Commentary: Small Cap Strategy

• The Fed’s September rate cut helped to spur a rally away from mega cap generative AI beneficiaries and toward broader market leadership including small cap stocks.
• The Strategy underperformed its benchmark as detractors in the communication services and IT sectors overcame strong performance in health care and consumer discretionary.
• The new “what comes next” is the looming U.S. presidential election between Vice President Harris and former President Trump, and what each would mean for the market.

Despite causing surges in market volatility during the quarter, a series of weaker than anticipated labor reports and subdued inflation readings helped pave the way for the Fed to cut interest rates by 50 basis points in September, its first cut since the beginning of the COVID-19 pandemic. The likelihood of further cuts and access to cheaper and easier to obtain financing also acted as an additional tailwind to the rotation away from the generative AI beneficiaries that dominated the first half of the year and toward broader market leadership favoring small cap stocks.

As a result, the benchmark Russell 2000 Index returned 9.27%, handily outperforming both the S&P 500 Index and the large cap Russell 1000 Index, which returned 5.89% and 6.08%, respectively. The rotation away from IT companies and into other sectors of the market also helped bolster the performance of value stocks, with the Russell 2000 Value Index returning 10.15%, 174 basis points ahead of the Russell 2000 Growth Index.

The ClearBridge Small Cap Strategy underperformed its benchmark in the third quarter, as detractors in the communication services and information technology (IT) sectors overcame strong performance by several of our health care and consumer discretionary holdings.

Stock selection in the communication services sector was a significant detractor during the period, largely due to not owning Lumen Technologies, which provides products and services including dark fiber, edge cloud services and internet protocol, among others. The company, which began the quarter with a $1.1 billion market cap, skyrocketed after it signed agreements with Microsoft and Corning to use its network and technologies to support their AI data center buildouts, resulting in a nearly 350% return and ending the quarter with a $7.2 billion market cap. However, despite this meteoric rise, we believe that the company remains a highly risky asset with a significantly leveraged balance sheet, and one not suitable for our focus on high-quality, long-term compounders.

Additionally, Vivid Seats, which operates as an online secondary marketplace for tickets in the U.S. and Canada, came under pressure for reducing its full-year 2024 guidance due to competitors ramping up their competitive pricing. However, we have conviction in management’s stance to not pursue volume at the expense of profits, and we are encouraged by Vivid Seats exceeding market expectations for second-quarter earnings. We believe the company’s strong balance sheet will allow it to persist through its peers’ short-sighted strategies.

Stock selection in the IT sector also detracted from performance, with the broadening of market participation into other sectors proving additional headwinds to several of our holdings. This included Bigcommerce, which provides a software platform that helps enable e-commerce. Struggles in the company’s go-to-market execution weighed on performance during the quarter, further extending its turnaround. Another IT holding, Indie Semiconductor, saw its stock price fall as a sharp contraction in the supply chain for the auto industry has caused the company’s revenue growth to stall. As a provider of automotive semiconductors and software, including for applications such as driver assistance systems, connected cars and electrification, the company has been further hampered by pushouts of new car models. Despite these near-term headwinds, Indie Semiconductor continues to have a strong backlog of orders and, as the automotive supply chain normalizes, we believe the company should see acceleration in revenue growth and share gains.

"Rather than gambling on an election’s outcome, we apply a probabilistic approach to evaluate a wide range of possibilities." 

Stock selection in the health care sector was the greatest contributor to relative performance, with three of our top five individual contributors coming from the sector. Lantheus, which makes diagnostic and therapeutic products that assist clinicians in the diagnosis and treatment of heart disease, cancer and other diseases, rose sharply in the third quarter after the Centers for Medicare and Medicaid Services proposed changes to its reimbursement policies for radiopharmaceutical products like Lantheus’s Pylarify. This allows Pylarify to continue to receive temporary pass-through reimbursement through 2026, mitigating investor concerns that this reimbursement would cease at the end of this year.

Another top contributor in health care, Corcept Therapeutics, saw its stock rise in the third quarter after strong earnings results and increased guidance for sales of Korlym, a hyperglycemia drug for adults with Cushing’s syndrome, which investors had been concerned would be vulnerable to the launch of a competitor’s generic version late last year. The company has seen added tailwinds from anticipation surrounding its next-generation version of the drug, which has fewer side effects, and is expected to release phase 3 data later this year and potentially file for FDA approval in 2025.

The consumer discretionary sector also contributed due to positive performance from stocks like Stride, which provides curriculum, software, and educational solutions created for online delivery to students in kindergarten through 12th grade. The company’s share price was buoyed by strong quarterly results, as it continues to attract and retain an increasing number of students, with enrollment growth continuing to surprise on the upside. In addition to its strong performance trajectory, we believe that the company’s unique offerings such as its growing Career Learning programs continue to be compelling opportunities to create further value.

American writer Ursula K. Le Guin once wrote, “The only thing that makes life possible is permanent, intolerable uncertainty; not knowing what comes next.” However, this hasn’t stopped investors and financial markets from trying to do just that with whatever topic or trend is fast approaching. In the 2000s it was “what comes next for the internet.” After the Global Financial Crisis (GFC) it was “what comes next for real estate.” And in the wake of COVID-19 it was, well, “what comes next for everything.” Having finally settled the question of what comes next regarding the rate cut cycle with the Fed’s 50 basis point cut in September, the new “what comes next” speculation is the looming U.S. presidential election between Vice President Harris and former President Trump — and particularly what the different permutations of electoral math would mean for the economy and the markets.

