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Commentary

Select Strategy

Second Quarter 2019

Key Takeaways
  • Solid fundamentals and robust multiple expansion caused fast growing companies to lead in an exceptional first half for equities.
  • We took advantage of an open IPO window, participating in four new issues with attractive, long-term growth profiles.
  • A higher than normal cash position, a reflection of high valuations for the companies we target and portfolio M&A activity, was a drag on relative performance.
Market Overview and Outlook

Investors expressed a strong preference for the fastest growing stocks in the market in the second quarter, extending a first-half run for growth. The Russell Midcap Growth Index was the best performer for the quarter with a 5.40% return and is up 26.08% year-to-date while the Russell 3000 Growth Index advanced 4.50% for the quarter and is up 21.41% for the year. Both indexes handily outperformed their value counterparts over each period. In addition, the S&P 500 Index added 4.30% in the second quarter to cap its best first-half showing (+18.54%) since 1997.

The Select Strategy maintains significant exposure to the fastest growing segments of the market by targeting stocks that we categorize as disruptors. These are companies like e-commerce platforms Shopify and MercadoLibre that are enabling the growth of new markets - in this case turning small businesses into competitive online merchants - through innovative sales, fulfillment and payment solutions. MercadoLibre is also the dominant player in a burgeoning Latin American market early in the secular growth of consumer spending.

Strong performing stocks like these have benefited from multiple expansion on top of upward earnings revisions. Shopify, for example, has seen its enterprise value-to-sales multiple zoom from 7X at the end of 2018 to a current 19X. A more accommodative environment has also fueled multiple expansion. As interest rates decline - the 10-Year U.S. Treasury yield fell 40 basis points in the second quarter - the present value of a company’s future earnings and cash flows rise.

Capital market activity has provided further confirmation of the desire for growth. The initial public offering (IPO) market saw its best quarter for deal volume in four years and best quarter for capital raised in nearly five years. We participated in four IPOs in companies we consider disruptors: Zoom Video, a cloud-based provider of video conferencing that topped revenue forecasts in its first post-IPO earnings report; CrowdStrike Holdings, a cloud-based cybersecurity provider; Pinterest, an already profitable social platform where users can express their interests and discover ideas through images they “pin” to their pages; and the RealReal, an online marketplace for used luxury merchandise, a growing niche for both millennial and baby boomer consumers. We also added a new position in Farfetch, a high conviction disruptor that went public in 2018 and operates an online luxury goods marketplace where both well-known brands and small boutiques can sell their merchandise.

Strategic acquirers are also seeking sources of above-average growth, leading to the proposed takeout of two portfolio companies: cloud-based biopharmaceutical data and analytics software maker Medidata Solutions by French technology conglomerate Dassault Systemes and data analytics provider Tableau Software by Salesforce.com.

 

"Organic growers are being recognized for their ability to outperform in most market environments."

 

The intensity of the growth stock rally has pushed the valuations of some disruptors to the point where we have become more selective in sourcing new ideas and adding to existing positions. This, combined with a busy period of M&A in the first quarter, has caused the portfolio to accumulate higher than normal levels of cash. We have been redeploying some sale proceeds into compounders like OUTFRONT Media, a new addition that is a leader in the established billboard and outdoor advertising business, and evolving opportunities – companies we consider temporarily mispriced with changing dynamics like rideshare provider Lyft after its disappointing first-quarter IPO. Despite these moves, cash was a drag on relative performance for the quarter.

Many of the indicators we follow, including operating margins, employment and the trend in interest rates, suggest a late cycle equity market. Earnings revisions are another key indicator, with negative revisions currently outnumbering positive ones. Reductions in guidance are skewed to cyclical stocks dependent on a strong economy for growth or tied to end markets with weakening demand. The Select Strategy is underweight these companies as well as those carrying heavy debt loads. Portfolio weakness during the quarter was centered in portfolio holdings like specialty hospital operator Surgery Partners and ATM provider Cardtronics with higher levels of financial leverage which the market has not been favoring.

As trade issues persist and business confidence falls, organic growers are being recognized for their ability to outperform in most market environments. We are confident in the range of opportunities available to our portfolio companies.

Portfolio Highlights

The ClearBridge Select Strategy outperformed its Russell 3000 Index benchmark for the second quarter. On an absolute basis, the Strategy had gains in eight of the nine sectors in which it was invested (out of 11 total) during the quarter. The main contributors to performance were the information technology (IT) and industrials sectors.

On a relative basis, stock selection contributed to performance. In particular, stock selection in the industrials and real estate sectors and a lack of exposure to the energy sector contributed the most to relative results. On the negative side, stock selection in the communication services sector, an underweight to the financials sector and the Strategy’s cash position detracted from relative results.

On an individual stock basis, the largest contributors to absolute returns in the second quarter were Shopify, Copart, MercadoLibre, Insulet and Wix.com. The greatest detractors from absolute returns were positions in comScore, Cardtronics, Surgery Partners, ForeScout Technologies and Lyft.

The Strategy initiated six new positions in the second quarter and closed two positions; Casa Systems in the IT sector and Grubhub in the consumer discretionary sector.

Aram Green

Portfolio Manager
18 Years experience
13 Years at ClearBridge

Related Perspectives

  • Select Strategy Update
    PM Aram Green analyzes the rotation out of growth and momentum stocks and how volatility has impacted portfolio positioning.
  • Select Strategy
    3Q19 Commentary: A rotation out of growth and momentum stocks, spurred in part by negative sentiment toward IPOs, weighed on results.
  • Select Strategy Update
    1Q19 Update: PM Aram Green discusses elements driving the strong snapback for growth stocks and potential opportunities in the IPO market.
  • Select Strategy
    1Q19 Commentary: Growth companies with disruptive business models were among the leading performers in a robust snapback rally.
  • Select Strategy
    4Q18 Commentary: Private equity investors continue to express interest in the disruptive businesses we own.

Related Blog Posts

  • Past performance is no guarantee of future results.

  • All opinions and data included in this commentary are as of the publication date and are subject to change. The opinions and views expressed herein are of the author and may differ from other portfolio 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 Investments, LLC  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.