- It was a quarter of cross currents, with the Russell 2000 Value Index surging after talk of tax reform heated up again in DC, while the growth index rose on biotechnology.
- Equity market expectations are much higher than they were a few years ago, which may be justified, but depend on some hard-to-predict major policy driver.
- We apply our process broadly across the market, looking to diversify our portfolio with attractively valued companies.
Market Overview and Outlook
The Russell 2000 rose once again in the third quarter of 2017, gaining 5.67% and marking its sixth straight quarter of gains. It was a quarter of cross currents, with the Russell 2000 Value Index surging after talk of tax reform heated up again in Washington, while the growth index rose more on the back of the Russell 2000 Biotechnology Index soaring 16%. That index is now up 33% since the end of May 2017, more than four times greater than the overall index and a headwind for active managers. Unsurprisingly, Morningstar’s small cap core (SCC) category underperformed by 144 basis points from May to September.
Our portfolio did even worse, unfortunately. We had managed to buck the trend and outperform our benchmark for a number of years, while other SCC active managers in general were underperforming, but we regressed meaningfully in the third quarter, trailing the benchmark by 275 basis points (bps) and the SCC category by more than 240 bps. Disappointingly, that’s the worst relative performance to the benchmark in the Strategy’s history, dating back to 2009. Much of the divergence came in the final six weeks of the quarter, as the portfolio lagged even the Russell 2000 Value Index by more than 250 bps from the intra-quarter bottom on August 18. Health care was the major issue, costing us about 200 bps, both because the sector did well (we were underweight) and several of our holdings did poorly, but this was also just one of those quarters where several of our holdings had idiosyncratic problems that each stripped 30-40 bps off of our performance. We’ll highlight some of the specific issues later in the letter, but suffice it to say for now that we believe the level of underperformance in this quarter will prove to be unusually high.
Broadly, however, we are concerned about the current state of the market. There are no major issues that we can point to in the general economy: GDP growth is fine, employment good, sentiment indicators mostly positive, interest rates still low, lots of capital available for investment, etc. But we view the world through the lens of market expectations, not simply economic outlook. Through this lens, it appears most U.S. markets are discounting very favorable outcomes. Here are some illustrations of this point:
High-yield spreads, at 312 bps, are near multi-decade lows, implying a low cost of high-risk debt (Exhibit 1). Meanwhile, volatility is unusually low: the Chicago Board Options Exchange Volatility Index (a.k.a. the VIX Index, a.k.a. the Fear Index) is at its lowest point since it was introduced (Exhibit 2).
Exhibit 1: High-Yield Spreads Near Multi-Decade Lows
Exhibit 2: The Volatility Index At Lowest Point Ever
As of Sept. 30, 2017. Source: Bloomberg. The Chicago Board Options Exchange Volatility Index reflects a market estimate of future volatility, based on the weighted average of the implied volatilities for a wide range of strikes. First- and second-month expirations are used until eight days from expiration, then the second and third are used.
It is also notable that the forward 12-Month P/E (including only positive earnings) of the Russell 2000 Index is higher than at any time except after the Internet bubble, when profits were expected to rebound faster than they did (Exhibit 3).
Exhibit 3: Russell 2000 Index Forward 12-Month P/E (Including Only Positive Earnings)
This level of accounting-factor valuation would be concerning by itself, but it is magnified by two other factors: 1) The percentage of loss-making companies is higher now than usual in the Russell 2000, so that subtracting those losses would mean an even higher P/E; and 2) the spread between the forward 12-month multiple and the trailing 12-month multiple (including positive earnings only) is wider than all but recessionary periods in the last two decades, indicating that the future earnings growth expectation is higher now than most periods (Exhibit 4).
Exhibit 4: Forward vs. Trailing 12-Month Multiple Spread (Including Positive Earnings Only)
As of Sept. 30, 2017. Source: Bloomberg.
This expectation for above-average future earnings growth may be based on hopes for a major tax cut (that falls directly to earnings, rather than being competed away) or some other structural value driver. That may be true, but we question whether the likelihood of value-creating growth in the market is much higher now, with the economy having expanded for nine years and employment close to full, than it was, say, in 2011-2014, when the recovery was much less advanced.
"We question whether the likelihood of value-creating growth in the market is much higher now, with the economy having expanded for nine years."
We are not attempting to make a market call or economic forecast but merely sharing the conditions we observe. Expectations are much higher than they were a few years ago. They may be justified, but, on a market-wide basis, they seem to depend on some major policy driver (be it a sloping yield curve, tax breaks, or something else) that we find much harder to predict than the conditions we needed to assume in 2011-2014 to conclude that stocks were undervalued. In general, it’s much harder for us to find mispriced companies now than it was last quarter, last year or any other time since the Strategy’s inception in 2009.
Nevertheless, we continue to look. We apply our process broadly across the market, looking to diversify our portfolio with attractively valued companies. We are finding them and continue to build a portfolio that we believe can outperform in both up and down markets. We appreciate your support.
The ClearBridge Small Cap Strategy underperformed the Russell 2000 Index, the Strategy’s benchmark, during the quarter.
On an absolute basis, the Strategy had gains in eight of the sectors in which it was invested for the third quarter (out of 11 sectors total). The primary contributors to the Strategy’s performance were the industrials, consumer discretionary, and information technology (IT) sectors. The main detractors from returns during the quarter were the health care and energy sectors.
On a relative basis, the Strategy underperformed its benchmark impacted primarily by stock selection and sector allocation. Stock selection in the health care sector detracted the most from relative returns. Stock selection in the financials sector also hurt relative returns. On the positive side, stock selection in the consumer discretionary sector contributed most to relative results.
On an individual stock basis, Sanchez Energy, PRA Group, Quotient, Sprouts Farmers Markets, and Lexicon Pharmaceuticals were the greatest detractors from absolute returns in the third quarter. Monro, HEICO, 2U, Gray Television, and Rush Enterprises were the largest contributors to absolute performance.
During the quarter we initiated positions in BlackLine, Cogent Communications, Cotiviti, Cubic, Encore Capital Group, MRC Global, EnPro, Textainer Group, Team, Tower Semiconductor, Tivity Health and Venator Materials. We closed positions in Popular, CIRCOR International, Matson, Medpace, Potlatch, PRA Group, Sanchez Energy, United Natural Foods and WebMD Health.