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Commentary: Mid Cap Strategy

Resilient Consumer Supports Results

Fourth Quarter 2020

Key Takeaways
  • Mid cap companies have benefited from appealing valuations relative to larger stocks and stand to gain, to a greater degree, from an accelerating economy. 
  • Performance was driven by the portfolio’s holdings in consumer sectors, which tend to be leaders in growth trends that accelerated during the pandemic or are directly tied to the economy’s reopening, as well as health care and financials.
  • We remained active in the fourth quarter, trimming and selling stocks that have worked and reinvesting in seven new companies where we see greater upside.
Market Overview

Clarity on the U.S. presidential election and a COVID-19 vaccine sparked equities to a strong finish in a challenging year for society, the economy and financial markets. Positive COVID-19 vaccine trial results and subsequent FDA approvals from Pfizer/BioNTech and Moderna triggered a rally that saw the S&P 500 rise 7.3% from November 9 through the end of the quarter.  The initial distribution of the vaccines in December as well as the passage of a $900 billion pandemic stimulus package further bolstered the upswing. Cyclical areas of the market rose the most on increased optimism about the eventual return to more normal activity. This optimism eclipsed the unknown fate of control of the U.S. Senate through year end, which will dictate legislative agenda for taxes and regulation.

The S&P 500 gained 12.2% in the fourth quarter to end 2020 up 18.4% while the benchmark Russell Midcap Index rose 19.9% for the quarter and 17.1% for the year. Market leadership shifted in the latter part of the quarter with value stocks outperforming growth. The Russell Midcap Value Index gained 20.4% compared to 19% for the Russell Midcap Growth Index. Despite this reversal, growth outperformed value by over 30 percentage points for the year. 

After multiple years of dominance by mega cap stocks, the market environment has become more supportive of small and mid cap companies. We believe mid caps in particular have benefited from appealing valuations relative to mega cap stocks and stand to gain, to a greater degree, from an accelerating economy. The yield on the 10-Year Treasury climbed 24 bps during the quarter to finish at 0.92%, potentially signaling rising expectations for growth and inflation as the economy recovers. Due in part to the massive liquidity provided by the U.S. Federal Reserve, conditions were not as dire for many companies in cyclical and financial sectors as their stock prices indicated. 

We have been vetting many of these traditionally defined value companies for some time and over the second half of the year several have made it into the portfolio, including recent addition Fifth Third Bancorp. The regional bank was conservative in recognizing credit reserves during the pandemic lockdown, which puts it in a favorable position to release reserves in 2021. Another regional bank, existing holding Western Alliance Bancorp, was a strong contributor in the quarter as it is also well-positioned to gain from a reopening of the economy. Both banks carry credit and interest rate sensitivity which should act as tailwinds if the recovery is as robust as anticipated.

The ClearBridge Mid Cap Strategy’s consumer holdings were also solid performers, led by online pet food and supplies merchant Chewy.com. Chewy is benefiting from new customers spending more money on pet food delivered to the home, and on services such as telehealth for pets, which should lead to recurring business long after the pandemic subsides. High-end auto components maker Aptiv is thriving in its role as a key supplier to the growing electric and autonomous vehicle market. Off-price retailer Ross Stores, restaurant supplier Performance Food Group and online travel agency Expedia, meanwhile, moved higher on reopening optimism. 

 

"Mid caps have gained over 80% since March and we have been cognizant of valuations for companies that have rallied the most."

 

We were encouraged as well by the results from several of our health care companies, which validate the crucial role biopharmaceutical companies have played in developing testing and treatments for COVID-19. Shares of Syneos Health moved higher as clinical research organizations that conduct lab testing for biopharmaceutical clients bounced back. Alexion Pharmaceuticals, a biotechnology company focused on rare diseases, rose on a takeout offer by AstraZeneca. Avantor, a diversified provider of specialty chemicals and lab products and services, showed strong growth in bioproduction revenue, an increasingly important part of our investment thesis. We added to our health care exposure in the quarter with the purchase of Horizon Therapeutics, a pharmaceutical company targeting rare and orphan diseases.

The Strategy’s information technology (IT) and industrials holdings delivered mostly positive results but failed to keep pace with the lower-quality, more leveraged companies that experienced a vigorous rally after “Vaccine Monday.” Monitoring and security software provider Splunk fell sharply after lowering guidance due to several large contracts being delayed while several other high-quality software companies failed to keep up with the market rally. Within industrials, Waste Connections was flat for the quarter despite topping earnings forecasts and raising its dividend over 10%, while Old Dominion Freight Lines trailed the broad market in spite of better than expected financial results.

