- A coterie of companies with products and services either advantaged or accelerated by the COVID-19 shutdowns and likely long-term evolutions of work-from-home policies were stellar performers for the Strategy.
- We made eight new investments during the quarter, including three IPOs, financed largely through trims in existing successful larger cap holdings.
- The overall market rose sharply, however dispersion widened considerably between growth/momentum stocks and more value-oriented names.
Market Overview and Outlook
This past quarter proved how little anyone can accurately predict overall macroeconomic and concurrent financial market dynamics in advance. A severe recession, with a horrific spike of the national unemployment rate to the mid-teens, was blunted by massive policy response to support incomes. The overall U.S. market rallied remarkably, much to the surprise of many commentators and experienced investors, from a record speed bear market bottom in mid-March.
The COVID-19 (C-19) pandemic, barely on the U.S. horizon at the turn of the year, engulfed us during the first quarter with widespread mobility restrictions, the best-known tactic to battle the invisible foe. While the trend of C-19 importantly buffeted markets and management actions during the most recent quarter, the movement for social justice and improved economic equality was the bigger pivot that emerged during the second quarter.
During the second quarter, the aphorism that “it’s a market of stocks, not a stock market” became abundantly clear. While the overall market rose sharply, dispersion widened considerably.
On the simple differentiation between growth and value, growth stocks outperformed by about 10 percentage points as measured by the Russell 2000 Growth Index versus its value counterpart. Sectoral relative performance was also wide. Various custom indexes and structured offerings highlight the stark performance difference between “work-from-home (WFH) stocks,” “stay-at-home stocks,” “initial reopening stocks” and more secularly challenged businesses. Factors also had influence with growth/momentum dominating most days, but occasionally value stocks had their moment to shine.
The first half of this year assuredly has been a banner one for capital market activity; IPOs have also been coming fast and furious.
A coterie of companies with products and services either advantaged or accelerated by the C-19 shutdowns and likely long-term evolutions of WFH policies were stellar stock market performers as near-term earnings and growth prospects accelerated. About 20% of the Small Cap Growth Strategy’s assets fall into this category. Examples include technology providers Chegg and DocuSign, health care services provider Livongo and BJ’s Wholesale in consumer staples.
A larger swath of the equity market has had modest to severe impact. And a bankruptcy wave is coursing through a number of industries (energy the most visible example) as companies were ill prepared from the perspective of financial structure for the C-19 shutdowns and macro demand shocks that ensued.
Overall, companies have adapted rapidly to 1) protect their employees’ safety, 2) serve their clients, 3) thoughtfully address their community responsibilities, and 4) ensure their capital adequacy. The vibrancy of the economic recovery will depend on the re-absorption of furloughed workers, with an average of 70% of layoffs over the past three months being classified as temporary job losses.
Another hallmark of this past quarter was the voracious capital market raising by U.S. corporations, whether in the fixed income, convertible or equity markets. For established issuers, we view these capital raises as “single premium term life insurance” which leads to relatively minor dilution to ensure long-term survival. We’re onboard with these capital raises given a very uncertain disease progression and recovering financial market prices. The first half of this year assuredly has been a banner one for capital market activity; initial public offerings have also been coming fast and furious.
We made seven new public investments during this quarter across a variety of industries, three of which were IPOs: SelectQuote, Shift4 Payments and Vroom. SelectQuote, in the financials sector, is a highly efficient online insurance broker, with a special focus on enrollment for Medicare Advantage enrollees. Shift4, in the IT sector, is an integrated merchant payments software and processor. The company offers a suite of software integrations and payment technologies that enable merchants to cope effectively with the multiplicity of customer interactions and differing customer access requirements. Vroom, in the consumer discretionary sector, is an online auto retailer/marketplace. Led by management with deep domain expertise in the digital marketing and automotive worlds, Vroom allows retail customers to efficiently buy and sell pre-owned vehicles online.
We also initiated a position in Brooks Automation, in the IT sector, which manufactures semiconductor capital equipment and life sciences technologies, with a commonality of expertise in robotics and automation under harsh conditions. These additions were largely financed through trims in existing successful larger cap holdings.
The sectoral outperformance of health care during 2020 and its increase to more than 35% of the benchmark during the June Russell rebalance led us to concentrate on new health care exposures, adding three positions. Ultragenyx is a rare disease biotechnology company with a lead commercial product offering benefits to patients with XLH disease. The company also has a number of other compounds in development as well as gene replacement therapies. iRhythm Technologies is part of the new breed of digital health care providers reimagining the way heart arrythmias are diagnosed. iRhythm’s wearable wireless sensors continually transmit patient data to the company’s analytics software, enabling real-time observation. Biohaven Pharmaceutical markets an interventional oral medication for acute migraine relief and has developmental programs for migraine relief with a nasal spray as well as using for prevention. Biohaven also has higher risk developmental programs in a variety of neurodiseases.
We also made one private placement investment during the quarter in Brain Corp. The company has developed deep expertise in advanced machine learning and computer vision systems for autonomous mobile robots. Brain’s first commercial applications are in the floor care/cleaning market and the company’s solutions are already being trialed for other autonomous use cases. The adoption of Brain’s solutions significantly reduces human labor and has a high return on investment for customers.
During the second quarter, the ClearBridge Small Cap Growth Strategy outperformed its Russell 2000 Growth Index benchmark by over 800 basis points. We’re pleased by that outperformance as the Strategy customarily lags in strong up markets, most recently the fourth quarter of 2019 when the index ramped 11.4%, and defends well in sharply lower markets due to our quality bias.
On an absolute basis, the Strategy had gains across nine of the 10 sectors in which it was invested during the second quarter (out of 11 sectors total), with the IT and health care sectors the leading contributors.
In relative terms, stock selection and sector allocation contributed to performance. Specifically, stock selection in the IT sector was the primary driver of results, while stock selection in communication services, financials and industrials were also additive, as was an underweight to the real estate sector. Conversely, stock selection in the health care and materials sectors and an overweight to the consumer staples sector detracted from relative performance.
The leading contributors to absolute returns during the second quarter included Wix.com, Trex, Chegg, Fox Factory and Inphi. Positions in Core-Mark Holding, Balchem, iRhythm Technologies, Aerojet Rocketdyne and Vocera Communciations were the greatest detractors from absolute returns.
In addition to the transactions mentioned above, we closed positions in WisdomTree Investments in the financials sector, CarGurus in the communication services sector and Shutterstock in the consumer discretionary sector.