Commentary: Small Cap Value Strategy

• The market is greatly overestimating the effect of higher rates and inflation on durable goods, materials and financial companies, while underestimating the impact on speculative assets.
• Rather than driven by positive growth catalysts, the reversal in value leadership during the third quarter was largely due to a selloff in traditionally defensive sectors.
• We have high conviction in our process and discipline and are focused on capitalizing on opportunities to lay the foundation for long-term success over a full market cycle.

Financial markets are entering a period unlike any we have seen in decades, and it shows. The uncertainty was reflected not just in rising stock volatility but also in erratic bond markets, where the 10-year U.S. Treasury note saw yields oscillate between 2.7% and 4.0% during the quarter. The playbook hasn’t been written for an economy where demand exceeds supply and unemployment is near all-time lows, yet interest rates are rising fast, liquidity is draining due to quantitative tightening, and inflation is rampant. Naturally, therefore, most market participants are relying on the playbook they know: Sell cyclicals and financials, buy staples and utilities and short highly leveraged balance sheets. This approach has been working fabulously well, but it risks running off the cliff with the other lemmings when the winds shift.

Valuation matters. Earnings can decline rapidly in a recession, providing little support for stocks, but the value of hard assets generally rises during periods of high inflation. Investors haven’t had to bother with balance sheet analysis for a decade, except momentarily during the financial crisis of 2008-2009. Even then, they were looking at highly leveraged banks, extremely overbuilt housing and overinflated home prices. The result was a major asset impairment at banks and homebuilders. This time around, residential investment has been continuously below long-term averages for a decade, housing inventories are at multi-decade lows (Exhibit 1) and banks have maintained strict underwriting standards and strong capital levels — not by their own choice, but by regulatory decree. We are unlikely to see significant losses in either residential or commercial real estate, and homebuilders’ book value will likely increase over the next few years, but both of these industries are trading near or below their tangible book value. Meanwhile, the book value of small cap biotechnology companies consists largely of cash, which is rapidly declining in purchasing power. Yet health care is considered a safe haven?

Exhibit 1: Housing Inventories Remain Constrained

Secondly, there are few excesses in the system. Not only are housing inventories historically low, but so are apartment vacancies. Rents continue to rise rapidly and are expected to continue to do so, given higher costs of ownership for landlords. Housing formation can slow to a certain extent, but eventually people will have to pay higher prices for housing. In addition, auto inventories are at record lows for both new and used vehicles. Despite higher interest rates, people need cars. The good news for consumers is that interest rates on homes and autos are lower than other loans, because they are secured by the asset. The bad news is that higher housing and auto costs may crimp their spending on discretionary items like video games, streaming services and crypto-currency speculation. Yet the Russell 2000 homebuilder and automotive subsectors have both underperformed year to date and trade well below average price-to-book levels (Exhibit 2).

Exhibit 2: Investors Undervalue Essential Goods

We believe the market is greatly overestimating the effect that higher interest rates and inflation will have on durable goods, materials and financial companies, while underestimating their impact on speculative and intangible assets. While it’s painful in the short term to see low-yielding utility and staples stocks outperforming high-yielding durable goods companies with significant demand tailwinds, we believe the long-run profits will be substantial.

Rather than driven by positive growth catalysts, the reversal in value leadership during the third quarter was largely due to a selloff in traditionally defensive sectors, including real estate and consumer staples, thanks to the aggressive drumbeat of interest rate hikes by the Fed. This rapid withdrawal of liquidity caused a rise in Treasury yields, reducing the relative attractiveness of these traditional recessionary safe havens. However, despite generating positive stock selection in both of these sectors, the Strategy underperformed its Russell 2000 Value Index benchmark during the quarter.

Health care weighed on our relative performance. While the broader sector benefited from being perceived as more defensive and having greater resilience in the event of a recession, a drop-off in market liquidity due to rate increases and uncertainty over profitability hampered many of the smaller and more growth-oriented companies within the biotech space. Syneos Health, a clinical research company that provides clinical trial services to companies in the pharmaceutical, biotech and medical device industries, saw its stock decline after customers delayed scheduling new trials as they navigate the current economic uncertainty. While we continue to remain underweight the sector, we are diligently look for health care names that align with our focus on high-quality companies with strong balance sheets and long-term value creation opportunities.

