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Commentary

Small Cap Strategy

Second Quarter 2018

Key Takeaways
  • Small caps outperformed large caps in the second quarter, led by health care and information technology companies.
  • Over the last quarter, six months, and 12 months, the quintiles with the highest expectations, lowest quality, and strongest momentum have steadily outperformed.
  • Other periods of similarly high convertible debt issuance have preceded technology bubbles bursting.
Market Overview and Outlook

Small caps had a strong second quarter, led by contributions from the health care and information technology (IT) sectors. As the Russell 2000 hit new record levels and small caps outperformed large caps, assets continued to flow into exchange traded funds (ETFs) that mimic either the entire market, sectors or factors that have performed well. Over the last quarter, six months, and 12 months, the quintiles with the highest expectations, lowest quality and strongest momentum have steadily outperformed. Given our focus on companies with the highest likelihood to outperform expectations and to preserve capital, this is the exact description of the type of market condition in which we would expect the Small Cap Strategy to have the highest chance to underperform, and it trailed the benchmark in the second quarter. The measurement of relative performance will by nature be a combination of what we own and what we do not own, thus open to errors of omission as well as commission.

In Exhibits 1–3 below, we show the performance attribution of the Russell 2000 Index in terms of three quantitative factors: valuation, earnings quality and market reaction or momentum. The lowest-ranked quintile in valuation, earnings quality and market reaction (i.e., the least attractive in terms of valuation and earnings quality and the highest momentum) outperformed the highest-ranked quintile in the second quarter and the past six and 12 months. The Strategy’s investment process is designed to identify investment opportunities where the expectations discounted in the price of a stock differ from the value of a corporation under a wide range of scenarios. Over the history of the Strategy, our bottom-up approach has tended to produce a portfolio that is overweight the valuation and quality factors and underweight momentum.

 

Exhibit 1: Valuation Trends

As of June 30, 2018. Source: Empirical Research Partners. 1 = most attractive by valuation factor, 5 = least attractive by valuation factor.

 

 

Exhibit 2: Earnings Quality Trends

As of June 30, 2018. Source: Empirical Research Partners. 1 = most attractive by earnings quality factor, 5 = least attractive by earnings quality factor.

 

 

Exhibit 3: Market Reaction (Momentum) Trends

 

As of June 30, 2018. Source: Empirical Research Partners. 1 = most momentum, 5 = least momentum.

 

We are always observing developments in the broader context of economies, financial markets and actions of participants with the goal of understanding what may be discounted in current prices of specific securities. Recently, Dealogic reported that $13 billion of convertible debt has been issued by companies in the technology sector so far in 2018, bringing the one-year total to $24 billion. Since 1998 there have been only three instances when 12-month issuance of convertible debt has topped $25 billion: two were during the 1999–2001 tech bubble and the other was in 2007. We are not making any predictions or specific investment decisions based solely on this data, but we pause to observe that corporations seem eager to take advantage of the available capital with equity options attached.

 

Exhibit 4: Convertible Debt Issuance and Tech Bubbles

As of June 30, 2018. Source: Stifel. Tech sector returns represented by S&P Technology Select Sector Index.

 

But performance issues have not been all exogenous. During the second quarter, fundamental developments in specific holdings also generated losses for the Strategy. Our investment case in Clearwater Paper (a pulp and paper product manufacturer) was originally based on the potential returns to be earned by the company’s capital investment program. However, the capital investments ended up costing more and taking longer to complete than originally expected. In the meantime, the loss of a major customer (Kroger) appears to have left Clearwater as the marginal-cost supplier in an oversupplied industry. With no remaining variant perception about the company, we exited the position in the second quarter.

While we didn’t get the outcome we expected from Clearwater, we have found success with similar calls in other holdings, for example, in health savings account provider HealthEquity, one of the strongest contributors to performance. An important part of our process is to understand the potential value of future capital deployment and compare that to what is discounted in the current stock price. Part of our investment case for HealthEquity is the potential future value of its investments in innovative products and customer service, which should lead to growth in the number of accounts as well as account sizes. In the last reporting period some of the market’s concerns about industry growth were alleviated, and HealthEquity’s growth in accounts and assets greatly surpassed the industry’s. We continue to own HealthEquity as we believe the investments it is making will drive market growth, market share expansion and asset accumulation at rates greater than are reflected in the price of the stock.

 

"We continue to find opportunities in undervalued companies even in today’s environment."

 

Our goal remains to deliver a resilient portfolio, one that can outperform over the long term under a wide range of market conditions. However, performance is not linear and periods of narrow markets that reward the strongest momentum and lowest quality reduce the Strategy’s chances of outperforming. We are confident that over the long term investing in undervalued companies will prevail and we continue to find such opportunities even in today’s environment.

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 eight of the sectors in which it was invested for the second quarter (out of 11 sectors total). The primary contributors to the Strategy’s performance were the IT, health care and consumer discretionary sectors. The main detractor from returns during the quarter was the materials sector.

On a relative basis, the Strategy underperformed its benchmark impacted primarily by stock selection. Stock selection in the financials, materials and real estate sectors detracted the most from relative returns. The Strategy’s cash position also dampened relative results. On the positive side, stock selection in the IT, industrials and health care sectors contributed most to relative results.

On an individual stock basis, Prothena, Clearwater Paper, ProAssurance, Tower Semiconductor and Encore Capital were the greatest detractors from absolute returns in the second quarter. Web.com, Quotient, HealthEquity, Gray Television and Team were the largest contributors to absolute performance.

During the quarter we initiated several positions, most significantly Itron, Dycom Industries, U.S. Concrete, Essent and BJ’s Wholesale Club. Balchem, Clearwater Paper, Gentex, Cubic and ForeScout Technologies were notable positions closed in the quarter.

Albert Grosman

Portfolio Manager
25 Years experience
11 Years at ClearBridge

Brian Lund, CFA

Portfolio Manager
18 Years experience
14 Years at ClearBridge

Related Perspectives

  • PM Perspectives: Gauging Varying Perceptions Among Small Caps
    PM Brian Lund discusses the Small Cap Strategy's valuation process & today's market.
  • Small Cap Strategy
    4Q18 Commentary: Small cap U.S. equities look more attractive than they have in several years, especially relative to private capital and large cap U.S. stocks.
  • Small Cap Strategy
    3Q18 Commentary: A quarter of strong outperformance shows the value of a longer-term perspective.
  • Small Cap Strategy
    1Q18 Commentary: The recent volatility provides a welcome respite from this momentum market.
  • Small Cap Strategy
    4Q17 Commentary: There are still opportunities where probability-weighted expected value exceeds current stock price, with a margin of safety.

Related Blog Posts

  • All opinions and data included in this commentary are as of June 30, 2018, 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.

  • 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.

  • Past performance is no guarantee of future results.