Cheap-Money Bubble of 2016-2021. Despite numerous bounces in tech stocks following their implosion in 2000, the sector went on to underperform the overall index dramatically in the subsequent decade. After the GFC in 2008, homebuilding was depressed for a decade, with new home construction below replacement levels, and financials underperformed over 10 years despite major improvements in credit quality. Now, following the end of cheap money, investors are eager to herald a return to low interest rates and venture capital as soon as the Fed stops raising rates. There is good reason to believe they will have to wait a long time for these excesses to wash out.
The zero-percent federal-funds rate and quantitative easing that followed the GFC led to a strong economic recovery, but it took a decade to kick in. The U.S. 10-year Treasury carried a yield below 3% from mid-2011 to 2021. Predictably, these low rates led investors to accept lower expected returns on riskier assets like stocks, while speculating at greater and greater levels with private equity, venture capital and phantom assets like cryptocurrencies. Growth stocks carried huge premiums, and the Russell 2000 Growth Index crushed the Russell 2000 Value Index by 27% from the beginning of 2017 to the end of 2019. COVID-19 and its accompanying mega-stimulus gave a final shot of adrenaline to this market, but it was not a change — it was more of the same medicine the market had been taking for 10 years, bringing markets to a very overextended state.
Unemployment is historically low, job openings are high, balance sheets are strong, consumers are not overleveraged, credit quality is pristine, and wages are rising, yet stock and bond prices are falling in anticipation of a coming recession. Inflation is a clear and present danger that the Fed has sworn to crush, which is the opposite of 2008, when it was worried about deflation. Yet the markets take any hint of a possible end to inflation and Fed tightening to drive up prices on the same risk assets that worked in the last cycle. Most notably, the 10-year Treasury note had a 3.5% yield in early January, despite the one-year Treasury bill at 4.7%, suggesting that the one-year rate will fall below 3.5% within two years. In the past 50 years, the 10-year rate has only been below 3.5% during the post-GFC period. Why should the conditions that existed from 2009-2018 be replicated now, when none of the deflationary forces at work then are apparent? The answer has a direct impact on stock selection.
Despite small caps positing positive returns for the fourth quarter, fears of a recession and the Fed’s commitment to a higher-for-longer rate hiking cycle were felt more acutely in small cap stocks than in their larger cap peers, with the Russell 2000 Index returning 6.23% compared to the 7.24% return of the Russell 1000 Index. However, value stocks also continued to find favor with investors amid economic uncertainty, with the Russell 2000 Value Index’s 8.42% return more than doubling the 4.13% return of the Russell 2000 Growth Index. Given the pro-cyclical tilt of our portfolio, this helped the Strategy outperform its Russell 2000 Value benchmark during the quarter.
Stock selection in the industrials sector was the leading contributor to relative outperformance during the period. The sector benefited as investor concerns over the severity of a potential recession abated during the period, helping instill greater optimism in more economically sensitive companies.
One of the portfolio’s greatest contributors was Wabash National (WNC), which designs, manufactures and distributes engineered solutions for the transportation, logistics and distribution industries. Continued strong demand for trailers helps drive sales for Wabash and benefited the stock price in the quarter. The company’s revamped pricing model has helped strengthen its margins and a growing backlog of new orders points to continued and greater potential value creation over the foreseeable future.
Likewise, Primoris Services (PRIM), which provides a range of construction, fabrication, maintenance, replacement and engineering services, also delivered strong performance during the period. The stock rebounded from a decline in the third quarter as margins improved from pricing catching up with cost inflation, which had weighed on the company’s performance through 2022. Primoris Services’s orders backlog also increased to an all-time high, despite much of the infrastructure work stemming from government legislation still not having reached bidding stage. We believe demand for Primoris’s services will be strong for many years to come and be a long-term driver of returns in the portfolio.
Our holdings in the materials sector also benefited relative performance during the period and included two of our top performing stocks. Commercial Metals (CMC), a steel and metal manufacturer, was a top performer. The company exceeded analyst expectations for quarterly earnings on the back of strong fundamental drivers, which have been significantly bolstered by the prospect of further infrastructure spending by the government. We believe the company will be able to capitalize on this increased investment and generate long-term returns for the portfolio.
Strong drivers for chemical manufacturer and distributor Olin (OLN) also drove portfolio performance. Olin is the largest provider of merchant chlorine; the company’s new CEO has strategically wound down capacity in order to improve pricing power and reduce the cyclicality of its business. We believe this new strategic direction for Olin will continue to create value for investors and we have high conviction in the company’s long-term potential.
Positive relative performance was partially offset by detractors within the health care sector, particularly health care equipment and solutions providers such as CareMax (CMAX). The company, which develops software and operates clinics to provide high touch, primary care for Medicare patients, has suffered from labor shortages in hospitals and customers pushing off purchases in preparation for a potential recession. Despite increasing its Medicare Advantage Membership approximately 49% year-over-year in the third quarter and raising full year guidance, the stock declined due to CareMax’s issuance of stock to complete the company’s acquisition of Steward Health Care System. We believe that CareMax, which has generated positive free cash flow in previous years, is well capitalized to expand strategically and build a profitable business that helps patients reduce systemic health care costs. As a result, we continue to maintain our conviction in the position.
