- Consumer discretionary and technology names drove performance during the quarter.
- Several acquisitions of portfolio companies illustrate the attractive characteristics sought by larger companies in search of new growth sources.
- In the midst of an extended period of above-average returns, small growth valuations remain in normal ranges relative to small value. We believe the cash generation of our holdings leaves the portfolio well positioned for the future.
Market Overview and Outlook
Small cap stocks participated in another period of solid performance for U.S. equity markets in the third quarter. The Russell 2000 Index gained 3.58% while the S&P 500 Index advanced 7.71% and the Russell Midcap Index added 5.00%. The benchmark Russell 2000 Growth Index gained 5.52%, outperforming the Russell 2000 Value Index by 392 basis points.
A strengthening U.S. economy provided ample support for the robust earnings growth small growth companies continue to produce. Second-quarter GDP grew at a 4.2% pace, the fastest rate since 2014, while unemployment remained at historically low 3.9%. Industrial activity remains solidly in expansion territory while the University of Michigan Index of Consumer Sentiment topped 100 in September for only the third time since 2004.
Such confidence helped consumer spending jump in the second quarter, providing a much-needed lift to smaller companies in the consumer discretionary sector. Fox Factory, a maker of specialty components for mountain bikes as well as off-road vehicles used by both commercial and leisure customers, was the leading performer in the portfolio as it continues to grow sales well above the market. Monro, which runs auto repair shops in the Northeast and parts of the Midwest, was another strong performer that benefited from an aging auto cycle and upgrades to its retail locations.
Information technology (IT), which comprises the Strategy’s largest exposure and overweight compared to the benchmark, continued to be a performance driver. Security software provider Fortinet, food delivery platform GrubHub and optimization software maker Aspen Technology were once again among the best performers for the quarter as both companies and consumers embrace digital tools. IT stocks have done so well recently – the sector is up 26.1% year-to-date in the benchmark – that we have been reducing our sector exposure to stay within our risk guidelines.
"A strengthening U.S. economy provided ample support for the robust earnings growth small growth companies continue to produce."
An abundance of quality smaller companies combined with a healthy initial public offering market of appealing new businesses has enabled us to restock the portfolio with new positions outside of IT. During the quarter, we participated in the IPO for Bloom Energy, a maker of fuel cells powered by natural gas that provide a cost-effective, off-the-grid energy source, especially in states with high electricity prices. The company has rolled out its fuel cells in about half of the U.S. and should increase coverage as the production cost curve continues to decline.
Quality small growth companies remain an attractive target for larger companies starved for growth. During the quarter, chipmaker Integrated Device Technology agreed to be acquired by a larger Japanese semiconductor company seeking exposure to the high growth verticals Integrated serves. Meanwhile XO Group, which runs wedding, pregnancy and parenting websites, agreed to be taken private by a rival platform.
Investors have asked repeatedly over the past year whether small cap growth stocks can sustain their momentum. While small growth valuations are not much higher than historical averages compared to small value, we are mindful of the recent outperformance of select small growth stocks. We have been closely monitoring the risk profile of the portfolio through individual stock selection and position size management and have made many changes to constantly recalibrate the portfolio’s potential risk/reward. This is a continual process and one we exercise with care to ensure we own companies with the resilience to perform regardless of the direction of market momentum.
We caution investors not to confuse the very strong fundamentals we insist on in our underlying investments with the performance of the asset class. Over the long term, we have observed that the value of an investment correlates well with the cash generation and returns delivered by that business. We believe the portfolio comprises a collection of great growth businesses with large opportunities, which gives us confidence going forward.
The ClearBridge Small Cap Growth Strategy outperformed its Russell 2000 Growth Index benchmark during the third quarter. On an absolute basis, the Strategy had gains in seven of the 10 sectors in which it was invested during the quarter (out of 11 sectors total). The largest contributors to performance were the IT and consumer discretionary sectors.
In relative terms, the Strategy’s outperformance was driven primarily by stock selection. Strong stock selection in the consumer discretionary, IT and industrials sectors as well as an overweight to IT contributed the most to relative performance. Stock selection in the newly created communication services sector, which expands the telecommunication services sector to include select companies from the consumer discretionary and IT sectors, as well as financials were detractors from relative results.
On an individual stock basis, the biggest contributors to absolute returns during the third quarter included Fox Factory Holdings, Fortinet, Trex, Integrated Device Technology and Grubhub. The biggest detractors from absolute returns included positions in athenahealth, Medidata Solutions, Copart, Acorda Therapeutics and Masonite International.
During the third quarter, the Strategy added positions in Bloom Energy in the industrials sector and Genomic Health in the health care sector and closed a position in Financial Engines in the financials sector.