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Commentary

International Small Cap Strategy

First Quarter 2019

Key Takeaways
  • The portfolio failed to fully participate in a momentum-driven rebound in international small caps due to our underweight to technology stocks.
  • Despite a muted recovery in emerging markets, including short-term headwinds in Brazil, we remain bullish on the outlook for the region.
  • The main areas of contrarian opportunity continue to include the UK and cyclical value stocks hampered by fears of a global slowdown.
Market Overview

After the dramatic fourth-quarter selloff, global markets rebounded strongly in the first quarter of 2019. Adding to the January effect, U.S. Federal Reserve Chairman Jerome Powell’s dovish turn re-ignited confidence in risk assets, driving global stocks to their best start in nearly a decade. Within this backdrop, the International Small Cap Strategy’s performance was mixed compared to the 10.65% gain for the benchmark MSCI EAFE Small Cap Index.

As discussed last quarter, the portfolio’s main overweights continue to be emerging markets and pro-cyclical sectors. We strongly believe that policy priorities around the world are now focused on generating growth and reflation of the real economy, as opposed to the prior decade’s focus on inflating asset prices. Perhaps the best example of this is China’s coordinated stimulus over the recent months, where tax cuts, bank reserve requirement ratio cuts and support for private enterprises are starting to manifest themselves throughout the economy. China Manufacturing PMI Index has snapped back since the start of the year, indicating stronger economic activity and improved labor market conditions. Value-added tax cuts are starting to flow through to lower consumer prices and stronger purchasing power. Combined with more progress on the U.S.-China trade and tariff negotiations, reflation polices have driven Chinese equities up 18% to start the year.

Despite their strong gains however, emerging markets as a whole did not bounce as much as their counterparts in Europe and the UK, mostly because they did not decline as dramatically in the prior quarter. This explains most of the portfolio’s regional underperformance trends. However, we do not assign much weighting to such short-term performance figures, as they are largely noise and unrelated to the underlying investment theses in our holdings.

Additionally, emerging markets were impacted by some late-quarter weakness in the Brazilian market. Optimism for the country’s newly elected reformist government was tempered after President Bolsonaro’s first 100 days proved chaotic. In particular, his hard line negotiating style and inability to secure a working majority in Congress now threaten his administration’s ability to make good on campaign promises of much needed pension reform and debt reduction. Faced with rapidly declining approval ratings, though, it appears that Bolsonaro has more recently shown willingness to soften his tactics and re-engage the opposition. Overall, we remain constructive on the recovery in Brazil if the country is able to implement this much-needed fiscal reform.

At the sector level, the first quarter was dominated by a return to growth and momentum factors, with information technology (IT) stocks leading the charge. As in prior years, IT continues to be a challenging sector for us, as valuations remain expensive, and unprofitable/unsustainable business models continue to flood the market. While our tech holdings generally performed well in the quarter, we remain underweight the sector as we do not see many ideas that warrant investment with a sufficient margin of safety.

Energy was another strong sector and contributed meaningfully to the portfolio’s performance. After the fourth quarter’s sharp drop, crude oil prices rebounded nearly 30%, led by Saudi production cuts, Iran/Venezuela sanctions and a weaker U.S. dollar. As investors feel increasingly comfortable that the global growth narrative remains on track, we believe demand for energy should remain strong through the summer months, and we remain meaningfully overweight the sector.

 

"Emerging markets remain attractively priced and are a leading beneficiary of dovish U.S. dollar policy and global reflation." 

 

In addition to the rally in energy, we also had winners in the communication services and consumer staples sectors where company-specific execution stories drove strong stock price appreciation. Entertainment One, whose content franchises include Peppa Pig, PJ Masks and the Mark Gordon family of television shows, continues to benefit from the scarcity of premium media assets. Nomad Foods, a leader in the Western European frozen food market, consistently drove market share and category growth in its key must-win markets. Thai Union, one of the world’s leading ambient seafood manufacturers, finally saw relief from high tuna prices. With lower input costs, and restructuring potential in its restaurant operations, we are optimistic on Thai Union’s continued profit recovery this year.

Conversely, consumer discretionary and materials were the biggest detractors for the quarter. One major theme impacting both sectors was the recent weakness in Brazil, which pressured holdings such as Arcos Dorados and Duratex. However, as previously discussed, we remain confident in the new administration’s efforts toward fiscal reform and believe that Brazil is a structurally attractive market where we intend to stay invested, particularly in companies leveraged to its large and improving consumer economy.

Another main detractor for the quarter was Just Group, a provider of retail and bulk annuity products in the UK. Recent regulatory changes necessitated a capital raise during the quarter, which impacted the stock but also lifted some uncertainty regarding its capital position. Longer term, consolidation and reduced competition have combined to create a stable pricing environment and opportunity for Just to take market share. Macro trends remain supportive as the UK property market and credit quality metrics have outperformed consensus expectations.

