Commentary

Key Takeaways

• Improving economic activity and the election of a U.S. president with a pro-growth policy agenda led to a sharp reversal in sector performance, with cyclicals taking leadership from bond proxies.
• Fundamental quality factors underperformed during the quarter but are critical to long-term success in international small company investing.
• The anomaly of stocks with high expected growth but low implied returns has been the source of long-term alpha generation for the Strategy.

Market Overview

International stock markets had a difficult fourth quarter with small capitalization stocks suffering wider losses than large caps. The developed market MSCI EAFE Small Cap Index declined 2.86% compared to a loss of 0.71% for the large cap MSCI EAFE Index while the MSCI World Index Small Cap, which includes U.S. and emerging markets stocks, gained 2.74%.

Global equities were primarily driven by the dramatic reversal in share prices after the U.S. presidential election. The U.S. dollar (USD) also jumped by an average of over 7% relative to the world’s leading currencies. Taken together, North American markets dominated performance with Canadian and U.S. companies up approximately 3%, and U.S. small caps up 9%. In USD terms, European shares ended the final interim off 0.4% while Japan closed the last three months basically unchanged as an underlying 15% gain was completely wiped out by an equivalent drop in the yen. Markets in Asia outside of Japan suffered from both a currency and stock price standpoint given concerns about the impact of a stronger dollar and tightening U.S. monetary policy along with President-elect Trump’s threats of broad import tariffs.

Signs of improving economic activity along with the election of a U.S. president with an explicitly pro-growth policy agenda led to a sharp reversal in sector performance. Rising interest rates fueled a 14% rise in global banking shares along with 7% to 9% gains in insurance and investment banking firms. As measured by the CRB index, commodity prices rose over 13% led by copper and oil while prices of steel and iron ore jumped by 40% or more. This resulted in outperformance by the energy, materials and industrials sectors for the quarter. One of the worst bond market corrections in history resulted in losses for interest sensitive real estate, telecom and utility companies. Defensive industries also experienced declines with consumer staples and health care stocks down by an average of 9%. Pharmaceutical and retailers did particularly poorly for the quarter due to structural concerns about pricing, regulations, import policies and technology driven competition.

"A higher level of volatility is not unusual in the initial stage of a style reversal."

Style and factor performance experienced an important shift in leadership during the quarter. The prior regime was dominated by low volatility, defensive quality, high dividend and strong momentum characteristics. By the middle of last year, companies displaying these metrics had become historically expensive and widely held in popular passive, quantitative and hedge fund portfolios. Post-election there was a dramatic reversal with outperformance by high beta, low quality, poor momentum and cyclical value stocks. The change was dramatic with a 14 percentage point move (from 5.7% behind to 8.4% ahead) in favor of value relative to growth on a trailing one-year basis between the third and fourth quarter. While this represented a four standard deviation event, a higher level of volatility is not unusual in the initial stage of a style reversal.

Multi-factor approaches to small company international investing tended to lag last year due to value exposure in the first half and then the underperformance of quality, growth and momentum metrics after the U.S. presidential election. This volatility is typical of reversion periods where singular and extreme characteristics dominate. Stocks tend to experience this brief “beta” led rally where short covering and aggressive investor repositioning reward low quality and distressed value metrics. Specifically, this phase is dominated by low price-to-book stocks with unfavorable “value trap” factors such as weak balance sheets, poor underlying profitability, consistent underperformance and overall low quality. This is then followed by a much longer period where improving fundamentals such as superior earnings growth, rising returns on capital and increasing dividends become effective characteristics in addition to undervaluation.

In the context of our investment discipline we focus on a combination of factors that deliver the superior long-term returns of value while seeking to avoid unrewarded exposures to low quality, high volatility and poor cyclical timing. Our holdings clearly display the contrarian characteristics of depressed valuations, low expectations and prior underperformance. But as an active manager, we seek the exceedingly rare combination of undervaluation with significant long-term growth potential as expressed by the “gap” between implied and expected long-term earnings growth (Exhibit 1).

Exhibit 1: Portfolio Implied vs Expected Growth Rates 

Source: ClearBridge Research, Bloomberg Estimates, InterSec Research.

