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By Albert Grosman | Brian Lund
Fundamentals Prevail as Market Washes Out Excesses
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.
“Inflation is a clear and present danger that the Fed has sworn to crush.”
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 benchmark during the quarter.
Stock selection in the information technology (IT) sector was the leading contributor to relative outperformance in the fourth quarter, benefiting from strong idiosyncratic drivers that helped our holdings overcome increased economic uncertainty. Extreme Networks (EXTR), one of the Strategy’s top-performing holdings, provides networking solutions worldwide through wired and wireless network infrastructure equipment and software development for network management, policy, analytics, security, and access controls. The company continues to exceed expectations thanks to its progress in consolidating its multiple offerings within a single platform and higher recurring software sales. As a result, the company has been able to accelerate its revenue growth and improve its profitability to the benefit of shareholders. Commvault Systems (CVLT), which provides software solutions for data backup and recovery, also proved resilient amid a challenging macro environment. The critical need by customers for Commvaults’ products and services has helped the company maintain strong execution and exceed analysts’ expectations, helping facilitate additional traction as the company transitions to a software-as-a-service (SAAS) business model. Despite positive recent performance, we feel strongly that the market continues to undervalue Commvault’s long-term drivers, potential for accelerating growth and improving cash flow generation.
Our holdings in the materials sector also benefited relative performance during the period. 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 also drove portfolio performance. Olin (OLN) 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. Companies such as R1 RCM (RCM), a provider of revenue cycle management to hospital and physician practices, and Omnicell (OMCL), which provides pharmacy automation solutions, continue to face challenges stemming from hospital labor availability, resulting in delays in collections and sales cycles. Additionally, many of these companies’ customers have placed freezes on capital investment and pushed contracts into the future in anticipation of a recession. However, we feel that market negativity surrounding these stocks is overblown and these companies have strong underlying drivers that will prevail. R1 RCM maintains a large book of long-term contract business, has increased cross-selling opportunities from its 2022 acquisition of CloudMed and should benefit from a growing demand to improve health care collections. We feel this will generate strong free cash flow and returns over time. Likewise, Omnicell is a leader in the pharmacy automation space, which we expect will be a long-term trend that will create significant value for shareholders.
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 three new positions during the quarter and exited one.
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.
Elsewhere in real estate, we exited our position in health care REIT Physicians Realty Trust (DOC). With interest rates rising and the capitalization rates for medical office buildings remaining flat, we determined that the margin between the company’s cost of capital and returns from its properties has narrowed to an unattractive level and elected to exit the position and redeploy capital into our higher-conviction holdings.
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 Strategy outperformed its Russell 2000 Index benchmark during the fourth quarter. On an absolute basis, the Strategy had gains in eight out of 11 sectors in which it was invested during the quarter. The leading contributors were the industrials, IT and financials sectors, while the health care sector proved the main detractor.
On a relative basis, overall sector allocation effects and stock selection contributed positively to performance. Specifically, stock selection in the IT, industrials, real estate, materials and financials sectors and an underweight to the health care sector contributed to relative returns. Conversely, stock selection in health care, utilities and consumer discretionary sectors detracted from performance.
On an individual stock basis, the biggest contributors to absolute returns in the quarter were Altra Industrial Motion (AIMC), Commercial Metals, Extreme Networks, Olin and Helmerich & Payne (HP). The largest detractors were R1 RCM, Omnicell, CareMax (CMAX), Lantheus (LNTH) and Maravai LifeSciences (MRVI).
In addition to the transactions listed above, we initiated a position in Crane (CR), in the industrials sector. During the period, portfolio holding Altra Industrial Motion entered into an agreement to be acquired. Additionally, our holding in special purpose acquisition company CONX (CONX) elected to split into shares of CONX and CONX stock warrant. Ultimately, we elected to redeem our investment in CONX upon the company’s announcement to acquire a company.
Albert Grosman Managing Director, Portfolio Manager
Brian Lund, CFA Managing Director, 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.
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