ClearBridge Investments Select Strategy Q1 2022 Commentary
Despite a rally at the end of the first quarter, growth stocks suffered significant losses to start the year as a confluence of forces worked against several higher segments of the market that had led performance through most of the COVID-19 pandemic and initial recovery. While the large-cap S&P 500 index ended down 4.60% for the quarter and the market-wide Russell 3000 index fell 5.28%, the high-growth NASDAQ Composite , fell 9.10% while small cap growth indices fared even worse, with the Russell 2500 Growth Index down 12.30. %.
The rotation out of growth and away from small businesses began in the fourth quarter as the Federal Reserve began to intensify its monetary tightening rhetoric and accelerated into the new year with 40-year high inflation impressions leading at the first interest rate increase of the cycle. Russia’s invasion of Ukraine in February has put extreme pressure on input costs for businesses around the world, much of which is passed on to consumers. This causes inflation to rise beyond our expectations and likely means that it will be higher and longer lasting. We expect the war and subsequent economic sanctions against Russia to put pressure on corporate margins and free cash flow throughout the year.
These macroeconomic effects on growth stocks were amplified by their overweighting in investors’ portfolios as well as by the extreme valuations reached during a rally at the start of the fourth quarter. The ClearBridge Select strategy is overweight growth and small cap stocks and suffered the worst of the selling pressure in these areas during the quarter. This resulted in an underperformance against our main benchmark, the Russell 3000 Index, which holds both growth and value stocks. The underperformance was less pronounced compared to the Russell 2500 Growth and Russell Midcap Growth indices.
The largest losses occurred among disruptors who make up a large portion of the portfolio. Since most of the valuation of these fast-growing companies is based on cash flows expected in the future, they most directly bear the brunt of valuation calculations when the denominator of discounted cash flow models – short-term interest rates – increases significantly. Higher rates also increase the cost of borrowing, which could potentially dampen consumer demand. These risks have impacted several disruptors whose businesses are related to e-commerce and consumer spending, with e-commerce enablement provider Shopify (SHOP), online used-car platform Carvana ( CVNA) and residential decking maker Trex (TREX) all down more than 50% for the quarter while footwear retailer Crocs (CROX) fell more than 40%.
One of the main objectives of the strategy is to generate different returns than passive portfolios and other active managers by focusing on stocks with company-specific drivers. These companies tend to be more insulated from macroeconomic forces and are generally more resilient throughout a market cycle. However, equities generally underperform in more pro-cyclical and macro markets. While our long-term bias towards innovation and growth has detracted from performance, our ownership of high-quality compounds and evolving opportunity stocks like Performance Food Group (PFGC), L3Harris Technologies (LHX) and CME Group (CME) helped offset some of the volatility in the first quarter. The resilience of these companies illustrates the balance we have sought to achieve in the portfolio with our positioning stocks throughout the COVID-19 period.
Risk management supports this balanced objective and we were active sellers during the quarter. We reduced our position in Pioneer Natural Resources (PXD) after the stock gained nearly 40% on the oil price spike and redirected some of that capital into the energy services sector.
After a period of several years of weak activity, we believe that new energy exploration activity should pick up, which would benefit stocks on the services and equipment side.
We have also reduced our exposure to consumers to manage heightened uncertainty surrounding retail spending in times of rising inflation and rising interest rates. This included selling clothing retailer American Eagle Outfitters (AEO), a version of online car-selling marketplace Carvana, and swapping a long-standing investment in low-cost retailer Ross Stores (ROST) for Burlington Stores (BURL). We see Burlington as early in its maturation cycle with a seasoned management team using a proven playbook. We also exited Cricut (CRCT), a handmade design tools and software platform, and pet supplies retailer Chewy (CHWY) after becoming increasingly concerned about their usage statistics. Online gaming platform Zynga (ZNGA) was sold before a strategic acquirer closed its takeover at a significant premium.
Additionally, the volatility provided opportunities to take new positions at attractive prices. Among the disruptors, this backdrop drove our buying of electric vehicle maker Tesla (TSLA) during a 25% correction in its shares, as well as Sentinel One (S) in the information security space. and Etsy (ETSY), an online marketplace for handcrafted products. . We also added two new consumer companies that we view as upgradable opportunities, theme park operator Six Flags Entertainment (SIX) and fragrance maker Coty (COTY). Finally, more attractive valuations resulting from broad selling pressure allowed us to add to existing software investments, including ServiceNow (NOW) and GitLab (GTLB).
Private investments and initial public offerings offer another attractive source of new ideas for the strategy, but the current aversion to riskier, higher multiple growth companies has mostly frozen activity in these markets. We typically see this during periods of market corrections, as private markets generally need time to catch up with public markets. We continue to talk to private and pre-IPO companies, but until we see stability return to equities, we expect issuance to be limited.
The return to more growth-oriented equities at the end of the quarter is encouraging and we believe that the qualities we are looking for in portfolio companies (innovative, self-funded companies with long growth avenues and company-specific operating levers ) are persistent attributes. While the market may not always appreciate their resilience (much like we saw at the start of COVID-19 in 2020), we believe that over longer periods owning companies with such characteristics will be rewarded. While recent variability in returns for some portfolio companies that we view as disruptors has been pronounced, we remain confident in the role of these higher-growth names in a balanced portfolio that also includes healthy exposure to larger capitalization companies. stable and ever-changing opportunities.
The ClearBridge Select strategy underperformed its benchmark Russell 3000 index in the first quarter. On an absolute basis, the Strategy suffered losses in nine of the 10 sectors it was invested in during the quarter (out of a total of 11 sectors). The information technology, consumer discretionary and industrials sectors were the main detractors from performance, while the energy sector contributed.
In relative terms, overall stock selection was the main drag on performance. Specifically, stock selection in the IT, consumer discretionary and industrials sectors had the largest negative impact on results, while stock selection in the healthcare and finance has also proven detrimental. On the positive side, stock selection in the communication services sector and an underweight to the sector contributed to performance.
On an individual stock basis, the top contributors to absolute returns during the first quarter were Pioneer Natural Resources (PXD), Zynga (ZNGA), Tesla (TSLA), Expedia Group (EXPE) and Performance Food Group (PFGC). The most significant individual detractors were Shopify, Trex, DocuSign (DOCU), Vertiv Holdings (VRTV) and Crocs (CROX).
In addition to the transactions mentioned above, the Strategy closed positions in Twilio (TWLO), Dynatrace (DT), Yext (YEXT) and HashiCorp (HCP) in the IT sector, Rivian Automotive (RIVN) and Global-e Online (GLBE ) in the consumer discretionary sector, Uber (UBER) in the industrials sector and Altimeter Growth (AGCB) in the financial sector.
Editor’s note: The summary bullet points for this article were chosen by the Seeking Alpha editors.