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Commentary

Small Cap Strategy

Fourth Quarter 2017

Key Takeaways
  • As we review the Strategy’s performance and reflect on the difficult year, we believe it is important to distinguish between process and outcome.
  • We remain as confident as ever that our process is sound and will yield better results in time, just as it has over the previous few years.
  • We are still finding unique investment opportunities where expectations embedded in the price of the stock are lower than the value of the corporation under a wide range of scenarios.
Market Overview and Outlook

The Russell 2000 Index added to its gains in the fourth quarter, advancing 3.34% and bringing the total for 2017 to 14.65%. Unfortunately, the Small Cap Strategy failed to keep pace and trailed the benchmark in the quarter by 76 basis points and 160 basis points for the year. Our goal is to construct a resilient portfolio that can outperform the benchmark over the long term in a wide range of market conditions. We fell short of this mark in 2017 in large part due to poor stock selection, especially within the health care sector, where the portfolio did well in 2016. As we review the Strategy’s performance and reflect on the difficult year, we believe it is important to distinguish between process and outcome. We fundamentally believe a sound investment process is the key to delivering on our long-term objective. Outcomes in the form of stock returns do not always follow in lock step, especially over short periods of time. The year certainly was not the outcome we wanted for investors, but we remain as confident as ever that our process is sound and will yield better results in time, just as it has over the previous few years.

Our investment approach is rooted in the belief that investing is a probabilistic endeavor. In assessing investment opportunities, we consider the intrinsic value of a corporation in a wide range of scenarios. The current stock price reflects one scenario, namely the embedded market expectations for future results. However, there are many scenarios that can unfold and result in markedly different outcomes, both above and below the current stock price. We seek to frame this range of outcomes and estimate the probabilities of seeing each come to fruition. This assessment is critical in understanding the risk profile of the opportunity, and we invest only when the probability-weighted expected value is greater than the current stock price with a sufficient margin of safety, which is informed by the magnitude and frequency of upsides and downsides. Critically, this does not mean that we believe there is a positive expected return in all individual scenarios. Our process readily acknowledges that all investments can produce bad outcomes. The question we must ask of our analysis is whether we appropriately considered the full range of outcomes a priori.

Our investment in Matson (MATX) is an interesting example of what we believe was a sound process that ended with a bad outcome for investors. Matson is a shipping company with routes serving Hawaii, Asia and Alaska. We invested in the company in the third quarter of 2015 after concluding that Matson would grow faster and have higher margins than embedded expectations in most scenarios. One scenario that was problematic for Matson and our investment was if a new competitor entered Matson’s routes in its most important market — Hawaii. We considered this an unlikely proposition for several reasons, but we knew it was a possibility, and that if it happened, it would be detrimental to Matson’s estimated intrinsic business value. Sure enough, in the third quarter of 2017 a new entrant emerged for the Hawaii market and the stock — and our assessment of business value — took a hit. We had considered the value of Matson in this scenario, but considered it a relatively low probability at the time of investment, because it would be very difficult for a new entrant to earn an acceptable return on a substantial capital investment. When the new entrant became a reality, we had to reconsider the position. We believe the stock overshot to the downside initially, so we held the position a bit longer before exiting after a modest rebound. This was not a positive outcome for the Strategy, but after review, we believe the process was sound, and it’s the type of investment we would make again. We can’t control the outcome, but we can control our process and its implementation. We continue to believe this will give us the best results over time.

 

"We remain encouraged by broad economic strength throughout the world."

 

Turning the page to 2018, we remain encouraged by broad economic strength throughout the world. Operating conditions for most industries are positive, encouraging investments in innovation as well as capital expenditures. The counterbalance is that expectations have also risen, as noted by the relatively high accounting factor multiples and all major stock indexes at or near-record-high levels. We are still finding unique investment opportunities where expectations embedded in the price of the stock are lower than the value of the corporation under a wide range of scenarios. We continue to remain vigilant, however, and try to understand the risks that we are taking in individual investments and the portfolio as a whole. We thank you for your support and we look forward to continuing to execute on our investment process to deliver a resilient portfolio that will generate excess returns, as we have over the long term.

Portfolio Highlights

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 seven of the sectors in which it was invested for the fourth quarter (out of 11 sectors total). The primary contributors to the Strategy’s performance were the industrials, consumer discretionary and financials sectors. The main detractors from returns during the quarter were the health care and real estate 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 materials sector also hurt relative returns. On the positive side, stock selection in the consumer staples, industrials and financials sectors contributed most to relative results.

On an individual stock basis, Triangle Capital, Veeco Instruments, Keryx Biopharmaceuticals, Realogy Holdings and Web.com were the greatest detractors from absolute returns in the fourth quarter. NMI Holdings, Sprouts Farmers Markets, Smart Sand, 2U and Murphy USA were the largest contributors to absolute performance.

During the quarter we initiated positions in Black Hills, Dynavax Technologies and ForeScout Technologies. We closed our position in Bankrate.

Albert Grosman

Portfolio Manager
26 Years experience
12 Years at ClearBridge

Brian Lund, CFA

Portfolio Manager
19 Years experience
15 Years at ClearBridge

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  • All opinions and data included in this commentary are as of December 31, 2017 and are subject to change. The opinions and views expressed herein are of the portfolio management team named above and may differ from other managers, or the firm as a whole, and are not intended to be a forecast of future events, a guarantee of future results or investment advice. This information should not be used as the sole basis to make any investment decision. The statistics have been obtained from sources believed to be reliable, but the accuracy and completeness of this information cannot be guaranteed. Neither ClearBridge nor its information providers are responsible for any damages or losses arising from any use of this information.

  • Past performance is no guarantee of future results.

  • Performance source: Internal. Benchmark source: Russell Investments. Frank Russell Company (“Russell”) is the source and owner of the trademarks, service marks and copyrights related to the Russell Indexes. Russell® is a trademark of Frank Russell Company. Neither Russell nor its licensors accept any liability for any errors or omissions in the Russell Indexes and/or Russell ratings or underlying data and no party may rely on any Russell Indexes and/or Russell ratings and/or underlying data contained in this communication. No further distribution of Russell Data is permitted without Russell’s express written consent. Russell does not promote, sponsor or endorse the content of this communication.