- The quarter was marked alternatively by fears of economic slowdown and exuberance over a potential interest rate cut from the Fed.
- Even though the U.S. 10-year bond rate fell 40 basis points to 2.0%, inverting the yield curve, small cap banks outperformed REITs and matched utilities, which are both considered bond proxies.
- We plan to remain broadly diversified and to resist the temptation to express a macro view in our portfolio. That would require us to be right not only about future rates, but also about how the market would react to them.
Market Overview and Outlook
The Russell 2000 Index sloshed up and down in the second quarter but ended up just a little over 2%. Our strategy outperformed thanks to a variety of financial and consumer discretionary stocks, offset by the reversal of first-quarter outperformance in health care and energy companies.
The quarter was marked alternatively by fears of economic slowdown and exuberance over a potential interest rate cut from the Fed, which led to an odd collection of industry performances. Even though the U.S. Government 10-year bond rate fell 40 basis points to 2.0%, inverting the yield curve, small cap banks outperformed REITs and matched utilities, which are both considered bond proxies. It’s a reminder that, even if one can guess right about something like the direction of interest rates, market expectations may have already anticipated that change and more.
Too often investors start to believe the often-repeated forecasts and start to think they have insight into what the market is about to do. If the market is falling and commentators say it will continue, they pull their money out. If biotechnology stocks are soaring and pundits say the train is leaving the station, they hop on board. Following the crowd like this is usually not a profitable strategy over time.
That’s why we always start with the expectations embedded in the stock price, i.e., what growth, investment rate and incremental return on invested capital does the company need to earn to be worth what it’s trading for. Then we can consider whether we have reason to believe the company can outperform those expectations, based on a probabilistic view of the future.
Predicting the future is a probabilistic enterprise, not a deterministic one. This is very clear in, say, horseracing, where there may be a favorite, but every horse in the race has some odds (set by the bettors) to win. It’s a fact that the value of a bet is the probability of the horse to win times the price of the bet. Yet even in that arena, experienced bettors and novices alike very often pick the horse they think will win, then bet on it no matter what the price, believing that knowing the horse is the important part. But, as professional handicapper Steven Crist says,
The issue is not which horse in the race is the most likely winner, but which horse or horses are offering odds that exceed their actual chances of victory. This may sound elementary, and many players may think they are following this principle, but few actually do. Under this mindset, everything but the odds fades from view. There is no such thing as “liking” a horse to win a race, only an attractive discrepancy between his chances and his price.1
As of this writing, the bond market and economists surveyed are both in near-unanimous agreement that the Federal Reserve will cut interest rates at its July meeting and the Fed Funds rate will decline almost 100 basis points in the next year, compared to a 60% chance of a rate increase in November 2018. That’s a remarkable change, given that: 1) unemployment remains near the lowest ever recorded; 2) rolling averages of non-farm payroll net additions have changed very little over the past year; and 3) inflation (as measured by the Consumer Price Index) remains stable very near the Fed target of 2%.
Will we, therefore, position the portfolio contrary to expectations of a rate cut? No. We plan to remain broadly diversified and to resist the temptation to express a macro view in our portfolio. That would require us to be right not only about future rates, but also about how the market would react to them. Going into the second quarter, the market priced banks in anticipation of interest rates declining, hurting bank profits. When they did, bank stocks outperformed the broader market. It’s better not to play the game of guessing the future, but instead to value stocks based on their long-term earnings potential and buy when the odds are in your favor.
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 seven 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 financials, industrials and consumer discretionary sectors. The energy and health care sectors were the main detractors.
"Predicting the future is a probabilistic enterprise, not a deterministic one."
On a relative basis, the Strategy outperformed its benchmark primarily due to stock selection. In particular, stock selection in the financials and consumer discretionary sectors contributed the most to relative returns. Meanwhile, stock selection in the health care and energy sectors detracted the most from relative performance.
On an individual stock basis, Foundation Building Materials, Itron, Lithia Motors, Aaron’s and Washington Federal were the largest contributors to absolute performance. 2U, Gray Television, Smart Sand, Akebia Therapeutics and Dynavax Technologies were the greatest detractors from absolute returns.
During the quarter we initiated positions in Wintrust, WesBanco and Palomar in the financials sector, Twin River and OneSpaWorld in the consumer discretionary sector and CommVault in the IT sector. We closed positions in LegacyTexas in the financials sector and Methode Electronics in the IT sector.