- 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
Exhibit 2: Earnings Quality Trends
Exhibit 3: Market Reaction (Momentum) Trends
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
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.
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.