- In the small cap market, lower interest rates helped yield proxies outperform, while low- or no-profit health care and energy stocks underperformed.
- The growth areas of our portfolio, in particular health care and technology, were drags on performance, even while non-bank financials provided some relief.
- Our approach focuses on understanding the economics of each investment candidate we consider and what they would be worth under a wide range of scenarios.
Market Overview and Outlook
Investor worry weighed on small caps in the third quarter, with the Russell 2000 Index returning -2.40% and lagging the large cap S&P 500 Index. Economic growth expectations remain one of the key concerns and key drivers of market performance. In that vein, slowing economies in Europe and China, coupled with weaker manufacturing readings in the U.S., have been on investors’ minds in recent months. U.S.-China trade talks are adding a layer of uncertainty and contributing to market volatility. In its efforts to calm the markets and sustain economic growth, the Fed reversed its course and cut the federal funds target rate for the first time in a decade in July and again in September. The cuts left the target rate at a range of 1.75%–2.00% and brought the Fed in alignment with the accommodative stances of other global central banks.
Economists and political pundits now seem to be confident about further downward moves in yields: “Of course the Federal Reserve will cut rates multiple times in the next year and long rates will fall.” But it is more difficult than they let on to reliably predict the future. Compare: “Of course interest rates will rise over the next year,” which we heard regularly a year ago. The 10-year U.S. Treasury note yield has fallen by almost 50% since the end of the third quarter 2018.
Rather than proffer predictions, we instead prefer to consider what may happen in the future as broadly as we possibly can and then proceed to understand the impact of the value of each investment we make under those scenarios. One of the behavioral biases that we seek to avoid is confirmation bias, which tends to be quite common among those that have a stated view of “what will happen.” If you don’t take a view on what will happen, you can interpret new information from a more objective perspective. We seek to eliminate the false precision of point predictions, instead trying to think about the risks and rewards of each investment under a range of potential outcomes. To be clear, we do not advocate going into the future blind. We just choose not to try to predict it. As we get new information, we can update our ranges as objectively as possible.
"We seek to eliminate the false precision of point predictions, instead trying to think about a range of potential outcomes."
Consider the after-effect of Hurricane Maria in Puerto Rico. The hurricane formed on September 16, 2017 and made landfall in Puerto Rico on September 20. Almost 3,000 people died, thousands were displaced, and the electrical infrastructure was ruined. 470,000 people, 14% of the total population, left the island in the subsequent two years. If you knew that would happen on September 16, 2017, would you want to own our portfolio company Evertec (EVTC), a transactions processor based in Puerto Rico that depends on transaction volume for profits? The market didn’t, sending the stock down almost 30% in the next two months. This move overlooked three important factors: 1) Valuation was already at a multi-year low prior to the storm, so expectations were low; 2) Evertec is an integral part of the government efficiency efforts, so it benefits from increased government transactions; and 3) Evertec is growing in the rest of Latin America. As a result, despite Puerto Rico still recovering from Maria, Evertec outperformed the Russell 2000 Index dramatically from September 16, 2017, to the end of the third quarter of 2019 (Exhibit 1).
Exhibit 1: Evertec Upended Low Expectations
Remember, predicting the future accurately is just the first step. The second, equally challenging step is to make a successful investment decision based on that prediction. Take, for example, the 2020 U.S. presidential election. We’re already seeing a growing number of predictions from Wall Street pundits about what investors should do if they “believe” a certain candidate will be nominated or wins the presidency.
Consider: What would investors have done three years ago, on the eve of the 2016 presidential election if they knew for sure what the outcome was going to be? Based on campaign promises, Mr. Trump was viewed as an ally of the steel industry, and in fact he did follow through on some promises, such as imposing tariffs on steel imported into the U.S. So, if one knew the outcome of that election ahead of time, one would reasonably buy U.S. steel stocks, right? For a period of two months that would have been a profitable investment (Exhibit 2). However, since then every major U.S. steel stock not only has underperformed but is in fact lower (a range of -15.8% to -78.3%) than it was on January 01, 2017 (Exhibit 3).
Exhibit 2: Steel Stocks Rose After 2016 Election
Exhibit 3: Steel Subsequently Upended High Expectations
Fast forward to 2019. In the second quarter, market momentum was going strong with investors bidding up the fastest-growing companies, regardless of how that growth was being financed. Would pundits have predicted the rotation in market leadership that has transpired over the last three months? In the small cap market, lower interest rates helped yield proxies (REITs, utilities, and consumer staples) outperform and low- or no-profit health care and energy stocks underperform. In the past, this kind of market has been favorable for our portfolio, which has frequently proven resilient in down markets. This quarter, however, the growth areas of our portfolio, in particular health care and technology, did not hold up as well, even while non-bank financials provided some relief.
