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Commentary: Mid Cap Growth Strategy

Casting a Wide Net for Quality Growth

First Quarter 2021

Key Takeaways
  • The Strategy outperformed through a rotation out of growth stocks as our preference for sturdy fundamentals and value-creating management teams provided ballast amid rising speculation in lower-quality names.
  • Recent results reflect the work done over the last several quarters to maintain diversified exposure to mid cap growth companies while paying close attention to risk.
  • We established nine new positions during the quarter across software, health care and companies geared for a reopening of the economy.
Market Overview

A rotation in market leadership that commenced last September continued to gain strength in the first quarter, with efforts to reflate the economy through fiscal and monetary stimulus helping the S&P 500 Index gain 6.2%. The benchmark Russell Midcap Growth Index declined 0.6% as investors expressed a preference for more attractively priced and cyclical plays over long-duration growth assets. The historic advantage mid cap growth stocks had enjoyed through the depths of the COVID-19 pandemic has evaporated, thanks in large part to the reopening trade that has predominated since “Vaccine Monday” last November. Over the trailing 12 months, the Russell Midcap Value Index is up 73.8%  compared to a gain of 68.6% for the Russell Midcap Growth Index.

From a sector standpoint, real estate (+22.3%) and energy (+19.6%) were the best performers in the benchmark but account for de minimis exposure. Among sectors with broader representation, the cyclical consumer discretionary (+6.8%), materials (+1.1%) and industrials (+0.6%) sectors also outperformed. Meanwhile, the information technology (IT, -3.3%) and communication services (-4.1%) sectors, which thrived in the work-from-home and e-commerce boom during the pandemic, as well as health care (-0.9%) underperformed.

The first quarter brought wild market action and volatility. After robust equity returns during 2020, investor expectations pivoted to a strong U.S. economy during 2021, powered by fiscal stimulus and “easy comps” for a lot of businesses.

As daily temperatures have started to rise due to the arrival of spring, so too has the 10-year Treasury yield. The benchmark yield has moved up 83 basis points since year end and 124 bps off the August 2020 bottom. While those moves are relatively modest compared to past decades, they are meaningful off a low base. They also reflect heightened awareness that costs have risen, in some cases meaningfully (logistics, commodities), as economic recovery continues. Whether an acceleration of inflation back to Federal Reserve targets or beyond is in the offing remains to be seen. Certainly the increase is flattering the economics of select businesses (i.e., yield-curve-sensitive earners, such as some financials) while compressing the valuation on more open-end high-growth businesses.

The ClearBridge Mid Cap Growth Strategy outperformed in the first quarter as our preference for sturdy fundamentals and value-creating management teams provided ballast amid rising speculation in newly public risk assets favored on online message boards. The work our team has done over the
last several quarters to maintain a high-quality, diversified portfolio while paying close attention to risk has contributed to this resilience through the latest market rotation.

 

"Rising prices are flattering the economics of select businesses while compressing the valuation on more open-end high-growth companies."

 

Indicative of our focus on targeting dynamic growth companies across the mid cap universe, the top 10 individual contributors for the first quarter were spread across seven sectors. United Rentals, in the industrials sector, benefited from improving equipment utilization and, as the largest domestic construction equipment rental company, stands to benefit should the Biden Administration’s infrastructure plan advance out of Congress. Information security provider Fortinet, in the IT sector, was another significant contributor as many now remote-based enterprises doing more work in the cloud need enhanced threat protection from data breaches and cyberattacks. The Strategy also saw contributions from the reopening trade through Expedia, in the consumer discretionary sector, as travelers resumed booking vacations, as well as Performance Food Group, in consumer staples, a supplier to the restaurant industry that is starting to find its footing as vaccination progress eases dining restrictions.

We also seek to promote consistent performance by applying discipline and diligence in managing the construction of the portfolio. Fourth-quarter 2020 earnings and 2021 guidance (when provided) have been strong, invariably. We have been parsing which companies have come through the challenges of 2020 much stronger versus those enjoying a cyclical recovery. We trimmed back several of our big winners from 2020 (ServiceNow, MercadoLibre) and have been vetting growth companies with more reasonable valuations.

Portfolio Positioning

We established nine new positions during the quarter, largely financed through trims in existing holdings.

Software continues to play a key role in digital transformation across the economy and we increased our exposure to this area with three names. HubSpot develops marketing automation software and is seeing strong uptake post-pandemic from small businesses that are far behind in digitally enabling their marketing, sales and related processes. HubSpot’s initial marketing product facilitates publishing of content to attract customers and nurture leads, but the company has seen growth accelerate as it makes progress selling a full suite of service and sales products to help with inbound customer support and converting leads. Five9 is a cloud-based contact center as a service software provider that is replacing aging on-premise legacy solutions that dominate the installed base. Companies are being forced to modernize and cloud penetration is still low; Five9 is positioned to benefit and should see further growth driven by its cross-selling add-on modules and an AI product that generates high revenue. Qualtrics is a leading customer experience software vendor that aggregates experience data to allow companies to derive insights and improve experiences for customers. The growing importance of customer experience increases the need for software solutions and Qualtrics is expanding internationally and creating new use cases to focus on employees and brands. 

