Investor Type
×

Tell us once and we'll remember.

I'm an...

Don't worry, you can always change this selection using the icons at the top left of the site.
Institutional Investor Advisor Individual Investor

Commentary

Small Cap Growth Strategy

Fourth Quarter 2018

Key Takeaways
  • A host of negative considerations largely overlooked earlier in the year caught up with stocks in the fourth quarter with smaller companies bearing the brunt of a sharp decline.
  • Health care and information technology companies drove portfolio performance during the quarter.
  • We have yet to hear of a material slowdown in economic velocity from our portfolio companies and opportunities remain abundant among small growth stocks.

A legendary investment strategist once famously opined “the market usually does whatever makes the most people most uncomfortable.” And that has certainly been the case this fourth quarter as U.S. stocks finished the year with a resounding thud, erasing all gains from earlier in the year. With bond indices also flat to down this year, we’ve had a year of “profitless prosperity” in financial markets.

Equity markets rallied for the first three quarters of 2018, riding a wave of favorable economic and corporate earnings reports, boosted in part by the tax cut stimulus. A host of negative considerations largely overlooked earlier in the year (tariff conflicts, cost pressures, ascending short-term interest rates, valuation, Washington dysfunction, political issues ex-U.S.) caught up with stocks this quarter and a sharp decline ensued. 

Small cap stocks, which had been the favored “risk on” trade of investors earlier in the year, bore the brunt of selling during the quarter. The Russell 2000 Index declined 20.20% while small cap growth stocks in the benchmark Russell 2000 Growth Index declined 21.65%. By comparison larger cap stocks (Russell 1000 Index) declined a more modest but still substantial 13.82%. For the full year, small cap growth stocks declined 9.31%; we are gratified that the Strategy delivered a modest yet still positive return of approximately 5.3% gross of fees. 

The euphoria of earlier this year has vanished, supplanted by investor pessimism about decelerating economic growth. Interest rates are higher (modestly) and for the first time in a long while, cash equivalents provide a nominal return worth considering. Equities have experienced a sharp downward price adjustment, with valuations appearing quite attractive in aggregate for growth businesses. Yet we would caution those valuations are framed by the unknowable, whether trade frictions and slowdowns in major economies are the pause that refreshes or the glissade into 2019 recession.

We have yet to hear of a material slowdown in economic velocity from our companies. Opportunities remain abundant. While there have been some dislocations to a variety of items (such as labor constraints, hurricane disruptions) we believe the investments in the portfolio will continue to demonstrate above-industry growth dynamics. Strategic and private equity investors agree, as the portfolio benefited from eight announced or closed takeovers during 2018. 

 

"Our investments generally have the financial resources to invest through a more guarded macro and capital markets environment."

 

During 2018, we made 14 new investments. The positions are in some cases modest and we are planning to increase them over time assuming continued good execution of the business case. As always, we look for i) businesses with growing and large opportunities, ii) self-financing capital structures and iii) managements with well-defined strategies to expand the business and benefit
shareholders.

Several new additions during the fourth quarter exemplify the characteristics we target in portfolio companies. Albany International, in the industrials sector, is a materials processing firm that specializes in fabric for paper packaging machinery. The company is expanding into the
development of carbon components for jet engines, a market with built-in demand from heavy order backlogs at Boeing and Airbus. The newer aerospace division should provide earnings leverage and make the overall business less cyclical.

Calavo Growers, in the consumer staples sector, is a distributor of avocados, avocado products and other fresh produce. Calavo makes prepared guacamole for a number of large retailers, providing a stable demand stream, and is investing in the processing and packaging of fresh cut fruits and vegetables for grocery chains. The company is a strong grower that should benefit from dietary trends toward fresh food.

Heron Therapeutics, in the health care sector, is a pharmaceutical maker with an existing anti-nausea treatment for patients going through chemotherapy. We are excited about the prospects for a next-generation non-opioid painkiller in Heron’s pipeline that is expected to receive FDA approval around the middle of 2019.

Outlook

As a reminder, the portfolio does not hold “the market.” Our practice is to invest with a concentrated number of progressive managements, developing and commercializing innovative products and services. Our investments generally have the financial resources to invest through a more guarded macro and capital markets environment. We structure the portfolio with resilient businesses which, over time, can result in substantially higher firm values.

The past quarter delivered dispiriting losses in financial assets. For the first time since the first quarter of 2016 the Strategy experienced a quarterly loss, about which we are displeased. Over the decade ended in December, during which there have been many periods of angst and uncertainty, the Strategy has delivered compound annual returns of 16.8% gross of fees.

No one can know for sure when markets have reached bottom and prices have “cleared.” We do know that our companies are energized by the large opportunities in front of them notwithstanding recent stock price declines. We believe singular attention to innovative growth companies and risk aware portfolio construction is the best method to capitalize on those opportunities.

Portfolio Highlights

The ClearBridge Small Cap Growth Strategy outperformed its Russell 2000 Growth Index benchmark during the fourth quarter. On an absolute basis, the Strategy experienced losses across all 10 sectors in which it was invested during the quarter (out of 11 sectors total). The largest detractors from performance were the industrials, information technology (IT) and health care sectors.

In relative terms, the Strategy’s outperformance was driven primarily by sector allocation. An overweight to the IT sector, an underweight to the energy sector and strong stock selection in the health care and IT sectors contributed the most to relative performance. Stock selection in the industrials, financials, consumer discretionary and communication services sectors and an underweight to the real estate sector were detractors from relative results.

On an individual stock basis, the biggest contributors to absolute returns during the fourth quarter included MindBody, Imperva, Vocera Communications, SendGrid and Chegg. The biggest detractors from absolute returns included positions in XPO Logistics, Grubhub, Integra LifeSciences, Trex and H&E Equipment Services.

During the fourth quarter, in addition to the purchases mentioned above, the Strategy closed a position in XO Group in the communication services sector.

Aram Green

Portfolio Manager
18 Years experience
13 Years at ClearBridge

Jeffrey Russell, CFA

Portfolio Manager
38 Years experience
29 Years at ClearBridge

Related Perspectives

  • Growth Opportunities in Digital Transformation
    PM Aram Green and Analyst Hilary Frisch discuss how software is transforming the way businesses compete.
  • Small Cap Growth Strategy
    3Q19 Commentary: Strength in the health care and industrials sectors, as well as favorable M&A activity, supported relative performance.
  • Small Cap Growth Strategy Update
    2Q19 Update: PM Jeff Russell highlights the drivers of portfolio performance and how the team took advantage of a healthy IPO market.
  • Small Cap Growth Strategy
    2Q19 Commentary: We were active buyers through a volatile quarter that saw small growth stocks close slightly higher.
  • Small Cap Growth Strategy
    1Q19 Commentary: Smaller growth companies led a sharp equity rebound supported by the Fed’s easier stance on interest rates.

Related Blog Posts

  • 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. 

  • 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.