Commentary: SMID Cap Growth Strategy

• The Strategy underperformed during a pronounced rotation out of higher-growth companies due to investor de-risking and a less accommodative macro backdrop.
• Solid results from several of our core compounders and innovative health care holdings helped offset a downtrend among higher-multiple businesses that were stellar performers in 2021 but faced tough comps heading into this year.
• We used opportunities created by heightened volatility to establish seven new positions while exiting eight other names to increase conviction in stocks with more attractive risk/reward profiles.

Despite a late rally to end the first quarter, small and mid cap growth stocks endured significant losses to start the year as a confluence of forces worked against higher-multiple segments of the market that had led performance through most of the COVID-19 pandemic and the initial recovery. While the large cap S&P 500 Index finished 4.60% lower for the quarter, the benchmark Russell 2500 Growth Index declined 12.30%. Value indexes continued to outperform growth given the multiple compression from higher interest rates and economic deceleration. The underperformance gap for growth in the first quarter was a pronounced 1,080 basis points.

The rotation out of growth commenced in the fourth quarter as the Federal Reserve began ramping up its monetary tightening rhetoric and accelerated into the first quarter with 40-year-high inflation prints leading to the first interest rate increase of the cycle. Russia’s February invasion of Ukraine put extreme pressure on input costs for businesses, which are being passed on to consumers. This is causing inflation to rise beyond our expectations and likely means it will be higher and more durable. We expect the war and subsequent economic sanctions against Russia to pressure U.S. company margins and free cash flow beyond the next couple quarters.

These macro effects on growth stocks were amplified by their overweight positioning in investors’ portfolios as well as valuation extremes reached during an early fourth-quarter rally. Innovation fell out of vogue this quarter during this period of portfolio de-risking. The initial public offering market, meanwhile, essentially ground to a halt after excessive supply in 2021.

During this sharp downward move for growth equities, the ClearBridge SMID Cap Growth Strategy trailed its Russell 2500 Growth benchmark. Strategy holdings were buffeted by a variety of macro and industry-specific factors. These ranged from the deleterious effect of higher mortgage rates on housing-related stocks, such as recyclable decking maker Trex, to financing headwinds in the biotechnology sector weighing on health care companies that service the industry like drug discovery, non-clinical development and manufacturing organization Charles River Laboratories and contract research organization ICON. A handful of stellar stock performers during 2021 faced “tough comps” heading into 2022 and underperformed, such as consumer names Etsy and Farfetch as well as data monitoring software maker New Relic and website tools developer Wix.com in the information technology (IT) sector.

More encouraging was the performance of several of the portfolio’s core growth names. ChampionX, a provider of chemical solutions to enable oil and gas exploration, production and distribution, participated in a strong market for energy stocks. Teledyne Technologies, a manufacturer of precision instruments, sensors and related equipment for a variety of industrial applications, was boosted by strong organic revenue and margin expansion guidance amid a challenging operating environment for many companies. The ahead-of-schedule financial deleveraging from its FLIR acquisition was also a catalyst. Performance Food Group, meanwhile, saw gains from improved dining out trends.

The Strategy also saw solid contributions from a handful of innovative health care companies. Neurocrine Biosciences performed well relative to lackluster biotech/specialty pharmaceutical industry performance on the back of lead compound Ingrezza achieving over $1 billion in revenues in 2021 despite reduced in-person psychiatric visits from COVID-19 limitations. Insulet, a leading provider of insulin pumps for diabetes patients, benefited from long-delayed FDA approval for its groundbreaking Omnipod 5 next-generation device. The Omnipod 5 is a tubeless insulin pump/patch integrated with a continuous glucose monitor and smart phone to algorithmically and dynamically adjust insulin levels in diabetic patients.

Heightened levels of volatility among the SMID cohort of growth stocks we target created attractive entry points during the quarter and we were active in repositioning the portfolio with seven purchases and eight sales.

"Heightened levels of volatility among the SMID growth cohort created attractive entry points during the quarter." 

In health care, we began a position in Biohaven Pharmaceutical, which develops neurology compounds. Management has accomplished an outstanding launch of lead drug Nurtec, for episodic and preventative migraine treatment, into a major growth vehicle with multi-billion-dollar potential globally. Biohaven has a number of other neurological compounds in the pipeline to treat rare disease states. We also added Doximity, which operates the largest professional social network for physicians. We believe Doximity is poised to gain share within its core addressable market for medical professional marketing, hiring and telehealth solutions. We also see significant opportunity for growth beyond this initial target market, driven by the potential for the company to add new member types, broaden its customer base, expand internationally and offer direct-to-consumer applications.

The Strategy also established a starter position in Zurn Water Solutions. Zurn is a pure-play water business that came out of Rexnord and is looking to double earnings over the next three to five years. The company has invested heavily in new product and recently acquired Elkay, a manufacturer of sinks and commercial water products.

Among Strategy exits, we eliminated online car sales platform Vroom due to continuing execution woes, operating deficits and a major pivot to sub-prime financing through a large acquisition. We exited specialty laser developer IPG Photonics due to continued price pressure from commodity laser producers and to provide a source of capital for better ideas, while we sold cybersecurity software maker Fortinet as its long-term growth caused its market capitalization to move above our target range.

We have many more questions than answers about the long-term implications of the Russian invasion and subsequent sanctions. There is much supposition how the war will be resolved, but only time will tell when investors begin to fully account for its impact and implications on economic growth. Companies have had to scramble to ensure continuity of supply, to rethink manufacturing and service economy footprints and to adjust safe inventory levels, with war-related economic sanctions adding to the uncertainties sparked by the pandemic.

Rather than make projections on which of many macro scenarios may play out, we can do best by our investors by maintaining the quality bias of a concentrated portfolio that offers exposure to a variety of growth opportunities. We continually examine the durability and magnitude of growth and returns by assessing the opportunity set and competitive advantage of each holding.

The comeback for more growth-oriented stocks to end the quarter is encouraging and we believe the qualities we look for in portfolio companies, such as innovative, self-funding business models and superior management teams, should shine through as current macro headwinds and geopolitical risks begin to dissipate.

During the first quarter, the ClearBridge SMID Cap Growth Strategy underperformed its Russell 2500 Growth benchmark. 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), with the IT, industrials, consumer discretionary and health care sectors the primary detractors, while the consumer staples and energy sectors were contributors.

In relative terms, overall stock selection and sector allocation detracted from performance. Specifically, stock selection in the IT, industrials and consumer discretionary sectors and an underweight to the energy sector hurt results the most. On the positive side, stock selection in the health care and consumer staples sectors and an underweight to the consumer discretionary sector contributed to relative performance.

The leading contributors to absolute returns during the first quarter included Enphase Energy, ChampionX, Teledyne Technologies, Performance Food Group and BJ’s Wholesale Club. Meanwhile, Trex, Etsy, New Relic, Burlington Stores and Charles River Laboratories were the greatest detractors from absolute returns.

In addition to the transactions mentioned above, we purchased Ashland Global in the materials sector and Allegro MicroSystems, Clear Secure and Onto Innovation, all in the IT sector. We also sold Purple Innovation in the consumer discretionary sector, SBA Communications in the real estate sector, Hologic in the health care sector, Copart in the industrials sector and Jack Henry & Associates in the IT sector.