Commentary: Small Cap Strategy

• Small caps benefited from market broadening and a post-election rally, before growing concerns about the direction of interest rates propelled large caps back to leadership in December.
• The Strategy outperformed its benchmark as strong stock selection and an underweight to the health care sector offset detractors in the materials sector. 
• Large cap valuations appear overstretched, leaving small caps at a historically wide discount. This creates tremendous potential in 2025 should earnings growth improve.

The fourth quarter proved a tumultuous one for small cap stocks, which rode a post-election rally before growing investor concern over the plans of the incoming Trump administration and an outlook calling for fewer-than-anticipated interest rate cuts propelled large caps back to leadership. Overall, small cap stocks generated positive returns, with the benchmark Russell 2000 Index returning 0.33% for the quarter, but failed to keep pace with large caps as the Russell 1000 Index and S&P 500 Index returned 2.75% and 2.41%, respectively. While value and cyclical names were the major participants of the post-election rally, a relative resurgence in growth in December helped the Russell 2000 Growth Index return 1.70% for the quarter and outpacing the Russell 2000 Value Index by 277 basis points.

"Large cap valuations appear overstretched, leaving small caps at a historically wide discount." 

Inklings of a market broadening in the fourth quarter sparked by Donald Trump’s election victory and investor optimism over greater deregulation and business-friendly policies were seen as a boon to equities, particularly small, value and cyclical stocks. This was further bolstered by additional interest rate cuts from the Federal Reserve. However, rate cuts came amid strong economic data that began to support the case for a slower easing cycle in 2025 than had been expected, contributing to a market rotation back to growth and large cap leadership. This, along with potentially reflationary policy from the Trump administration, such as tariffs, as well as slight upticks in inflation, put some upward pressure on interest rates, causing some weakness in economically sensitive and rate-sensitive sectors.

The ClearBridge Small Cap Strategy outperformed its benchmark in the fourth quarter, as our underweight and stock selection in the health care sector helped to overcome weakness in our materials holdings.

The prospect of higher rates continued a pushout of health care R&D spending and the potentially disruptive nomination of RFK Jr. as Secretary of Health and Human Services soured sentiment on vaccine uptake and development broadly — these factors weighed heavily on several health care subsectors, notably biotechnology, pharmaceuticals and related supply chains. However, our underweights to these sectors and exposure to the generally less volatile medical devices and services companies, complimented by strong drivers within our biotech holdings, helped to make health care our greatest overall contributor to relative performance.

Our top contributor for the quarter was biotech company Scholar Rock, which rallied over 300% in the days following the news that its candidate for spinal muscular atrophy, apitegromab, met its primary endpoint in Phase 3 trials. Scholar Rock intends to submit regulatory applications to U.S. and European medical regulators in early 2025. We capitalized on the surge to trim into strength but believe the company may have an even larger opportunity with apitegromab within the growing obesity market due to its ability to preserve lean muscle mass for patients on GLP-1 medications.

Likewise, Verona Pharma proved a strong contributor after it released strong quarterly earnings highlighting the strong launch of Ohtuvayre, its chronic obstructive pulmonary disease (COPD) treatment following FDA approval in June. We believe Ohtuvayre can capture a significant proportion of the $10 billion COPD market. Additionally, the company’s strong cash position leaves it well positioned to continue operations through its initial product launch without the need for further capital injections.

Stock selection in the materials sector weighed on performance, largely driven by a decline in Olin, a producer of commodity chlor-alkali products and their derivatives Olin reported weaker third-quarter margins and demand for its epoxy products and were also down on news that a competitor plans to build a new chlor-alkali plant that will likely increase competition and decrease Olin’s pricing power within the domestic chlorine market. However, we believe that the competitor’s timeline to begin operations in 2026 is very aggressive given the construction and regulatory permitting process needed, and further that destocking headwinds are beginning to abate, leaving Oiln well positioned for an eventual recovery.

We took advantage of the volatility in health care to make several adjustments to our positioning, adding companies like Keros Therapeutics and GoodRX. Keros, a biotech developing treatments for protein issues such as low blood cell counts, offered a compelling entry price reflecting low embedded expectations due to a selloff following the temporary pause of its pulmonary hypertension drug in Phase 2 testing, while its Elritercept drug Phase 2 and 3 trials remain on track. GoodRX provides information and tools that enable customers to compare prices to save on their prescription drugs. We believe the market is currently underestimating the company’s growth potential and its ability to ramp up scale given its software-based, capital-light business model. We sold Tarsus Pharmaceutical, which develops eye treatments, as it reached our assessment of fair value.

We also added First Watch Restaurant, which operates fast casual restaurants focused exclusively on breakfast and lunch. We believe the company represents one of the most attractive growth profiles in casual dining, and that its decision to forego dinner in favor of earlier meals allows it to maintain low labor costs and avoid more diverse and costly dinner menu items, enabling attractive margins. Following concerns that the company’s operations might be impacted by the fall hurricane season in Florida, which represents approximately 20% of First Watch’s locations, we were able to capitalize on the pullback to initiate a position.

We exited our position in cyber security solutions provider Rapid7, which has failed to successfully adapt to a deterioration in its core vulnerability management market despite its broadening of its offerings into to new bundles for larger clients. Combined with the departure of key personnel throughout 2024, we exited the position in favor of JAMF, which has similar market exposure but with better growth opportunities and a more attractive valuation.

The ClearBridge Small Cap Strategy outperformed its Russell 2000 Index benchmark during the fourth quarter. On an absolute basis, the Strategy had gains in five of the 11 sectors in which it was invested during the quarter. The leading contributor was the health care sector, while the materials and consumer discretionary sectors were the main detractors.

On a relative basis, overall stock selection contributed to performance. Stock selection in and an underweight to the health care sector, as well as stock selection in the real estate sector, proved beneficial. Conversely, stock selection in the information technology (IT), materials, consumer staples and financials sectors and an underweight to the IT sector weighed on performance. 

On an individual stock basis, the biggest contributors to absolute returns in the quarter were Scholar Rock, Allegiant Travel, Verona Pharma, Primoris Services and Q2. The largest detractors were Meritage Homes, Acadia Healthcare, Olin, ICF International and Maravai Lifesciences.

In addition to the transactions listed above, we initiated new positions in Crescent Energy and International Seaways in the energy sector, YETI in the consumer discretionary sector and Talen Energy in the utilities sector. We exited positions in Rythm Pharmaceuticals, AMN Healthcare, Maravai Lifesciences and Vaxcyte in the health care sector, Bloomin’ Brands in the consumer discretionary sector, Gray Television in the communication services sector and Expro and CNX Resources in the energy sector.