ClearBridge Small Cap Strategy Portfolio Manager Commentary Q2 2022
Recession A Possibility, Not A Certainty
The headline for the second quarter of 2022 was the stock market and the Federal Reserve began to take inflation seriously. For the Fed, the implications were clear: it needs to raise interest rates. The market, however, doesn’t have a straightforward course of action. The initial response in April and May was to push the Russell 2000 Growth index down more than the Russell 2000 Value Index. Higher inflation means higher discount rates, so that cash flows farther out in the future are worth less than they were when rates were low. In June, however, growth outperformed value, as cyclical sectors like energy and materials began to price in a recession and defensive sectors like health care and utilities became relative safe havens. Which can investors expect for the foreseeable future — higher discount rates favoring value stocks, or higher recession risks favoring growth stocks?
While the standard answer — no one knows — certainly applies, perhaps a more satisfying answer is the odds are not even; one side of this trade earns a much higher return than the other. Rather than seeking to predict the future, our investment process gauges the impact of various scenarios on a company’s valuation and determines if the odds of a specific scenario have been misapplied toward one direction or another. Currently, the odds that inflation will continue above trend and that discount rates, including both the risk-free rate and equity risk premium, will be higher are quite high. Although issues with global supply chains may begin to resolve themselves and the demand for labor may moderate alongside wage increases, inflationary forces are largely still in place. The labor market remains hot, oil prices are still elevated and inventories for big-ticket items such as autos and houses are depleted. These trends have a long way to go before the Fed will stop raising rates and/or profits at cyclical companies are seriously damaged.
Valuations, though, are tilted strongly toward a recession. While growth valuations have come off their 2021 extremes, they remain historically high. The enterprise value/sales ratio for the Russell 2000 Growth Index is above its long-term average, despite the huge number of IPOs and SPACs that went public in the past couple of years pushing the number of unprofitable companies in the index above 35%. Many of these growth companies, especially in biotechnology and IT, have very few physical assets and will need further funding from the capital markets over the next few years, catalysts that hurt valuations in an inflationary environment. Cyclical stocks, on the other hand, often own hard assets that are appreciating in value (like land on a homebuilder’s balance sheet, which is worth much more today than when it was put on the books two or three years ago), are generating lots of cash and have low-cost debt that can be more easily repaid given inflation’s reduction in the dollar’s value. Yet small cap homebuilders are trading below tangible book value despite finished inventory being completely sold out and gross margins being higher than ever, meaning the market thinks that not only is the value of their landholdings worth less than their book value, but also that the companies’ future operations will destroy value. The same is true for energy companies, currently trading at low-single-digit P/Es despite oil prices hovering around $100, a level much higher than most need to remain profitable.
People tend to react to data rather than analyze it. They see the odds of a recession rising and think, “I have to run the recession playbook.” These reactions often ignore current conditions (already high growth valuations relative to value) as well as the odds of that outcome happening. The economy may very well be headed to a recession, which will overwhelm the homebuilding and energy markets and make biotech and IT ultimately the better playbook. However, this result requires a number of specific economic catalysts that we currently don’t observe as well as the hurdle of having to overcome the value of currently huge cash flows, to make them worth the current prices we see them trading at in the market. As such, we think that makes that bet pretty unlikely.
“We believe our subprime lenders are victims of public perception rather than any meaningful change to their long-term economics.”
The Strategy performed in-line with its Russell 2000 benchmark during the quarter, as positive contributions from our stock selection in sectors such as consumer discretionary and energy were offset by declines across a number of sectors, including industrials and financials.
Despite broad challenges to the sector’s overall performance, our stock selection within the consumer discretionary sector proved beneficial during the quarter. Specifically, positive performance was largely driven by our holding Murphy USA (MUSA), which operates a chain of retail gas stations across the U.S. offering retail motor fuel products and convenience merchandise. Murphy USA’s share price rose after beating market expectations for the first quarter, as the company’s strong cost discipline and exceptionally low fuel breakeven points relative to its peers have allowed it to earn higher margins from spiking gas prices. Additionally, the company has a strong consumer loyalty program that has driven increased market share for Murphy in snack foods and other in-store categories. We have high conviction in the company and believe it will continue to be a long-term growth compounder for the portfolio.
