- Myriad externalities weighed on investor sentiment and sparked a rotation out of growth and momentum-driven stocks.
- Strength in the health care and industrials sectors supported performance relative to the benchmark.
- We remained active in repositioning the portfolio, adding several innovative companies in the health care and technology sectors.
Market Overview and Outlook
Equity markets were impacted by a mounting list of externalities during the third quarter which combined to spark an exit from fast growing and newly public companies. The list of concerns included President Trump’s Twitter blitz on the U.S.-China trade war, global manufacturing and other macro indicators showing more signs of a global slowdown, drone and missile attacks on oil infrastructure in Saudi Arabia and the expanding Ukrainian/U.S. impeachment inquiry. Global central banks, including the U.S. Federal Reserve, moved aggressively into monetary easing while massive flows into the perceived “safe haven” of U.S. Treasurys drove 10-year yields down 55 basis points intra-quarter and 34 bps by quarter end.
The rotation out of growth and momentum into value drove sharp individual stock dislocations. Within the SMID cap universe, the benchmark Russell 2500 Growth Index (-3.18%) underperformed the Russell 2500 Value Index by 331 basis points during the quarter. The initial public offering (IPO) market, meanwhile, became challenged with several high-growth disruptors breaking deal price or not getting to market.
In a difficult SMID cap growth environment, the Strategy outperformed the benchmark modestly. Part of that can be attributed to strong showings by several of the portfolio’s health care and industrials holdings. Cambrex, a supplier of compounds services used in the production of generic drugs, agreed to be acquired by a private equity buyer at a roughly 50% premium. Insulet, a developer of insulin infusion systems for diabetes patients, reported better than forecast revenues in the second quarter and raised full-year guidance as sales for its Omnipod insulin management system were up 51% year-over-year. Meanwhile, Trex, a manufacturer of wood alternative decking products for residential and commercial customers, rose on strong demand for its new product, Trex Enhance. We also believe the high-quality bias that drives stock selection provides stability during a volatile market environment.
Despite generally downbeat sentiment for the asset class, our research of the public and private markets continues to identify compelling opportunities in innovative companies. We made seven new investments during the quarter, including one IPO (Dynatrace) and a post-IPO purchase (Chewy.com). 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. Chewy.com, which debuted in June, is the e-commerce category leader in the recession-resistant pet category and has earned differentiation from competitors through a focus on customer service.
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.”
Within health care, we made an investment in Catalent, a provider of outsourced drug development and manufacturing services for biopharmaceutical companies. Catalent is a top three participant in the sizable contract development and manufacturing market. Management has successfully steered the business to biologics and high growth gene replacement therapies. We envision higher single digit growth and financial deleveraging given the relatively low capital intensity of the business.
We also added a position in SVMK. Formerly known as SurveyMonkey, the company has rebranded into a feedback company focusing on customer feedback, market research and employee engagement/HR feedback. Currently 90% of their revenues are subscription-based and the company has pivoted to focus on enterprise customers as well as international opportunities.
In addition to sourcing new growth ideas, 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 five positions. Medidata Solutions in the health care sector and Tableau Software in the IT sector were sold ahead of the closure of their acquisitions by strategic buyers. We exited a position in 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 sold out of Core Laboratories, a maker of reservoir description and similar drilling enhancement technologies for oil & gas exploration and production companies. In addition to the headwind of weak oil prices, we lost confidence in the necessity of Core Labs’ services in a slowing capex environment.
As we enter the fourth quarter, the uncertainties with potential to negatively impact stock prices are only increasing. We are already in a manufacturing recession and are keeping a close eye on how companies are managing through the slowdown to keep it from spreading to other parts of the economy. Tariffs are hitting these companies directly so any resolution of the U.S.-China trade standoff would relieve pressure. In such an environment, we feel good about our portfolio of less cyclical companies with greater visibility to end demand and better balance sheets compared to the small and mid cap growth market overall.
The ClearBridge SMID Cap Growth Strategy outperformed its Russell 2500 Growth Index benchmark during the third quarter. On an absolute basis, the Strategy had gains across four of the 10 sectors in which it was invested during the quarter (out of 11 sectors total). The primary contributor to performance was the industrials sector while the primary detractor was the consumer discretionary sector.
In relative terms, the Strategy’s outperformance was driven by stock selection and sector allocation. Specifically, stock selection in the health care and industrials sectors drove results. Stock selection in the materials, communication services and IT sectors also helped as did an overweight to the real estate sector and an underweight to health care. Meanwhile, stock selection in the consumer discretionary sector had a negative impact on relative performance.
The biggest contributors to absolute returns during the third quarter included Insulet, Trex, Burlington Stores, DocuSign and Inphi. Positions in New Relic, Grubhub, Wix.com, Farfetch and Mettler-Toledo were the greatest detractors from absolute returns.
During the third quarter, in addition to the transactions previously mentioned, we initiated positions in Americold Realty Trust in the real estate sector, Tradeweb Markets in the financials sector and Smartsheet in the IT sector and closed a position in ServiceNow in the IT sector.