Portfolio Positioning 

The year did not turn out like it was supposed to, but we stuck to our investment process and focused all our attention on individual stocks. As the pandemic broke out in the first quarter and business activity was curtailed, the Mid Cap team stepped up our due diligence, vetting all pre-existing facts about our portfolio holdings to make sure everything we owned was going to be able to cope with the pandemic, regardless of how long it lasted. We stayed nimble through the height of the selloff and early recovery, operating with greater turnover than in prior years by quickly moving on from business models with uncertain visibility and into new opportunities created by the pandemic. 

The mid cap market has gained over 80% from March lows and we have been cognizant of valuations for companies that have rallied the most. We funded our seven purchases during the quarter by trimming several winners as valuations grew fuller, including SolarEdge Technologies, Carvana and Chewy, and taking profits on a handful of other names that have recovered quickly: Copart, Vail Resorts, Synopsys and Xilinx. 

Rather than pick cyclical themes, our new additions have been driven by our bottom-up stock picking process. Carnival should benefit from pent-up demand for cruises and other leisure activities as vaccinations allow people to emerge from stay-at-home activities in 2021. Several portfolio additions should benefit from self-help efforts and new management teams. Ashland Global is a specialty chemical company, with a sustainable portfolio of chemicals manufactured from renewable sources rather than hydrocarbons. Resideo Technologies is a home electronics company spun off from Honeywell that focuses on mostly residential comfort, thermal and security solutions and maintains an installed base of over 150 million homes. 

We also purchased ON Semiconductor, whose auto business should benefit from content growth in new cars, the shift to electric vehicles as well as a cyclical inflection in volumes and inventory restocking in 2021. A new CEO has a track record for moving companies to higher-value-add products and improving their margin structures to significantly improve earnings power. 

Outlook

Looking ahead to the new year, we anticipate volatility will remain high. Economic forecasts are improving but we still see a number of uncertainties that need to be resolved before macro growth can return to a normal pace. We are encouraged by the initial distribution of vaccines as a key driver that should ease restrictions and spur the resumption of consumer and business activity, perhaps as early as mid-2021. 

Amid this transition, we continue to drive returns in the portfolio from stock selection and balance the portfolio across growth and value businesses. Our objective is to find growth companies that can invest at higher returns and compound them for years to come as well as value companies that can improve shareholder results through a return to normalized earnings or via new management who can enhance previously non-optimal business practice.

Portfolio Highlights

The ClearBridge Mid Cap Strategy outperformed its Russell Midcap Index during the fourth quarter. On an absolute basis, the Strategy had gains across all 11 sectors in which it was invested during the quarter. The leading contributors were the IT, financials, consumer discretionary and industrials sectors. 

On a relative basis, overall stock selection contributed to performance. Specifically, stock selection in the consumer discretionary, financials, health care and consumer staples sectors drove results. Conversely, stock selection in the industrials, IT, real estate and materials sectors, an overweight to consumer staples and an underweight to the energy sector detracted from relative returns.

On an individual stock basis, the biggest contributors to absolute returns in the fourth quarter were Western Alliance Bancorp, Aptiv, Performance Food Group, Lam Research and Chewy. The largest detractors from absolute returns were Splunk, Clarivate, Masonite International, Reynolds Consumer Products and Horizon Therapeutics.

In addition to the transactions listed above, we initiated a position in Maravai LifeSciences in the health care sector and closed a position in Western Digital in the IT sector.  

Brian Angerame

Portfolio Manager
27 Years experience
21 Years at ClearBridge

Matthew Lilling, CFA

Portfolio Manager
15 Years experience
11 Years at ClearBridge

Related Perspectives

  • Past performance is no guarantee of future results.

  • All opinions and data included in this commentary are as of the publication date and are subject to change. The opinions and views expressed herein are of the author and may differ from other portfolio managers or the firm as a whole, and are not intended to be a forecast of future events, a guarantee of future results or investment advice. This information should not be used as the sole basis to make any investment decision. The statistics have been obtained from sources believed to be reliable, but the accuracy and completeness of this information cannot be guaranteed. Neither ClearBridge Investments, LLC  nor its information providers are responsible for any damages or losses arising from any use of this information. 

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