Commentary

Key Takeaways

• The perception and anticipation of macro factors and events have an impact on what is discounted in stock prices, and we look to capitalize in situations when expectations of a certain outcome are too low or too high.
• We continue to find undervalued investment opportunities; however, we would describe them as more idiosyncratic or limited in scope.
• Entering an uncertain 2017, we will continue to focus on what we can control: the diligent application of our process to identify undervalued investments and measure the risks we take in the overall portfolio.

Market Review & Outlook

Performance across the Russell 2000 Index was far from uniform in 2016, and it certainly was far from what pundits were predicting at the outset of the year, or as events unfolded. 2016 can be divided into two distinct periods: From January 1 to February 11, the Russell 2000 declined 15.9%; but from February 12 until the end of the year, it rose 44.3%, with a 13.9% return following the presidential election. The Small Cap Strategy outperformed the index in both of those periods, by roughly 150 basis points and 540 basis points, respectively. We were able to navigate a turbulent 2016 because we remained consistent in our approach since the inception of this strategy - use an economically sound process to identify undervalued companies across all industries and characteristics, while carefully understanding the risks we take.

We did not make radical changes to the portfolio during 2016 that would help explain our performance. In fact our portfolio turnover for the year was relatively low at 41%. What did help us in 2016 was the continued application of our process broadly and consistently regardless of the direction of the market or other macro factors. The perception and anticipation of macro factors and events do have an impact on what is discounted in stock prices, and we look to capitalize in situations when expectations of a certain outcome are too low or too high. During 2015 and into the first few months of 2016, we identified several investments as likely undervalued, based on fears that certain macro exposures would be very detrimental. Several of these investments can be described as being in historically cyclical companies, though they span a wide range of industries and with distinct underlying economic drivers.

"What helped us in 2016 was the continued application of our process broadly and consistently regardless of the direction of the market and/or other macro factors."

After a strong period for small cap stocks, we continue to find undervalued investment opportunities; however, we would describe them as more idiosyncratic or limited in scope. For example, in 2015 disruptions in the energy complex produced opportunities across multiple industries with both direct and indirect energy exposure. We do not see a comparatively broad opportunity set today. Nevertheless, we are finding candidates in narrower areas of disruption such as food deflation. While the historic pricing pressure on food is wreaking havoc among grocers and suppliers, the investment opportunity set it is creating is more limited than what occurred with energy in 2015. The degree of undervaluation has also declined in general. Over the last few quarters we have described the likelihood of a modest increase in the number of our positions as valuation gaps narrowed, but to date we have remained at about 80 holdings. Still, the portfolio remains diverse, which is a very important contributor for us reaching our goal of delivering a portfolio that can outperform over the long run in a variety of markets.

Sprouts Farmers Market (SFM) is an example of the type of investment opportunities we are finding today. The company operates a chain of retail grocery stores and has come under pressure from the aforementioned deflationary environment for food. However, we believe price deflation hysteria has masked a strong retail concept with compelling economics and significant long-term growth potential. We recently invested in Sprouts based on our conclusion that the value of the free cash flow generated by existing stores, along with the value created by deploying incremental capital into new stores, exceeds the current valuation. Food deflation, like any other cyclical phenomenon, will eventually reverse, although that is not a necessary condition for our investment in Sprouts to be profitable over the long run.

We do not know what 2017 will bring, but we will continue to focus on what we can control: the diligent application of our process to identify undervalued investments and measure the risks we take in the overall portfolio.

Portfolio Highlights

The ClearBridge Small Cap Strategy had a positive absolute return for the fourth quarter, outperforming the benchmark Russell 2000 Index. Relative portfolio outperformance was driven by security selection effects, while sector allocation effects were neutral and the interaction of sector allocation and security selection detracted from relative returns. In particular, stock selection in information technology and producer durables contributed to relative returns during the fourth quarter. Meanwhile, stock selection in the consumer discretionary sector hurt relative performance.

In terms of individual securities, LegacyTexas Financial Group, First Interstate BancSystem, GATX, Veeco Instruments and Washington Federal were the largest contributors to performance, while the biggest detractors included OneMain Holdings, Endologix, Quotient, 2U and Murphy USA.

Over the course of the quarter, we initiated six new positions: Extraction Oil & Gas, NMI Holdings, Radius Health, Smart Sand, Web.com Group and WNS. We also exited eight positions: Applied Micro Circuits, Brookdale Senior Living, DHI Group, Dynegy, Endologix, Fogo de Chao, Frank’s International and Portland General Electric.