ClearBridge Mid Cap Growth Strategy Q3 2022 Portfolio Manager Commentary

By Brian Angerame | Aram Green | Matthew Lilling | Jeffrey Russell

Consolidating Conviction Through Uncertainty

Market Overview

Equity markets continued their downward slide during the third quarter, as investors grew increasingly anxious over the combination of aggressive interest rate increases from the Federal Reserve and the growing likelihood of a recession. The S&P 500 Index declined 4.88% over the three-month period, extending its decline to 23.87% year to date. With business visibility evaporating due to these macro headwinds, growth stocks showed greater resilience than value, with the benchmark Russell Midcap Growth Index giving back 0.65% compared to a decline of 4.93% for the Russell Midcap Value Index.

Investors hoping that a policy-engineered recession would spur a reversal in central bankers’ hawkishness were sorely disappointed as the U.S. economy proved just healthy enough for the Fed to continue aggressively raising rates by another 75 basis points in September as part of its war on persistent inflationary pressures. Candid statements by Fed Chair Powell and other policymakers signaling their intent to continue raising rates beyond previous targets, regardless of the economic consequences, caused equities to retreat further.

Hawkish monetary policy, combined with continued supply chain disruptions stemming from COVID-19 lockdowns in China, war in Ukraine, critically low levels of energy and other commodities and multi-decade high inflation sent investors looking for stability in the most defensive market sectors. Hard questions about companies’ ability to sustain growth rates, margins and earnings guidance in the event of a recession continued to largely favor price-taking companies with undifferentiated products in sectors such as energy and consumer staples. Amidst such headwinds, even the highest quality companies have struggled to rise above the noise and pessimism.

Within the Russell Midcap Growth Index, energy (+5.41%) was the top performing sector during the quarter, benefiting from tight supply for energy, particularly within starved European markets. The consumer discretionary (+0.90%), information technology (IT, +0.87%) and industrials (+0.85%) sectors all generated positive returns and, along with the financials (-0.21%) sector, outperformed the broader index. The more interest rate sensitive real estate sector (-7.35%) proved the worst performer, with the health care (-6.10%), utilities (-2.72%), consumer staples (-2.28%) and materials (-1.67%) sectors also trailing the broader index’s performance.

The ClearBridge Mid Cap Growth Strategy’s health care holdings proved to be the main detractor from relative performance in the third quarter. With many biotechnology stocks reliant on the capital markets to help finance their operations, investor sentiment for health care companies supporting such customers declined, despite small changes in earnings trajectories for these companies. Vaccine-related companies further suffered as the market saw dwindling COVID-19 revenues.

The portfolio’s worst performing stock during the quarter, Catalent, develops and manufactures drugs, biologics, cell and gene therapies and consumer health products. The company saw its shares derate after it missed earnings expectations partially due to a drop-off in its COVID-focused biologics business. Catalent (CTLT) is responding by reshuffling internal assets to increase synergies and focus on its strong non-biologic franchises, such as its high-growth and high-quality gummy vitamin business.

The company has begun correcting its supply chain issues and has thus far successfully navigated inflationary pressures, setting up an improving margin picture over the next few years.

Our industrials holdings generated positive performance during the quarter due to strong idiosyncratic drivers and greater earnings clarity. One of the portfolio’s top performing stocks was WillScot Mobile Mini (WSC), a North American leader in turnkey modular space and portable storage solutions.

The company has been able to drive increases in margins and market share through its value-added products and initiatives, including fully furnished spaces, modular customization abilities to suit different client purposes and improvements in logistics and supply chain management. Additionally, WillScot’s long-term contracts and pricing power as an industry leader have allowed it to pass through cost increases on contract renewals.

Two of the portfolio’s top five performing stocks came from the IT sector. Paylocity (PCTY), which provides cloud-based human capital management and payroll software solutions, benefited from a persistent need for the company’s payroll and tax services to small and medium-sized businesses.