The abnormally outsized contribution of highly volatile Canadian commodity stocks, which accounted for over half of the total return for the year in the MSCI ACWI ex U.S. Small Cap Index, clearly illustrated this dynamic. Our research and experience shows that despite short bursts of outperformance, fundamental quality factors are particularly critical to long-term success in small company investing. As we passed the 10^th anniversary of our International Small Cap strategy in 2016, the merits of our stock-based factor combination process are evidenced by a strong alpha ranking and best in class risk metrics.

Unlike in the U.S. where improving sentiment towards the domestic economy drove smaller capitalization stocks sharply higher, international local demand expectations remained depressed. As the effect of the U.S. election “beta” bounce fades and global economic sentiment improves, fundamentally strong small companies are poised to deliver strong gains. We continue to focus our attention on regions and markets with improving demographic trends such as China which is positioned to benefit from the rising incomes of over 500 million affluent and aspirational millennial consumers. This future demand should help ease the pain of structural reforms the country is now enduring with strong growth in the domestic consumer economy and higher value-added manufactured goods. We continue to emphasize the “new” sectors in China that cater to this growing consumer cohort.

Japan could also see an uptick in consumer spending as consumers there are enjoying rising wages and 1% mortgage rates while a newly invigorated affinity for foreign tourists boosts demand at hotels and retailers. Valuations remain attractive and we expect to increase our holdings in Japan over the next few months. The weaker euro and likely loosening of fiscal policy by European governments should combine to produce better than expected domestic demand on the Continent, also beneficial to smaller companies targeting local demand. Europe remains our largest regional weighting.

Since the International Small Cap Strategy’s inception, our multifactor investment discipline has been focused on identifying and exploiting opportunities in companies with tremendous long-term growth potential not reflected in their stock prices. As contrarian managers, we consider buying companies with above-average growth characteristics at the low point in their implied profit cycle as our margin of safety. This anomaly of high expected growth/low implied returns has been the source of our long-term alpha generation and within small caps, we believe it is persistent and reproducible. We expect the closing of price-value gaps will continue to occur and drive portfolio performance as the global economy and equity markets work through the significant policy and sentiment shifts discussed above.

Portfolio Highlights

The ClearBridge International Small Cap Strategy underperformed its MSCI EAFE Small Cap Index benchmark during the fourth quarter. On an absolute basis, the Strategy had gains in one of the sectors in which it was invested for the fourth quarter (out of nine sectors total) - financials. The information technology (IT), industrials, and real estate sectors were the primary detractors from returns during the quarter.

In relative terms, stock selection decisions detracted from returns. On the other hand, sector allocation contributed to overall performance during the quarter. Stock selection in the industrials sector detracted the most from relative performance. The energy sector hurt relative returns driven by stock selection, while both stock selection and an overweight allocation in the IT sector also negatively impacted returns. Conversely, strong stock selection and an underweight allocation in real estate most helped relative performance during the period. An underweight position in the health care sector also boosted relative returns.

"We continue to focus our attention on regions and markets with improving demographic trends."

On a regional basis, stock selection and an underweight allocation in Japan were the primary detractors from relative performance over the period. In Japan, relative underperformance was driven by our holding in DeNA Co., Ltd. Stock selection caused the North America region to underperform on a relative basis. On the positive side, stock selection in Europe Ex UK contributed the most to relative performance. Within the region, the strongest contributor was Sweden. Additionally, stock selection and an underweight allocation in Asia Ex Japan also contributed to relative performance over the period. Hong Kong helped relative gains in the region, which was largely driven by our position in ASM Pacific Technology.

On an individual stock basis, DeNA, Ambarella, OUTSOURCING, Amec Foster Wheeler, and S B S Holdings were the greatest detractors from absolute returns during the fourth quarter. Outokumpu Oyj, ASM Pacific Technology, Wessanen, SThree and San-in Godo Bank were the largest contributors to absolute performance.

During the fourth quarter, the Strategy initiated a number of new positions, including Ebara Corp., Elis SA and Vesuvius PLC in the industrials sector, Jimmy Choo in the consumer discretionary sector and UBE Industries in the materials sector. We also closed several positions, including Sulzer AG in the industrials sector, Nexity and CIFI Holdings in the real estate sector, Pason Systems in the energy sector and e2v technologies in the IT sector.