- Our portfolio showed resilience in a down quarter for the market, thanks primarily to stock selection in consumer staples and utilities.
- At the start of 2019, small cap U.S. equities look more attractive than they have in several years, especially relative to private capital and large cap U.S. stocks.
- We are finding more unique investment opportunities where expectations embedded in the price of the stock are lower than the value of the corporation under a wide range of scenarios.
Market Overview and Outlook
The fourth quarter of 2018 was a wild ride for everyone involved in the U.S. stock market. The small cap Russell 2000 Index dropped throughout the quarter, ending down more than 20% and erasing all gains for the year, while the large cap Russell 1000 Index fell about 14%. Our portfolio did slightly better than our benchmark, the Russell 2000 Index, thanks primarily to stock selection in consumer staples and utilities, offset by underperformance in financials and information technology (IT), where the portfolio was overweight. The good news is that stock valuations are much more attractive now, especially among small caps.
The dramatic fourth-quarter drop in small caps changed the complexion of the market significantly. For much of the last two years, we have said that market expectations were becoming elevated generally, so that it was becoming harder to find new ideas for the portfolio. The economy has remained positive, and the 2017 tax bill certainly increased economic profits in the short run (it remains to be seen if those excess profits are competed away over time, as standard financial theory would suggest), but higher valuation multiples require long-term value creation to be justified, not just a good year or two. The fourth quarter’s 20% drop was a stern reminder of this principle, when little changed fundamentally in the economy, but expectations for the future quickly soured.
The good news is that the drop washed away quite a bit of the excess. The general estimated 12-month price-to-earnings ratio for the Russell 2000 Index is now lower than it’s been since 2013, after soaring to a post-crisis high in 2017. In addition, as small caps have underperformed large caps in four of the last five years, and by 380 basis points annually, the difference between the forward earnings multiple of the Russell 2000 and Russell 1000 is also smaller than it has been since 2013 (Exhibit 1).
Exhibit 1: Estimated P/E Ratio (NTM)
Furthermore, the earnings multiples for companies with positive earnings (i.e., excluding negative last 12-month (LTM) earnings) is very close to a post-crisis low for the Russell 2000. It is also now below the positive earnings multiple for the Russell 1000, which has been a very rare occurrence in the last 10 years. This is true not just on forward earnings, but also on trailing earnings, so it is not just the result of bullish analyst estimates.
Exhibit 2: Actual Trailing 12-Month Price/Positive Earnings Ratio
We have also noted there is an increasing percentage of stocks in the small cap market that are unprofitable, and that continues to be the case. About 38% of the index had negative LTM earnings, as of the end of 2018. This number has been rising, as the number of IPOs of companies with negative earnings has been rising. According to Kailash Capital, the percentage of IPOs for companies losing money completed in 2018 hit 83%, an all-time high.
Exhibit 3: Percentage of IPOs with Negative Earnings
At the start of 2019, small cap U.S. equities look more attractive than they have in several years, especially relative to private capital and large cap U.S. stocks. We are finding more unique investment opportunities where expectations embedded in the price of the stock are lower than the value of the corporation under a wide range of scenarios. For example, we initiated a position in SkyWest, a regional airline operator that we have followed for several years. The stock sank in the fourth quarter, along with many other airlines, on economic worries, but SkyWest’s model is very different from most others. About 90% of its flights are sourced from carrying regional legs for major airlines (e.g., Delta and United Airlines) on a pay-by-route basis, so that SkyWest takes no fuel or passenger-load risk. It has upgraded its fleet and improved its contracts in recent years to protect profitability. It will not be immune in a downturn, but it should have significantly lower decremental margins than its peers and better than expectations.
The ClearBridge Small Cap Strategy outperformed the Russell 2000 Index, the Strategy’s benchmark, during the quarter.
On an absolute basis, the Strategy had gains in one of the sectors in which it was invested for the quarter (out of 11 sectors total). The primary contributor to the Strategy’s performance was the utilities sector. The main detractors from returns during the quarter were the financials and health care sectors.
On a relative basis, the Strategy outperformed its benchmark impacted primarily by sector allocation. The Strategy’s cash position, an underweight to the energy sector and stock selection in the health care, consumer staples and consumer discretionary sectors contributed the most to relative returns. Meanwhile, stock selection in the financials, IT and energy sectors detracted the most from relative performance.
On an individual stock basis, EVERTEC, Black Hills, Inter Parfums, PNM Resources and Monro were the largest contributors to absolute performance. Cadence Bancorporation, HealthEquity, Extraction Oil & Gas, Venator Materials and Liberty Oilfield Services were the greatest detractors from absolute returns.
During the quarter we initiated positions in SkyWest, Lithia Motors, Bank OZK, Cooper-Standard and OUTFRONT Media. We closed positions in REV Group, Tivity Health, Allegiant Travel and Realogy.