ClearBridge Multi Cap Growth Strategy Q2 2022 Portfolio Manager Commentary
Getting into the sleeves of portfolio evolution later
Growth stocks entered a bear market in the second quarter as worsening inflation and aggressive Federal Reserve actions weighed on corporate earnings and investor confidence. Ongoing price pressures, global supply chain disruptions and growing recession risks sent the S&P 500 index down 16.10% for the quarter, marking its worst start to the year (-19, 96%) since 1970.
Rising interest rates continued to weigh most heavily on growth stocks, whose future earnings are discounted, with the benchmark Russell 3000 Growth Index falling 20.83% for the quarter and underperforming the Russell 3000 Value index of 842 basis points. Growth paths are worth 1,500 basis points year-to-date. To put that into perspective, the underperformance of growth versus value over the past three and six months is among the most severe of the Russell 3000 indices dating back to 1995.
A worse-than-expected consumer price index of 8.6% for May prompted the Federal Reserve to raise rates by 75 basis points in June, the biggest hike since 1994, and forecast ambitious tightening for the rest of the year. The 10-year Treasury yield jumped in mid-June to a four-year high of 3.5%, eventually ending up 67 basis points for the quarter at 3.01%.
Although not immune to the general market pullback, the ClearBridge Multi Cap Growth strategy outperformed the benchmark during the second quarter and has remained in the lead year-to-date. As we discussed last quarter, the consistently growing, strong free cash flow generating, more moderately valued companies that form the foundation of the strategy supported results as growth stocks rout (Table 1) . We view these companies as enduring integrators, with strong leadership positions and effective management teams capable of executing successfully in this challenging macroeconomic environment. In addition, balance sheet strength supports shareholder returns through actions such as buyouts, dividends and business development activities. We believe these companies should emerge even stronger on the other side of the recession.
Exhibit 1: The growth/value gap continues to widen
Equally important, the increased levels of volatility provided the Strategy with opportunities to buy stocks of growth companies on our watch list, as well as add existing positions at attractive levels. These actions reinforce the balance we have sought to achieve as our portfolio construction process has evolved over the past 18 months and help position the strategy to outperform over the long term.
Continued market sell-offs in the second quarter offered entry points into a number of pipeline ideas that were significantly more expensive months ago, but are now more appropriately priced for the portfolio. We took the opportunity to add three new names to the strategy: Diageo (DEO) in the consumer staples sector, Snowflake (SNOW) in the information technology (IT) sector and Airbnb (ABNB) in the consumer discretionary.
Diageo is a leading global distiller and brewer serving the large (over $500 billion) and fragmented spirits market. With its high-end product portfolio, we view Diageo as a stable preparer poised for sustained, above-industry growth. The company’s margins remain below pre-COVID levels in a number of geographies and should continue to recover as channels reopen, although we also see opportunities for continued margin expansion beyond this. rebound period. The spirits category is not immune to declining consumer spending or inflation; however, the majority of Diageo’s earnings come from the US market, which has historically been more resilient. Additionally, the company has a number of margin levers to help combat rising input costs.
Snowflake operates a cloud-based data platform for small and medium businesses and enterprise customers. The company is a major beneficiary of the migration of software spending to the cloud, as well as the growing strategic importance of data. With the potential to cater to the large and growing data cloud market, an opportunity of around $250 billion+ by 2026, we see a long streak of growth ahead. Although the company is already profitable, we believe Snowflake still has significant leeway for free cash flow headroom expansion.
Airbnb is the world’s leading online alternative accommodation platform. We believe the company is well positioned to capitalize on the large and growing travel and experiences market, with higher e-travel growth potential post-pandemic due to pent-up demand and increased flexibility of the work from anywhere. Airbnb is very profitable today, although we see room for further margin expansion. Additionally, the secular fundamentals of growth, a more variable cost structure and a strong balance sheet should help the company outperform through the cycle compared to its consumer discretionary peers.
The severity of the current sell-off, exacerbated by extremely negative investor sentiment, particularly towards growth stocks, has compressed the multiples of a number of portfolio companies despite strong fundamentals and led us to add to several existing positions . One example is cybersecurity software provider, CrowdStrike (CRWD), which continues to perform well in a robust demand environment for its endpoint security solutions with quarterly results and forecasts beating expectations. Similarly, we added to disruptive growth companies HubSpot (HUBS) and Doximity (DOCS) during the quarter.
With our most recent transactions, we are in the final rounds of the overall portfolio transition we began in early 2021. The result of the repositioning is a more balanced and diversified portfolio of companies with a stronger growth profile while maintaining a valuation discount as compared to the benchmark.
As fear continues to mount in the markets, owning industry leaders with a strong and flexible balance sheet is essential. Robust companies with tailwinds have seen their stock prices correct along with more speculative companies and a recession is becoming the consensus. After the sharp correction, we believe we are approaching levels in stock prices and sentiment where risk/reward becomes asymmetric on the upside. We think a pick-up in M&A activity would be an early signal that undervalued assets are becoming monetized. The collapse in growth valuations has been painful, but sets a solid foundation for long-term investors like us who are able to look ahead five to ten years.
We have reduced leverage in the portfolio and have confidence in the experienced management teams that run the companies we own. Going forward, we will continue to apply a high-conviction business owner approach while seeking to maintain balance and be opportunistic with portfolio additions. We believe this philosophy should result in a high active share strategy that is well positioned to generate outperformance for long-term investors.
The ClearBridge Multi Cap Growth strategy outperformed its benchmark Russell 3000 Growth Index in the second quarter. On an absolute basis, the Strategy recorded losses in the seven sectors in which it was invested (out of a total of 11 sectors). The main detractors were the IT, industrial and communication services sectors.
Relative to the benchmark, overall stock selection and sector allocation contributed to performance. In particular, stock selection in the Health Care and Communication Services sectors, an overweight to Health Care and an underweight to Consumer Discretionary boosted results. Conversely, stock selection in the information technology, materials, industrials and consumer discretionary sectors, an overweight in communication services and an underweight in consumer staples weighed on performance. the performance.
On an individual stock basis, positions in Vertex Pharmaceuticals (VRTX), UnitedHealth Group (UNH), Twitter (TWTR) and Ionis Pharmaceuticals (IONS) were the top contributors to absolute returns over the period. The main detractors were Broadcom (AVGO), Wolfspeed (WOLF), Johnson Controls (JCI), HubSpot (HUBS) and Lyft (LYFT).
In addition to the transactions mentioned above, we have liquidated a position in Pentair (PNR) in the industrial sector.
Editor’s note: The summary bullet points for this article were chosen by the Seeking Alpha editors.
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