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Commentary

Select Strategy

Third Quarter 2018

Key Takeaways
  • Companies with disruptive business models in the consumer discretionary and information technology sectors drove performance for the quarter.
  • The differentiated, high-return businesses we target in the portfolio remain attractive to strategic acquirers. 
  • We took advantage of attractive valuations to add several companies in our evolving opportunities segment.
Market Overview and Outlook

Large cap growth stocks led the continued robust performance of U.S. equity markets in the third quarter, with the S&P 500 Index gaining 7.71%, the Russell 2000 Index adding 3.58% and the benchmark Russell 3000 Index advancing 7.12%. The Russell 3000 Growth Index rose 8.88%, besting its value counterpart by 349 basis points. 

The Select Strategy benefited during the quarter from its exposure to differentiated businesses at multiple stages of maturity. To participate wherever we see the greatest potential for capital appreciation, the Strategy invests across four segments: disruptors, compounders, evolving opportunities and alternatives. Our portfolio construction process is geared toward generating performance in each segment through company-specific drivers rather than macro factors. We favor stocks that deploy capital internally back into their businesses at very high rates of return. 

Sector allocation is a function of this process and leads us to areas of the market such as the consumer discretionary and information technology (IT) sectors that are home to many of the stocks we categorize as disruptors. These companies, which comprise about half of the portfolio, are disrupting existing markets with a next generation technology, like ServiceNow is employing for enterprise IT managers, or a new approach to serving customers such as Wix.com in providing digital tools for small business owners to build a rich web presence.  

Carvana is a good example of a disruptor seeing results from investing in their business. Carvana has re-imagined the used car marketplace by developing a platform for buying, reconditioning and efficiently distributing vehicles to where demand is highest. The company’s early investment in several markets and the development of a nimble logistics network is now being realized as it takes share from smaller regional players and local used car dealerships. 

Compounders are the second largest allocation in the portfolio, representing about a third of assets. These companies are consistent cash flow generators with leadership positions in the markets they serve.  Ross Stores is a compounder whose solid execution has enabled it to deliver some of the best same-store sales growth in the off-price retail segment.  Ross is more insulated from the risks of inflation than other retailers as consumers who shift their spending patterns due to higher prices will likely shop at discounters. 

We think regularly about how the different segments of the portfolio fit together and pay attention to segment exposures and position size to manage the risks inherent in targeting high-growth businesses. Over the course of the year, we have been taking profits in some of our strongest performers in the disruptor segment and redeploying into areas with more attractive valuations. During the third quarter, we added three new positions in the evolving opportunities segment: Expedia, PerkinElmer and Lowe’s. Evolving opportunities consist of companies we believe are temporarily mispriced but have an identified catalyst that should lead to improvement. 

 

"We seek to invest alongside astute, forward-looking management teams skilled at adapting to today's ever-changing economy."

 

Expedia, the leading online travel booking site in the U.S., is in the midst of a large capex cycle led by a new CEO that will transition its operations to the cloud and expand its presence in international markets. Operating in the cloud should lead to greater business efficiencies while maintaining a greater inventory of hotel rooms overseas should allow it to take share from its primary competitor, Booking.com. Expedia is also improving its HomeAway experience for owners, which should be one of the many benefits to come from its current investment program.

PerkinElmer provides scientific testing and diagnostics across the health care, industrial and food safety markets. The company is expanding into higher-growth businesses including non-invasive prenatal testing and immunodiagnostics that has led to a re-rating of the stock that we expect will continue.  

With individual company fundamentals driving results, we seek to invest alongside astute, forward-looking management teams skilled at adapting to the ever-changing dynamics within their business and industry. Lowe’s is a good example. We established a position in the home improvement retailer after it named Marvin Ellison its new CEO. Lowe’s has underperformed Home Depot on the cost side for some time and we believe Ellison, the former head of U.S. stores at Home Depot, can instill better spending discipline.  

The dynamic characteristics we look for in our portfolio companies also tend to be attractive to strategic acquirers looking for new sources of growth. Two companies were the target of acquisitions in the third quarter. XO Group, which runs TheKnot and related pregnancy and parenting websites, agreed to be taken private by a rival platform. Sirius XM Satellite Radio, meanwhile, announced its intention to purchase portfolio holding Pandora Media, which offers an online streaming service.

U.S. equities have delivered healthy returns over a bull market now in its ninth year. At this point in the cycle, we believe performance will come through stock selection rather than the simple market exposure offered by passive vehicles. The Select Strategy maintains a high active share approach that has produced a vastly different portfolio than those available through market or factor-tracking ETFs. Risk management is a key characteristic of our active approach and we believe our diversification across four segments of investments leaves the portfolio well positioned to weather the growing concerns in global markets around trade, inflation and rising interest rates. 

Portfolio Highlights

The ClearBridge Select Strategy outperformed its Russell 3000 Index benchmark for the third quarter. On an absolute basis, the Strategy had gains in six of the eight sectors in which it was invested during the quarter (out of 11 sectors total). The largest contributor to performance was the IT sector. 

In relative terms, the Strategy outperformed its benchmark due to sector allocation. An overweight allocation to the IT sector and stock selection in the consumer discretionary sector were the primary contributors to relative results. An underweight to the financials sector and a lack of exposure to the energy sector also helped. Conversely, stock selection in the health care and industrials sectors detracted from relative returns during the period. 

On an individual stock basis, the largest contributors to absolute returns during the third quarter included Fortinet, Carvana, Trex, Cardtronics and Ross Stores. The biggest detractors from absolute returns included positions in IPG Photonics, athenahealth, Zillow Group, Copart and Casa Systems.

The Strategy initiated three new positions in the third quarter: Expedia and Lowe’s in the consumer discretionary sector as well as PerkinElmer in the health care sector. We also closed a position in Financial Engines in the financials sector following its acquisition by a private equity firm. 

Aram Green

Portfolio Manager
18 Years experience
13 Years at ClearBridge

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  • All opinions and data included in this commentary are as of September 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.

  • 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.