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Commentary

Select Strategy

Fourth Quarter 2018

Key Takeaways
  • Smaller cap and more growth-oriented companies that are a primary focus in the portfolio suffered the widest losses in a volatile quarter.
  • Private equity investors continue to express interest in the disruptive businesses we own, resulting in several announcements or closures of acquisitions during the quarter.
  • We were active through the volatility, selling or trimming 10 positions and deploying the proceeds into other parts of the portfolio.
Market Overview and Outlook

Volatility rose sharply in the fourth quarter, sending U.S. equities to broad losses as investors fretted over risks related to slowing global growth, rising interest rates and peak corporate earnings. The S&P 500 Index suffered its second-worst December on record (-9.03%) to finish down 13.52% for the fourth quarter and register its first annual loss (‑4.38%) since the global financial crisis. The benchmark Russell 3000 Index fell 9.31% in December, 14.30% for the quarter and 5.24% for 2018.

Smaller companies underperformed larger ones as the Russell 2000 Index declined 11.88% during December to finish down 20.20% for the quarter. Growth stocks also trailed value stocks during the selling as the Russell 3000 Growth Index fell 16.33% for the quarter, underperforming its value counterpart by 409 basis points. Despite these headwinds, the Select Strategy held up better than the market during the December drawdown.

During spikes in volatility and credit spreads as we saw in the fourth quarter, it is not surprising for smaller companies and more growth-oriented areas of the market to underperform. We continue to find better long-term opportunities in these areas but acknowledge these stocks could be out of favor for a period of time as the market adjusts to new realities and risks.

Recent market action reflects a return to normalized valuations and earnings growth rates as monetary and fiscal stimulus measures are simultaneously removed from the economy. The Federal Reserve raised short-term interest rates for the fourth time in 2018 in December as it continued a path of tightening. Meanwhile, the boost to corporate earnings from late 2017 tax reform is starting to wear off as EPS growth is forecast to decelerate and companies face tougher quarterly comparisons.

The Strategy was hurt during the quarter from its exposure to higher-growth, higher-beta companies, several of which carry higher levels of leverage that were particularly punished by the market. Two holdings in the health care sector that took on additional debt to fund recent acquisitions were among the worst performers. Surgery Partners, which has conducted several small acquisitions to expand the number of surgery centers it operates, was also hurt by limited liquidity in its shares as high private equity ownership makes the stock difficult to trade during periods of high volume and volatility. Syneos Health, meanwhile, used leverage to fund an acquisition 18 months ago that has expanded its core clinical research business to include marketing services around new drug launches. We are confident that both companies can support the amount of debt on their balance sheets as their price recoveries to start 2019 suggest.

 

"During the quarter, the selling of equities was mostly indiscriminate, with particularly negative sentiment toward leveraged companies."

 

During the quarter, the selling of equities was mostly indiscriminate, with particularly negative sentiment toward leveraged companies and certain other areas of the market dictating price movements. As a high active share manager, we utilized the volatility to our advantage by selling or making meaningful trims to 10 positions out of a portfolio of just over 60 names. We directed the proceeds of those sales across the portfolio, adding to positions in companies we consider disruptors as well as steady compounders and companies going through a transition that we categorize as evolving opportunities.

About a third of our sells during the quarter resulted from takeout offers by private equity investors. These included information security provider Imperva, health care technology firm athenahealth (which has been controlled by activist investors seeking a strategic transaction) and XO Group in the online wedding vertical. Private equity investors are assuming a more prominent role in targeting small and mid cap companies with dynamic growth characteristics or whose value is not being realized by current management. Private equity firms are often nimbler than publicly-traded strategic acquirers in making bids and most recently have targeted software-as-a-service companies like portfolio holding MindBody, a platform for booking yoga and fitness classes that spiked nearly 70% after receiving an offer from Vista Equity Partners.

MindBody and the other recent takeouts fall in the category of companies we call disruptors that account for the largest portion of the portfolio. These are companies that are upending existing markets or creating new ones with a new approach to serving customers like MindBody or a next generation technology like the data visualization software developed by Tableau Software.

In addition to taking long equity positions across three categories of companies, we also have the ability to invest in alternative asset classes and investment strategies. During the quarter, we sold several stocks to cover short positions that had reached our downside target objectives.

Recent results highlight the importance of risk management in the portfolio construction process. Rather than move to cash when volatility rises, we start our risk process in the initial research and vetting of companies being considered for purchase. By thoroughly understanding the industry- and company-specific risks that could influence every position, we can build a portfolio of strong business models and diversified performance drivers mostly independent of macro factors. Information security software provider FireEye, for example, develops cutting edge technologies to ward off cyberattacks and protect enterprises at all their vulnerable endpoints. The risk of reputational damage and customer losses from security breaches has made spending on such security measures a must for company managements.

We seek to balance a company’s growth dynamics with valuation sensitivity. This is another form of portfolio risk management as it causes us to avoid areas of the market like energy, where we do not see the potential for long-term value creation. Not owning energy proved beneficial over the last year as the sector has faced the headwinds of declining oil prices and lower capex. We are also underweight companies in consumer staples and financials where we are not confident that companies can effectively differentiate themselves and sustain an enduring competitive advantage. Though the latter industry has experienced extreme multiple compression on fears of a credit cycle, if it does not materialize we would expect the group to rerate. Financials is an area we are currently spending more time investigating.

While the recent quarter proved difficult, we are encouraged that many of our portfolio companies that reached oversold levels have begun to rebound on what we believe are superior business models that continue to be backed by sound fundamentals.

Portfolio Highlights

The ClearBridge Select Strategy underperformed its Russell 3000 Index benchmark for the fourth quarter. On an absolute basis, the Strategy had losses across all nine of the sectors in which it was invested during the quarter (out of 11 sectors total). The largest detractor from performance was the IT sector.

In relative terms, overall stock selection and sector allocation detracted from performance. Specifically, stock selection in the health care, communication services, industrials and consumer staples sectors and an underweight to consumer staples were the primary detractors from relative results. On the positive side, stock selection in the IT sector and a lack of exposure to the energy sector contributed to performance.

On an individual stock basis, the biggest detractors from absolute returns included positions in Carvana, Surgery Partners, Fortinet, Apple and Yext. Imperva, Tableau Software, MindBody and athenahealth were the largest contributors to absolute returns during the fourth quarter.

The Strategy initiated two new positions in the fourth quarter: Summit Materials in the materials sector and nLight in the IT sector. We also closed several positions including athenahealth in the health care sector, XO Group in the communication services sector as well as Akamai Technologies, Imperva and IPG Photonics in the IT sector.

Aram Green

Portfolio Manager
18 Years experience
13 Years at ClearBridge

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  • Past performance is no guarantee of future results.

  • All opinions and data included in this commentary are as of December 31, 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.

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