- The first quarter of 2019 was almost the mirror image of the final quarter of 2018.
- The need for companies to invest is low, with capacity utilization still showing plenty of slack and economic growth tepid.
- We are including scenarios that involve rapid market instability in our probability-weighted valuations of our companies.
Market Overview and Outlook
The first quarter of 2019 was almost the mirror image of the final quarter of 2018. The small cap Russell 2000 Index rose almost 15%, after falling in the fourth quarter. The ClearBridge Small Cap Strategy outperformed in each case. In the first quarter, we benefited from a strong showing in health care, as well as financials. Our biggest drag for the quarter was cash, as well as consumer discretionary.
What a difference a dovish Federal Reserve makes. Between the last two Fed meetings of 2018, at both of which it raised the funds rate by 25 basis points (0.25%), the Russell 2000 Index fell more than 23%. After the December meeting, where the Fed announced a more dovish approach in the future, the Russell 2000 rose just shy of 20% through the end of the first quarter. The Fed was surely not the only reason why the market soared, but it did happen despite: the longest U.S. government shutdown in history; a decline in consensus GDP growth forecasts for 2019; and, according to Jefferies, estimates for a 15% drop in small cap first-quarter 2019 earnings, which would be the worst quarterly earnings decline since 2009. That’s a lot of negative news for investors to overcome, but an accommodative Fed heals many wounds.
Following the Fed announcement, much of the financial media was back to talking about Goldilocks and how this expansion could go on for a long time. Economists see blue skies in all directions, now that the Fed has backed off raising rates at a historically low peak and may even start easing prior to a recession. And the optimism has strong foundations, as many economic indicators are pointed in a positive direction.
At times like these, it’s good to remember Hyman Minsky. You probably haven’t heard his name much since 2008, but his central proposition was that long periods of steady prosperity and investment gains promote leveraged risk-taking in pursuit of continued gains, leading eventually to rapid instability. The U.S. now has nearly full employment and steady GDP growth, having just received a massive corporate stimulus in the form of lower taxes in 2018. Market volatility was historically low prior to the fourth quarter. The Fed is holding short rates at 2.50%, with the 30-year U.S. Government bond rate at 2.90%. The need for companies to invest is low, with capacity utilization still showing plenty of slack and economic growth tepid.
Exhibit 1: Capacity Utilization Showing Slack
In this environment, to generate higher returns on equity, investors have an attractive option: add leverage. The cost of borrowing is low, and more and more debt is available on “covenant-light” terms. Leveraged-loan funds have grown to rival the high-yield bond market in size, but with floating-rate yields that hedge against higher rates. Investors are reacting accordingly, especially private equity, with the 12 largest leveraged buyouts in 2018 going off at an average of 8.7x EBITDA before add-backs, according to The Economist.1 Overall non-financial corporate debt to GDP is now the highest it’s been since 1950.
Exhibit 2: Non-Financial Corporate Debt at All-Time High
The market is not unaware of this situation. We have learned that in a few different ways in the past year. First, the stock of any creditor, bank or otherwise, that has shown any hint of credit problems has sold off sharply. In the fourth quarter of 2018, we were able to buy shares of Bank OZK near its tangible book value, after it reported two credit impairments. This is a bank that has a long history of excellent underwriting, including during the 2008 financial crisis, where it saw only a slight increase in losses. It was rated the top-performing regional bank for the prior three straight years by S&P Global Market Intelligence. Yet, at the first whiff of credit issues, investors were selling it as if it would never earn an excess return on equity again. We were delighted to take the other side of that proposition.
Second, companies with higher leverage underperformed badly during the risk-off fourth quarter of 2018, though they bounced back in the risk-on first quarter of 2019. According to Jefferies, the top quintile of Russell 2500 Index stocks in terms of interest coverage and assets to equity outperformed the bottom quintile by more than 1000 and 600 basis points, respectively, in the fourth quarter of 2018. Those figures reversed in the first quarter of 2019, with the top quintile underperforming the bottom quintile by 900 basis points on interest coverage and 660 basis points on assets to equity.
"While the market may seem sunny and volatility low once again, high leverage still carries risks."
Our investment takeaway is that, while the market may seem sunny and volatility low once again, it will be a scramble for chairs when the debt-market music hints at stopping. We need to position our investments accordingly. As always, we are not relying on our ability to predict when the inevitable problem will arrive or what will cause it. The strong market could go on for a dozen more years. We simply want to keep an eye on the environment and ensure that we are not taking risks that we may not be aware of in our portfolio. That means, among other things, diligently monitoring the types of risks that our banks and other non-bank financing holdings (e.g., Aaron’s, OneMain Financial, and Main Street Capital) are taking, as well as measuring how they affect the beta of our overall portfolio during events. It means including scenarios that involve rapid market instability in our probability-weighted valuations of our companies. Because once it happens, we’ll be hearing Minsky’s name a lot, and we don’t want that to surprise us.
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 all of the sectors in which it was invested for the quarter (out of 11 sectors total). The primary contributors to the Strategy’s performance were the information technology (IT), health care and financials sectors. The consumer staples and utilities sectors were the laggards.
On a relative basis, the Strategy outperformed its benchmark primarily due to stock selection. In particular, stock selection in the health care, financials and energy sectors contributed the most to relative returns. Meanwhile, stock selection in the consumer discretionary sector detracted the most from relative performance. The Strategy’s cash position also weighed on relative results.
On an individual stock basis, Amarin, Gray Television, Rapid7, Aaron’s and Quotient were the largest contributors to absolute performance. Hudson, Great Western Bancorp, ORBCOMM, Cooper-Standard and ProAssurance were the greatest detractors from absolute returns.
During the quarter we initiated positions in Great Western Bancorp in the financials sector, Carrizo Oil & Gas in the energy sector, Commercial Metals in the materials sector, Brandywine Realty Trust and PotlatchDeltic in the real estate sector, Acadia Healthcare in the health care sector, NextEra Energy Partners in the utilities sector and QuinStreet in the communication services sector. We closed positions in NMI Holdings in the financials sector, Extraction Oil & Gas in the energy sector and BlackLine in the IT sector.