Information technology (IT) proved a headwind to performance, and included the portfolio’s worst performing stock, NCR, during the quarter. Broadly, the increase in interest rates discounted longer-term cash flows, compressed multiples and pressured share prices for the typically more growth-oriented sector. Still others felt pressure for company-specific reasons, such as the market’s disappointment that ATM and point-of-sale software company NCR was no longer the center of a bidding war between two private equity firms. However, we have high conviction in management’s decision to split the company, allowing for each entity to devote greater time and attention to optimizing very profitable and high cash flow generating businesses. We continue to own NCR as we believe the assets, and their respective free cash flow generation, are undervalued regardless of whether it continues as one company or two.

The Strategy benefited from its positioning in less interest-rate-sensitive companies within the real estate sector, where the aggressive increase in rates and hawkish outlook made it the benchmark’s second worst performing sector of the quarter. RLJ Lodging Trust, which specializes in premium-branded, high-margin hotels, benefited from its ability to adjust pricing to account for higher costs. Likewise, Corporate Office Properties Trust’s long-term leases with government agencies and contractors, particularly those focused on national security, make it less sensitive to higher rates and economic downturns than its more commercial-office peers. Although both companies saw their stock prices decline during the period, they outperformed the broader real estate sector.

We recognize that the same market tremors that have weighed on performance have also created significant opportunities to add companies that have been mainstays of our watchlist at exceptionally compelling entry points. We continue to refine our positioning to meet the challenges of today but continue to maintain high conviction in the companies we own and their long-term prospects. During the quarter we added five new positions and exited six.

We took advantage of the selloff in the IT sector to initiate a new position in Euronet Worldwide. 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 recognize these periods for what they are: a transitional disconnect between stock prices and their inherent values." 

We also seized the opportunity to add Anterix, in the communications services sector, which owns nationwide wireless spectrum. The company believes its holdings at the 900MHz frequency are ideally suited to create private LTE networks for infrastructure assets, namely utilities, and it has only just started licensing its spectrum under very long-term agreements, with three contracts signed thus far. We believe these deals are just the beginning, and the value of Anterix’s spectrum greatly exceeds that implied by the stock price.

We exited a number of stocks during the period, including Sprouts Farmers Market and Goodyear Tire & Rubber. Strong investor sentiment for consumer staples helped bolster Sprouts’s stock price to a level we believe reflected the fair value of the company, and we exited the position to capture the positive returns on the stock. Alternatively, we sold our position in Goodyear due to the cavalcade of concerns including the company’s elevated debt levels, inflationary pressures from higher input prices, continued manufacturing challenges in the auto industry and complications with the company’s manufacturing volume. With substantial exposure to the automotive industry through other portfolio holdings, we elected to consolidate our exposure within those higher-conviction holdings.

Market downturns, such as the one we find ourselves in, are never pleasant but are nevertheless a component of the full market cycle. While these observations do little to assuage our disappointment in short-term performance, we recognize these periods for what they are: a transitional disconnect between stock prices and their inherent values. This creates challenges for long-term managers as short-term markets are often ruled by investor sentiment and macro factors, which in this case are both pointing toward recession. However, our process of investing in high-quality companies with strong balance sheets and long-term earnings drivers is designed to generate attractive returns over the full market cycle, not just a part of it. As such, we have high conviction in our process and discipline, and focus on capitalizing on opportunities to lay the foundation for long-term success.

The ClearBridge Small Cap Value Strategy underperformed its Russell 2000 Value Index benchmark during the third quarter. On an absolute basis, the Strategy had losses in eight out of 11 sectors in which it was invested during the quarter. The leading detractors were the IT and financial sectors while the energy, consumer staples and health care sectors were the positive contributors.

On a relative basis, overall stock selection and sector allocation weighed on performance. Specifically, stock selection in the IT, financials and energy sectors, as well as an underweight allocation to the health care sector detracted. Conversely, stock selection in the industrials, real estate, consumer discretionary, consumer staples and materials sectors and overweight allocation to the energy sector contributed to relative returns.

On an individual stock basis, the biggest contributors to absolute returns in the quarter were CareMax, International Seaways, Murphy USA, Cadre and Marten Transport. The largest detractors from absolute returns were NCR, Oportun Financial, Primoris Services, Gray Television and NorthWestern.

In addition to the transactions listed above, we initiated positions in Terex in the industrials sector, Piedmont Office Realty Trust in the real estate sector and Cara Therapeutics in the health care sector. We also exited positions in SkyWest in the industrials sector, Brandywine Realty Trust in the real estate sector, Advantage Solutions in the communication services sector and Quotient in the health care sector. During the period, portfolio holding East Resources Acquisition, a special-purpose acquisition company (SPAC), voted to extend its investment window and allowed the portfolio managers to redeem their investment for cash, which we did.