We are paying particularly close attention to the candidates’ approaches regarding taxes and tariffs. In terms of tax policy, both candidates have proposals aimed at reducing taxes for service workers and the middle class but differ in that Harris suggests increasing taxes on high-income earners while Trump has advocated extending tax cuts to the wealthy. In terms of tariffs, a Harris presidency would likely continue to follow the path set by the current administration whereas Trump has proposed a bevy of new, protection-oriented tariffs which could cost middle class households approximately $2,600 USD per year and act as a de-facto tax — counterbalancing many of the benefits of reduced taxes.¹ Additionally, immigration remains a contentious issue, with possible implications across a wide range of manpower-dependent sectors such as consumer staples and industrials should changes in policy result in more stringent entry requirements and an increase in deportations.

It can be difficult to avoid falling into the trap of speculating what a win one way or another would mean for the investors, particularly as the small cap market’s discounting function — which provides a glimpse into how the broader market anticipates the changing fortunes of publicly traded companies — has been potentially hampered by a decline in actively managed small cap assets, which have declined from 80% of small cap funds twenty years ago to below 50% today as passive ETF grow larger.

This substantial decline in actively traded assets in the small cap universe over the last two decades has had greater implications beyond merely a lack of transparency into the collective sentiment in the market. For instance, the highly anticipated September employment report — closely watched to gauge the likelihood and strength of the Fed’s anticipated rate cut — caused a spike in market volatility akin to those seen during the much more substantial upheavals of the Dot-Com burst, the GFC and the COVID-19 pandemic (Exhibit 1). Likewise, we are seeing this kind of increased volatility surrounding earnings season as a smaller number of active players making decisions are being amplified and followed by large passive funds. This was especially prevalent in the third quarter, which proved the most volatile earnings season since the GFC, with the average S&P 500 stock seeing an approximately 5% change in its price during earnings season — the largest aggregate change in over a decade.

Exhibit 1: September Employment Spurs Elevated Volatility

Coming full circle, these recent and outsize shocks stemming from the results of relatively routine events means that it has become even more difficult for the market and investors to determine “what comes next.” We are, of course, not immune to the impact and the implications that different tax policies, regulatory regimes and trade decisions would have on small cap companies. However, rather than gambling on an election’s outcome, we continue to apply a probabilistic approach in evaluating a wide range of possibilities and constructing our portfolio around strong companies with good balance sheets that are the most likely to persevere and prevail against the widest range of outcomes.

Our largest new position during the quarter was Meritage Homes, in the consumer discretionary sector, which builds single family attached and detached homes in the western and southeastern U.S. While higher mortgage rates have weighed on homebuilders and the demand for housing, we continue to believe that there is a systematic shortage of housing in the U.S., and that a decline in interest rates and subsequent mortgage rates should prove a boon to homebuilders. Beyond broader sector tailwinds, we opted to move our capital from Century Communities to Meritage given the latter’s higher historical level of returns at a comparable current valuation.

We also added a new position in Hain Celestial, in the consumer staples sector, which makes organic and natural products including infant formula, frozen desserts, plant-based beverages such as soy, rice and oat and frozen meat alternatives among others. Hain has seemingly been written off by the market, but new management has launched a company-wide turnaround effort that we believe will result in a more focused, profitable and growing company.

We exited our position in Everi, in the consumer discretionary sector, which provides games, cash access and customer relationship technologies to the casino industry. The company announced its intention to be acquired during the period by Apollo Global Management and, as we did not anticipate a better offer for the company, we elected to sell the position.

Despite our disciplined, bottom-up, fundamentals-based approach to investing, we recognize that large macro events such as the upcoming election will result in a lot of speculative “what’s next” for companies, their valuations and the broader direction of the market. However, as the collective wisdom of the market becomes more opaque due to the increased presence and outsize impact of passively managed and index funds, we believe that it is even more important for investors to adhere to a disciplined investment process to navigate the increase in these short-term volatility spikes. By employing a probabilistic approach, married with a focus on constructing a portfolio of strong companies with excellent balance sheets and compelling individual catalysts, we believe that our process is well-equipped for the long-term, but we acknowledge that the ride will not always be a smooth one.

The ClearBridge Small Cap Strategy underperformed its Russell 2000 Index benchmark during the third quarter. On an absolute basis, the Strategy had gains in nine of the 11 sectors in which it was invested during the quarter. The leading contributors were the health care and financials sectors, while the energy and communication services sectors detracted.

On a relative basis, stock selection in the health care, consumer discretionary and materials sectors also proved beneficial to performance. Conversely, stock selection in the communication services, financials, IT, industrials and real estate sectors and an overweight to the energy sector weighed on performance.

On an individual stock basis, the biggest contributors to absolute returns in the quarter were Everi, Lantheus, Tecnoglass, Corcept Therapeutics and Verona Pharma. The largest detractors were Valaris, Vivid Seats, Matador Resources, Janus International and Bigcommerce.

In addition to the transactions listed above, we initiated new positions in Guardian Pharmacy Services and Helen of Troy in the consumer discretionary sector, Tarsus Pharmaceuticals, Insmed and Vaxcyte in the health care sector, WSFS Financial in the financials sector, Expro in the energy sector and Silgan in the materials sector. We exited positions in Helmerich & Payne and Magnolia Oil & Gas in the energy sector, Avient and Constellium in the materials sector, Centuri in the industrials sector, Group 1 Automotive in the consumer discretionary sector, Advanced Energy Industries in the IT sector, playSTUDIOS in the communication services sector and R1 RCM in the health care sector.