Health care stocks were the biggest detractor for the index and for the portfolio as well, despite being underweight the sector. Lexicon Pharmaceuticals saw negative interim data from its partner Sanofi’s phase-3 trials of Lexicon’s lead drug, sotagliflozin, for type-2 diabetes. Lexicon had the rights to over $1 billion of payments from Sanofi for meeting research and commercial milestones, but Sanofi decided to pull the plug on most of its trials and buy out of the agreement. With Lexicon already having failed to get approval for type-1 diabetes and seeing slow sales for its marketed drug, Xermelo, we exited the stock.
Amarin, our best stock over the past year, suffered an unexpected setback when the FDA rescinded its priority review of the label for Vascepa, Amarin’s only drug, during the third quarter. The agency scheduled an advisory committee meeting for the drug in November and moved the decision date from September to December 2019, which (combined with an equity issuance in July) caused the stock to tumble. Quotient, also a strong performer in recent quarters, declined on essentially no news.
In technology, 2U, a supplier of graduate education platforms for accredited colleges, also detracted significantly, continuing its weak performance for the year. It has become clear that enrollment in its online programs is not meeting past expectations, and that investments in marketing to boost the effort are not generating returns. We have reset our valuation for the company lower, but believe it remains a good value.
Other IT holdings were significant contributors. Tower Semiconductor saw strong organic revenue growth (11% sequentially) in the second quarter, which largely offset the cost drag of a new contract with a large customer. The good news is that capacity utilization is improving and demand outlook is positive, based on Tower’s decision to invest additional capital to expand production. The company won a new contract for a facial-recognition solution that could prove to be high volume starting in 2020. We continue to own Tower, which should continue to create value as an important supplier of critical technologies to areas of growing semiconductor demand.
Non-bank financials also made positive contributions, such as consumer finance company OneMain, which delivered another very strong quarter, beating estimates meaningfully on strong growth in receivables and solid credit metrics. The company also announced a $2/share special dividend, which we believe is only the beginning of returning capital to shareholders, given the strength of the underlying business and the meaningful debt reduction since the SpringLeaf/OneMain merger in 2015. We continue to own OneMain, as we see potential for further capital deployment at very strong risk-adjusted returns.
Financial markets and global economies are extremely complex and adaptive. We choose to focus in the areas we believe we can add value and produce long-term risk-adjusted returns for our investors. We cannot add value through superior knowledge of the future and the ramifications of that knowledge. We don’t think anyone can over time (without some legally sketchy behavior). What we focus on instead is understanding the economics of each investment candidate we consider and what they would be worth under a wide range of scenarios. We assess the market’s forecast as well, what the current price implies about future scenarios, and invest when we think the odds are in our favor. This leads to a better understanding of the risks we take and why, which allows us to update our understanding with new information and change course when we’re losing our edge. We then seek to understand how risks from each stock aggregate in our overall portfolio, so we can avoid concentrating our risks in certain future scenarios. In sum, we would rather be approximately right than precisely wrong.
The ClearBridge Small Cap Strategy underperformed the Russell 2000 Index, the Strategy’s benchmark, during the quarter.
On an absolute basis, the Strategy had gains in four of the 11 sectors in which it was invested for the quarter. The primary contributors to the Strategy’s performance were the real estate, financials and consumer staples sectors. The health care and energy sectors were the main detractors.
On a relative basis, the Strategy underperformed its benchmark due to stock selection, partially offset with sector allocation. In particular, stock selection in the health care, materials and communication services sectors detracted the most from relative returns. Meanwhile, stock selection in the financials sector contributed positively to relative performance, as did an underweight to the health care sector.
On an individual stock basis, Palomar Holdings, Itron, Tower Semiconductor, Marten Transport and OneMain were the largest contributors to absolute performance. Venator Materials, Amarin, 2U, Lexicon Pharmaceuticals and Liberty Oilfield Services were the greatest detractors from absolute returns.
During the quarter we initiated several new positions, the largest of which were in Kite Realty in the real estate sector, K12 in the consumer discretionary sector, Blucora in the financials sector, Covetrus in the health care sector and Matador Resources in the energy sector. We also eliminated several positions, the largest of which were in Liberty Oilfield Services and Carrizo Oil & Gas in the energy sector, Kinsale Capital in the financials sector, STORE Capital in the real estate sector and RingCentral in the IT sector.