Additionally, the company is a beneficiary of higher interest rates, as they have been able to invest deposits from its clients for tax and payroll purposes in short-term securities at higher rates, offering an attractive way to increase the company’s revenues and helping to offset increases in inflationary costs. Aspen Technology (AZPN), which develops software to optimize manufacturing operations and supply chain functions particularly within the energy industry, benefited as tightness in energy markets helped to drive demand from oil and natural gas producers for the company’s solutions.

Stock selection in the consumer discretionary sector proved a tailwind to performance. Etsy (ETSY), which operates a number of online marketplaces for craft and artisan goods, delivered second quarter results that demonstrated the company’s pricing power, cash flow generation, and margin upside remain intact. While Etsy is experiencing declines in gross merchandise sales, it is seeing better than expected take rates and improved margins. We believe the company is well-positioned to grow advertising spending on its marketplace, bring in new buyers and strengthen its e-commerce advantages.

Portfolio Positioning

We maintain high conviction in the portfolio’s holdings and positioning and continue to diligently monitor position sizing to maximize risk/reward in evolving market conditions. We elected to exit two positions during the period and use the proceeds to increase the size of our highest conviction investments.

“We maintain high conviction in the portfolio and continue to diligently monitor position sizing to maximize risk/reward in evolving market conditions.”

We eliminated our position in Avalara (AVLR), in the IT sector, which provides cloud-based solutions for transaction tax compliance. The company is being taken out by private equity firm Vista Equity Partners at $93.50 per share, a meaningful premium to its pre-deal price.

We also elected to exit our position in health care holding Teleflex (TFX), which designs, develops and manufactures single-use medical devices for common diagnostic and therapeutic procedures in critical care and surgery. The rollout of the company’s UroLift System, a minimally invasive outpatient procedure for treating an enlarged prostate, has suffered emerging from the COVID-19 pandemic due to a number of delays and nursing shortages, resulting in the business growing below our expectations. The sale enables us to consolidate our health care exposure in companies that we believe have higher growth potential and more certain earnings runways.

We added to our position in made-to-order burrito chain Chipotle Mexican Grill (CMG). Despite restaurants typically being seen as more sensitive to an economic downturn, the company has consistently been able to exceed expectations through its ability to passthrough inflationary increases in both materials and labor through strong pricing power. Chipotle’s investments in digital technology have enabled it to leverage the higher margin delivery business, highlighted by the implementation of “Chipotlanes”, a digital drive through option in suburban areas where customers pay in advance online, to drive significant increases in restaurant volumes.

Outlook

Investor uncertainty surrounding the economy, interest rates and corporate margins remains high, and looks likely to remain so for the foreseeable future. However, rather than find ourselves mired in the market’s pessimism, we see these events as an opportunity to capitalize on compelling growth company valuations and convey our assets into our highest conviction holdings.

Although tested by these market tremors, we remain committed to our mission of investing in high-quality, innovative companies that will leverage these challenges to capture even greater market share and improve their long-term growth prospects. We believe adhering to our investment philosophy will allow the Strategy to persevere through these challenges and emerge stronger on the other side.

Portfolio Highlights

The ClearBridge Mid Cap Growth Strategy underperformed the Russell Midcap Growth Index during the third quarter. On an absolute basis, the Strategy had losses across eight of the 10 sectors in which it was invested during the quarter (out of 11 sectors total). The leading detractors were the health care and IT sectors, while the industrials and consumer discretionary sectors were positive contributors.

On a relative basis, overall stock selection detracted from performance. Specifically, stock selection in the health care, IT, financials and communication services sectors weighed on returns. Conversely, stock selection in the industrials and consumer discretionary sectors contributed to returns.

On an individual stock basis, the biggest contributors to absolute returns in the quarter were Paylocity, Avalara, WillScot Mobile Mini, Etsy and CoStar (CSGP). The largest detractors from absolute returns were Catalent, Avantor, Syneos Health (SYNH), Fortinet (FTNT) and AppLovin (APP).

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Editor’s Note: The summary bullets for this article were chosen by Seeking Alpha editors.