The Strategy also benefited from our holdings in oil and petroleum refiner HF Sinclair (DINO), in the energy sector. As a leading producer of gasoline, diesel fuel, jet fuel and other petroleum-based products, the company has seen substantial demand in the wake of energy supply shocks resulting from low inventories globally. Additionally, the international economic sanctions placed on Russian energy exports in the wake of its invasion of Ukraine have severely limited the ability of European refiners to access the necessary inputs to meet demand and remain competitive, which has further benefited their American counterparts. Finally, the company has diverse investments in pipelines, renewable fuel projects and specialized lubricants that make its cash flows relatively consistent for a refiner. Despite producing near maximum capacity, HF Sinclair continues to build a backlog for its refined products and will continue to benefit from high energy prices and global demand for the foreseeable future.
The financials sector proved a headwind to relative performance during the period, as growing concerns over the probability of entering a recession weighed on public perception of the sector. Our allocations to subprime lenders such as PROG and Oportun Financial (OPRT) were particularly impacted due to fears that a recession would result in a significant increase in credit losses, particularly at the lower end of the credit spectrum. While we acknowledge that a recession would indeed result in an uptick in loss rates, prior economic downturns have shown these companies to be efficient and experienced operators within the subprime lending market and that economic downturns result in minimal impact to their overall earnings. As such, we believe PROG and Oportun Financial are victims of public perception rather than any meaningful change to their long-term economics and continue to maintain confidence in the positions.
Despite having strong conviction in our portfolio positioning, such periods of unprecedented market uncertainty and volatility require us to maintain vigilance for opportunities to strengthen our risk-return profile. We have a robust watchlist of high-quality companies that we maintain as possible inclusions to the portfolio, and we made several adjustments during the quarter where we encountered compelling opportunities.
We took advantage of the selloff in the information technology (IT) sector to reduce our underweight there and initiated a new position in Euronet Worldwide (EEFT). The company is a global leader in providing payment and transaction processing and distribution solutions to financial institutions, retailers, merchants and individual consumers through ATM networks, point-of-sale management and fraud management, among other services. Transaction volumes within the company’s highly profitable consumer ATM business suffered significantly over the last two years as a result of COVID-19 lockdowns and shelter-in-place restrictions, but we see tremendous opportunities for this business segment to fully recover over the next two years and lead to further improvements in the share price.
We exited our position in Masonite (DOOR), in the industrials sector, which manufacturers, markets and distributes interior and exterior doors for residential and non-residential buildings. While we still feel there are strong long-term drivers within the residential construction, repair and renovation industry, the continued outpacing of demand versus supply within the housing market prompted us to shift our exposure from building-product manufacturers toward homebuilders that trade below book value despite record margins. As a result, we exited Masonite and increased our exposure to Century Communities (CCS), which has a multiyear runway for significant growth that should increase book value over the next few years.
We believe the market is pricing in high odds of a recession. However, while this remains a very real probability, we believe that continued tightness in labor markets, diminished inventories for big-ticket items, and current home sales means it is not necessarily a certainty. Even so, rather than lose perspective in trying to dictate the direction of macro market factors, we continue to rely on our fundamentals-based approach to identify companies with high current cash flows and compelling asset values trading at attractive valuations. We continue to find great values in the commodity, chemical, homebuilder, oil & gas and leasing industries, as reflected in our overweight allocations within the consumer discretionary and materials sectors. By basing our assessment on rigorous analysis and experienced management, we maintain a broad and objective perspective, balancing short-term challenges without losing sight of long-term opportunities.
The ClearBridge Small Cap Strategy outperformed its Russell 2000 Index benchmark during the second quarter. On an absolute basis, the Strategy had losses in all 11 sectors in which it was invested during the quarter. The leading detractors were the industrials, IT and financials sectors, while the consumer staples, utilities and energy sectors were the main contributors.
On a relative basis, overall stock selection contributed to performance. Specifically, stock selection in the consumer discretionary, energy and real estate sectors contributed to relative returns. Conversely, stock selection in the industrials, financials, IT and materials sectors as well as an overweight to the communication services sector detracted.
On an individual stock basis, the biggest contributors to absolute returns in the quarter were Murphy USA, Lantheus (LNTH), Stride (LRN), Sovos Brands (SOVO) and HF Sinclair. The largest detractors from absolute returns were SMART Global (SGH), PROG, Amarin (AMRN), Textainer (TGH) and Sterling Check (STER).
In addition to the transactions listed above, we initiated positions in National Bank Holdings (NBHC) and Redwood Trust (RWT) in the financials sector and Extreme Networks (EXTR) in the IT sector. We also exited positions in SkyWest (SKYW) and Shoals Technologies (SHLS) in the industrials sector and 1stdibs.com in the consumer discretionary sector.
Editor’s Note: The summary bullets for this article were chosen by Seeking Alpha editors.