Another detractor during the period was Maravai LifeSciences (MRVI), which provides products to enable the development of drug therapies, diagnostics, novel vaccines, and support research on human diseases. The company continues to face headwinds from both investor skepticism over the loss of its COVID-19 revenue and continued supply chain disruptions in the company’s bioprocessing consumables division, which weighed on the stock’s performance. We believe the value of the company’s nucleic acids business has been overly discounted relative to its long-term potential, and that the company’s position as a leading supplier to the growing field of mRNA vaccine research and development leaves it well positioned to be a long-term compounder within the portfolio.
Portfolio Positioning
We maintain high conviction in our portfolio positioning and holdings, particularly in light of elevated economic uncertainty and limited market visibility. However, we are constantly evaluating new opportunities to strengthen our position and maximize our upside potential. As such, we maintain an extensive backlog of companies which we feel may merit inclusion in the portfolio given the right circumstances. We also consistently evaluate our holdings for any developments that may undermine our confidence or invalidate our investment thesis. As such, we added six new positions during the quarter and exited six.
We added Eagle Materials (EXP), in the materials sector, which produces and supplies heavy construction materials and light building materials including cement, concrete and gypsum wallboard. Eagle’s low-cost advantage in wallboard, where other companies have seen much higher input cost inflation, and significant capacity constraints in cement manufacturing have translated to improving returns on capital despite a downturn in the housing industry. Nevertheless, the stock trades at a discount to its peers that have weaker returns and competitive positions. We believe Eagle will continue to expand margins through pricing and earn good incremental returns on its investments through both organic growth and potential acquisition opportunities.
We also seized the opportunity to add PotlatchDeltic (PCH), in the real estate sector. The company owns 1.8 million acres of timberland in the U.S. as well as six sawmills, an industrial-grade plywood mill and a rural timberland sales program. The stock has been weak since lumber prices peaked in 2022, creating an exceptionally compelling entry point far below the value of its net assets. We believe the company will be able to successfully navigate through a potential downturn in construction without meaningful impairment of its assets based on its strong balance sheet. Additionally, as PotlatchDeltic’s inventory of trees will increase in value over time, the company will benefit from delaying its harvesting activity until the market rebounds to a more attractive level.
We exited our position in Urban Outfitters (URBN), in the consumer discretionary sector, which engages in the retail and wholesale of consumer products through its brands Urban Outfitters, Anthropologie, Bhldn and Free People. While the company continues to possess several positive attributes, we felt that its relative valuation and long-term value creation opportunities were not as compelling as other new opportunities that we found within the market. Ultimately, we used this as an opportunity to consolidate our overall consumer discretionary exposure.
Outlook
We seek to avoid behavioral pitfalls like anchoring and recency bias by thinking probabilistically about the future. Most probably, it will not be like the recent past. However, regardless of the uncertainty we face entering 2023, we are confident in our ability to adapt to new market conditions and capitalize on emerging opportunities. We have high conviction that our philosophy of investing in high-quality companies with strong balance sheets and long-term earnings drivers that should produce returns on capital well above market expectations. Using this as the cornerstone of our portfolio management process, we believe we will be able to deliver attractive long-term returns over a full market cycle.
Portfolio Highlights
The ClearBridge Small Cap Value Strategy outperformed its Russell 2000 Value Index benchmark during the fourth quarter. On an absolute basis, the Strategy had gains in nine out of 11 sectors in which it was invested during the quarter. The leading contributors were the industrials, financials and consumer discretionary sectors, while the main detractor was the health care sector.
On a relative basis, overall stock selection and sector allocation contributed to performance. Specifically, stock selection in the industrials, IT, financials, materials and consumer discretionary sectors and an underweight allocation to the health care sector benefited performance. Conversely, stock selection in the health care and communication services sectors detracted from relative returns.
On an individual stock basis, the biggest contributors to absolute returns in the quarter were Maxar Technologies (MAXR), Wabash National, Commercial Metals, Olin and Kite Realty (KRG). The largest detractors from absolute returns were CareMax, Gray Television (GTN), Maravai LifeSciences, Everi (EVRI) and Syneos Health (SYNH).
In addition to the transactions listed above, we initiated positions in Everi and Bloomin’ Brands (BLMN) in the consumer discretionary sector and Maravai LifeSciences and Lantheus (LNTH) in the health care sector. We exited positions in Maxar Technologies and Cadre (CDRE) in the industrials sector, Piedmont Office Realty Trust (PDM) in the real estate sector, Acadia Healthcare (ACHC) in the health care sector and International Seaways (INSW) in the energy sector.
Albert Grosman, Managing Director, Portfolio Manager
Brian Lund, 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. |
Editor’s Note: The summary bullets for this article were chosen by Seeking Alpha editors.
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