- A rotation out of growth and momentum stocks, spurred in part by negative sentiment toward newly public companies, weighed on performance.
- We continued to take profits in the portfolio’s most disruptive companies due to a combination of valuation and portfolio rebalancing after the group’s robust results.
- Our focus remains on companies with differentiated business models, adaptable management teams and underappreciated growth prospects.
Market Overview and Outlook
Investor sentiment was as volatile as equity prices during a third quarter that witnessed a rotation out of growth and momentum into value, which drove sharp individual stock dislocations. While the Russell 3000 Value Index, top heavy in the largest value stocks in the market, beat its growth counterpart by 13 basis points for the quarter, value outperformance was more pronounced at lower capitalizations. The Russell 2500 Value Index, which excludes the largest companies in the market, outperformed the Russell 2500 Growth Index by 331 basis points. That’s a sharp reversal from the second quarter, when investors gravitated to the fastest-growing stocks in the market and the Russell 2500 Growth Index outperformed its value equivalent by 225 bps.
A prime culprit for the retreat from risk was the initial public offering (IPO) market, which became challenged with several high-growth disruptors breaking deal price or not getting to market. The unwind and eventual withdrawal of the WeWork IPO has more investors questioning the growth rates and longer-term profitability of smaller, disruptive companies. While a headwind in the short term, we believe such questioning of the fundamentals of companies entering the public markets is healthy. Our due diligence of private companies has always included an analysis of their ongoing capital needs post-IPO as well as how their business models will generate recurring revenues — two areas where investors having been pushing back of late.
Such souring investor sentiment hurt our information technology (IT) holdings, especially on risk-off days when the exit from growth was most pronounced. This rotation hurt portfolio holdings we categorize as disruptors that had run up earlier in the year, including e-commerce website developer Wix.com, Latin American e-commerce portal MercadoLibre and enterprise software-as-a-service provider (Saas) ServiceNow.
Despite generally downbeat sentiment for growth stocks, our research of the public and private markets continues to identify compelling opportunities in innovative companies. We made nine new investments during the quarter, two of which were IPOs — performance monitoring software maker Datadog and Livongo Health, which is applying artificial intelligence to help patients manage their health conditions. Overall, the IPO market has been a fertile source of new idea generation and has done well with year-to-date returns of 22.3% per Renaissance Capital. Results are weaker, however, on a cap-weighted basis with a slew of disappointing debuts by this year’s class of “unicorns.”
"Overall, the IPO market has been a fertile source of new idea generation."
"Overall, the IPO market has been a fertile source of new idea generation."
We added several software companies during the quarter serving key areas of enterprise demand. Dynatrace develops application monitoring software, similar to existing holding New Relic, and is evolving its profitable business to a cloud-based platform that should lead to improved margins. Medallia helps many of the world’s largest companies enhance their customer’s experience through software-based surveys. It too is moving from serving companies on-premise to making its surveys and analytics cloud-enabled. Such transformation is typical of the stocks we describe as evolving opportunities, temporarily mispriced companies whose changing dynamics should lead to better outcomes. We also gained shares of salesforce.com (CRM) following its acquisition of portfolio holding Tableau Software. CRM is one of the original SaaS developers, the market leader in customer relationship management and a standard tool among most enterprise sales teams. It adds to our group of steady compounders continuing to gain share in existing markets.
World Wrestling Entertainment (WWE) is another new addition to our evolving opportunities bucket where stock weakness created an attractive entry point. WWE has struggled recently due to content issues around injuries to its top stars hurting viewership. We expect content will improve and reach will expand with the debut of new programming on Fox and the signing of international rights contracts.
We added to our bucket of steady compounders with the purchase of L3Harris Technologies, formed during the quarter from the merger of intelligence systems and specialty avionics supplier L3 Technologies and communications and electronics systems developer Harris Corp. We see a lot of synergies in the combination, which now has the size and scale to directly compete for more defense contracts rather than wait for project work from larger competitors.
Alongside our search for disruptive, mispriced and misunderstood companies with compelling growth profiles, we actively manage portfolio risk to keep individual positions from having an outsized impact on performance. This process entails an ongoing review of the rationale for owning every company in the portfolio and in the third quarter led us to exit four positions.
We exited cybersecurity software maker CrowdStrike Holdings after a strong debut raised valuation concerns. We sold Masonite International as industry trends for the maker of doors for the new construction and renovation markets remain sluggish with no clear catalyst to realize value, and Lions Gate Entertainment as the company’s strategic pivot to Starz hasn’t created value at a time when operating costs for talent creation are escalating. We also pared losses in newly public online luxury goods maker Farfetch which sold off after disappointing results and a poorly received acquisition.
For the last several quarters, in addition to the sale of full positions, we have been opportunistically trimming portfolio exposure to disruptors. This effort to reduce our momentum and growth beta continued in the third quarter but was not enough to offset the significant sentiment swings discussed above. The current mood of the market, however, will not dissuade us from our approach of targeting companies with differentiated business models, adaptable management teams and growth opportunities not fully discounted by the market.
The ClearBridge Select Strategy underperformed its Russell 3000 Index benchmark for the third quarter. On an absolute basis, the Strategy had gains in six of the nine sectors in which it was invested (out of 11 total) during the quarter. The main contributors to performance were the real estate and industrials sectors.
On a relative basis, stock selection detracted from performance. In particular, stock selection in the IT, communication services and consumer discretionary sectors had the most significant impacts on relative results. On the plus side, stock selection in the health care and industrials sectors and an overweight to IT contributed to performance.
On an individual stock basis, the largest contributors to absolute returns in the third quarter were Insulet, Trex, DocuSign, Ross Stores and SBA Communications. The greatest detractors from absolute returns were positions in Farfetch, Lyft, Wix.com, New Relic and Yext.
In addition to the transactions mentioned earlier, the Strategy initiated new positions in Zynga in the communication services sector and Twilio in the IT sector.