“It is a tale told by an idiot, full of sound and fury, signifying nothing.” -William Shakespeare (from Macbeth, spoken by Macbeth)
- Stocks ended the quarter slightly higher while enduring significant volatility related to trade tensions, regulatory actions and slowing growth.
- We were active buyers through the turbulence, participating in a handful of IPOs and establishing several other new positions.
- The portfolio’s focus on companies with sustainable business dynamics backed up by robust capital discipline enabled it to hold up well during “risk-off” periods.
Market Overview and Outlook
Macbeth’s reflection on life seems an apt characterization of second-quarter equity market dynamics. The small cap growth market basically ended where the quarter began, but oh what fury in between:
- Early May reports of a China trade deal were dashed. Acrimony broke out with sanctions on both sides (Huawei, rare earths, etc.). At quarter end, negotiators and Presidents Trump and Xi gathered at the Osaka G-20 meeting to work on key differences. Trade anxieties were compounded by the Trump administration’s promise of unilateral tariffs on Mexico as a cudgel to slow the flow of Latino immigrants to the U.S.; the Mexican agreement in early June blunted that suggestion.
- Real-time economic statistics in a variety of areas and regions showed deceleration or deterioration while interest rates collapsed (the 10-year U.S. Treasury ended the second quarter at 2.0%) and the U.S. yield curve inverted.
- Overhangs from the Department of Justice and the Federal Trade Commission, as well as Congressional hearings on the big Internet platforms, caused a swoon in the higher growth Internet/software sector.
As one market commentator aptly noted, “Investors are getting chopped up between covering underweights/shorts and flocking back into old favorites.” The stock market continues to be whipped around by factors and baskets; we continue to take advantage of that as active long-term investors focused on business development and crucial portfolio company fundamentals.
During this period of slowing profit growth expectations (which we expect to be reaffirmed during second-quarter earnings season) we continued to be busy.
"The stock market continues to be whipped around and we continue to take advantage as active long-term investors."
While growth investors were centered on what turned out to be the less than splashy initial public offering (IPO) debuts of Lyft and Uber, we participated in three successful IPOs where we are looking to build a long-term presence. Revolve Group, in the consumer discretionary sector, is an online-only fashion retailer that differentiates itself through a heavy reliance on data to drive product development and social media influencers to market its products. The company is profitable and continues to be run by a pair of entrepreneurs who founded the brand in 2003. PagerDuty, in the information technology (IT) sector, provides a cloud-based incident and internal surveillance platform for IT teams. Integrated with numerous software products and partners, the company’s software identifies system degradation or outages, and notifies appropriate personnel in a variety of ways to avert or minimize enterprise technology incapacity. Grocery Outlet, in the consumer staples sector, is a deep-discount, opportunistic brand grocer selling both low-cost branded goods and staples. The company has an innovative owner/partner structure that drives localized experience as well as competitive returns.
We also began starter positions in two other investments. Glaukos, in the health care sector, is an innovative ophthalmic tech company with a range of minimally invasive ocular stent implants to reduce pressure within the eye from glaucoma, a leading cause of vision impairment and blindness. The company has an established implantable business with direct distribution in 17 countries as well as a host of related pipeline products. Among these is iDose, which is used for drug delivery within the eye, potentially obviating the need for glaucoma drops which have poor patient adherence and compliance. iDose is in phase 3 trials.
Bandwidth, in the communication services sector, provides a cloud-based software platform that enables businesses to run voice and text communications across mobile and other connected devices. As a vertically integrated provider of software and networking, it has a unique value proposition relative to newer software providers or legacy network players and consequently has built substantial market share with leading hyperscale technology, consumer, and enterprise software customers. The company has recently expanded its sales force to take advantage of the secular growth of communications shifting to the cloud and proliferating through app usage. Following this period of reinvestment, the company should see both accelerating revenue and profitability growth as it competes in a rapidly expanding communications end market.
Top five holding Medidata Solutions agreed to be purchased by Dassault Systemes at a decent premium. We’ve seen the business dramatically expand and develop in the six years since Medidata entered the Small Cap Growth Strategy. We also bade farewell to two unsuccessful investments: biotechnology firm Acorda Therapeutics, which was hurt by concerns about product uptake and capital availability and media measurement provider comScore, which sold off on capital concerns and management instability.
We also experienced a few fundamental disappointments which we view as transitory. Drugmaker\ Heron Therapeutics unexpectedly received a complete response letter from the FDA for its non-opioid treatment for post-surgery pain, which will delay commercial rollout for approximately a year. In addition, chipmaker Inphi was down mid-quarter due to the Commerce Department’s ban on shipments to Chinese telecom equipment maker Huawei before recovering as trade tensions eased.
Exhibit 1: Strategy Upside and Downside Capture
Overall however, the portfolio held up well during “risk-off” periods. Our relentless attention to sustainable business dynamics backed up by robust capital discipline is a critical foundation. During the jarring May small cap correction, the portfolio outperformed the Russell 2000 Growth benchmark. That outperformance is consistent with the Strategy’s long-term favorable upside/downside capture (Exhibit 1).
The ClearBridge Small Cap Growth Strategy outperformed its Russell 2000 Growth Index benchmark during the second quarter. On an absolute basis, the Strategy had gains across seven of the 10 sectors in which it was invested during the quarter (out of 11 sectors total). The primary contributors to performance were the industrials and health care sectors.
In relative terms, the Strategy’s outperformance was driven by stock selection and sector allocation. Specifically, stock selection in the health care, consumer staples, industrials and consumer discretionary sectors and an underweight to health care drove results. Meanwhile, stock selection in the communication services sector had a negative impact on relative performance.
The biggest contributors to absolute returns during the second quarter included Copart, Insulet, Medidata Solutions, Trex and Wix.com. Positions in comScore, Heron Therapeutics, Shutterstock, Surgery Partners and Cardtronics were the greatest detractors from absolute returns.
In addition to the transactions mentioned above, we also closed a position in Integrated Device Technology in the IT sector.