Outlook and Positioning

As the narrative of the Great Reversion continues to unfold, and policy and political agendas support recovery in the real economy, we see the long-suffering victims of the past long cycle as best positioned to benefit. Specifically, the main areas of contrarian opportunity continue to be emerging markets, the UK and cyclical value stocks hampered by fears of a global slowdown.

Emerging markets remain attractively priced and are among the leading beneficiaries of a dovish U.S. rate and dollar policy and global reflation. Major markets such as China and Brazil have tangible catalysts that should continue to drive economic recovery, and we also continue to explore names in Mexico and Southeast Asia where market expectations remain low.

Despite the gloom and doom surrounding Brexit, the UK was actually the best-performing region in the first quarter. This is a great example of the contrarian mindset we often discuss with respect to our process. For several quarters now, attractive valuations have led us to add continuously to our UK holdings, particularly sectors exposed to the domestic economy such as housing, staffing and banking. While the risks around Brexit remain, we believe they are well known, and companies have been preparing for separation for two years. Though near-term economic activity has been hampered by the uncertainty, once a decision is finally reached the UK will be able to move forward with new-found freedom to establish its own trade policies and business regulation.

Europe also continues to be an area of contrarian value where we have also added to the portfolio, particularly in cyclicals. Over the past year, eurozone stocks have been mired by weak domestic recovery and a large dependence on exports, particularly to emerging markets and China. As growth in its trading partners normalizes, Europe stands to be a derivative beneficiary. Additionally, from the policy angle the ECB remains committed to keeping monetary supply as accommodative as necessary, and low interest rates should be supportive of solid credit growth and improving labor market demand in the region. Upcoming European parliamentary elections in May could also set the stage for more expansionary policies to support growth.

Portfolio Highlights

The ClearBridge International Small Cap Strategy underperformed its MSCI EAFE Small Cap Index benchmark for the first quarter. On an absolute basis, the Strategy had gains in 10 of the 11 sectors in which it was invested. The primary contributor to performance was the industrials sector.

In relative terms, overall stock selection and sector allocation detracted from performance. Stock selection in the materials and industrials sectors, as well as an underweight to IT, hampered relative results. Conversely, stock selection in the consumer staples and energy sectors and an overweight to energy contributed to relative performance.

On a regional basis, stock selection in Europe Ex UK and the United Kingdom hurt results while stock selection in North America and an underweight to Japan proved beneficial.

On an individual stock basis, QGEP Participacoes, SBS Holdings, Entertainment One, Nomad Foods and CIMC Enric Holdings were the greatest contributors to absolute returns during the quarter. Positions in Criteo, Just Group, Honma Golf, Star Bulk Carriers and Kathmandu Holdings were the largest detractors from absolute performance.

In the first quarter, we initiated a number of new positions, the largest being Duetz, Bucher Industries and Galliford Try in the industrials sector, CYBG in the financials sector and Criteo in the communication services sector. We also closed several positions, the largest being Honma Golf in the consumer discretionary sector, Nomad Foods in the consumer staples sector, Doosan Bobcat and Europcar in the industrials sector and Aroundtown in the real estate sector.

The ClearBridge International Small Cap Strategy underperformed its MSCI EAFE Small Cap Index benchmark for the first quarter. On an absolute basis, the Strategy had gains in 10 of the 11 sectors in which it was invested. The primary contributor to performance was the industrials sector.

In relative terms, overall stock selection and sector allocation detracted from performance. Stock selection in the materials and industrials sectors, as well as an underweight to IT, hampered relative results. Conversely, stock selection in the consumer staples and energy sectors and an overweight to energy contributed to relative performance.

On a regional basis, stock selection in Europe Ex UK and the United Kingdom hurt results while stock selection in North America and an underweight to Japan proved beneficial.

On an individual stock basis, QGEP Participacoes, SBS Holdings, Entertainment One, Nomad Foods and CIMC Enric Holdings were the greatest contributors to absolute returns during the quarter. Positions in Criteo, Just Group, Honma Golf, Star Bulk Carriers and Kathmandu Holdings were the largest detractors from absolute performance.

In the first quarter, we initiated new positions in Duetz, Bucher Industries and Galliford Try in the industrials sector, CYBG in the financials sector and Criteo in the communication services sector. We also closed several positions, the largest being Honma Golf in the consumer discretionary sector, Nomad Foods in the consumer staples sector, Doosan Bobcat and Europcar in the industrials sector and Aroundtown in real estate sector.


Sean Bogda, CFA

Portfolio Manager
26 Years experience
11 Years at ClearBridge

Paul Ehrlichman

Head of Global Value, Portfolio Manager
36 Years experience
11 Years at ClearBridge

Safa Muhtaseb, CFA

Portfolio Manager
31 Years experience
11 Years at ClearBridge

Grace Su

Portfolio Manager
18 Years experience
11 Years at ClearBridge

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