Compass also falls in the software camp. The real estate technology company and brokerage is disrupting the traditional residential broker market with tools that improve operational efficiency for brokers. Their tools have first-mover advantage in the industry and are attracting top brokers from the best markets, resulting in significant market share gains in a short period of time. 

We added two new positions in health care. Teladoc is a leading play on telemedicine, a hyper growth market with significant opportunity for increases in utilization accelerated by the COVID-19 environment. The company is well-positioned for this evolution in treatment after years of work building out its network of doctors and payors. Its recent merger with Livongo expands the company’s customer base and increases the number of products to cross-sell such as holistic, chronic disease and second opinion services. International expansion is another significant opportunity. Teleflex is a diversified medical device company with leading market share in several low-cost consumable niche categories, creating high-margin recurring revenue streams with steady growth and pricing. Its unique UroLift product has the potential to accelerate growth of the company with its strong positioning as the only minimally invasive product to treat BPH in the prostate gland with no side effects, a treatment area with a large total addressable market. 

New purchase Lyft, the No. 2 U.S. rideshare operator, is exclusively focused on the secular growth opportunity in the rideshare market and stands to be a direct economic reopening beneficiary. The company made tremendous progress on margins during 2020 and improved its ability to meet long-term targets. Lyft is also leveraged to the eventual transition to autonomous driving.

We also participated in two IPOs during the quarter: Petco Health and Wellness, the leading pet retailer in the U.S., and Bumble, which runs a popular social media dating app. Petco is benefiting from the secular trend of higher pet ownership. The company has taken steps to become a multi-channel retailer, combining online sales with traffic driving services to its stores like vet clinics and grooming that should drive above-market growth. Bumble is a women-first dating app founded in 2014 and is the second-highest grossing dating app globally. The company will benefit from a near doubling of industry spend in the next five years plus company-specific initiatives in international expansion, improved app payer conversion and higher average revenue per user premium tier upgrades.

The Strategy closed out of insurer Progressive after recent appreciation moved it out of our mid cap range. We also exited biotechnology firm BioMarin Pharmaceutical after a number of its clinical catalysts had played out, while RealPage, a provider of software to the residential rental market, was sold ahead of its acquisition by private equity firm Thoma Bravo.

Outlook

The changes in Washington have brought a return to more normal policymaking at an overall lower decibel count but with a greater penchant for opening the fiscal purse strings. The $1.9 trillion American Rescue Plan combined with speculated multi-trillion policy initiatives for infrastructure and green spending has caused concern about high deficits, in turn starting the conversation on corporate and individual tax increases. As legendary Illinois Republican Senator Everett Dirksen (apocryphally) once stated, “a billion here, a billion there and pretty soon you’re talking real money.”

Tightening monetary conditions (due to higher interest rates) and eventual tax increases are eventually contractionary. Of course there’s a short-term offset from the present fiscal spending. These evolving policy arcs and the supporting tactics to finance them (i.e., drug pricing) bear watching and may well cap equity returns until better defined.

The bottom-up fundamental work we have completed on target mid cap growth companies, with the support of our analysts, helps us identify which stocks and sectors are getting expensive, which other areas are more attractive and where we should be participating. We believe this bottom-up approach positions us for whatever policy regime is in the offing, balancing exposure to above-average and underappreciated growers and providing access to companies operating in large addressable markets. 

Portfolio Highlights

During the first quarter, the ClearBridge Mid Cap Growth Strategy outperformed the benchmark Russell Midcap Growth Index. On an absolute basis, the Strategy had gains across nine of the 10 sectors in which it was invested during the quarter (out of 11 sectors total), with the consumer discretionary, health care and communication services sectors the leading contributors.

In relative terms, outperformance was primarily driven by stock selection. Specifically, stock selection in the communication services, health care, IT, industrials, consumer staples and financials sectors and an overweight to the consumer discretionary sector drove results. Conversely, stock selection in the real estate sector detracted from relative performance.

The leading contributors to absolute returns during the first quarter included United Rentals, Fortinet, Expedia, Pinterest and Burlington Stores. Positions in Splunk, Copart, Datadog, Atlassian and CoStar Group were the greatest detractors from absolute returns.

In addition to the portfolio activity mentioned above, we closed a position in DoorDash in the consumer discretionary sector.

Brian Angerame

Portfolio Manager
27 Years experience
21 Years at ClearBridge

Aram Green

Portfolio Manager
20 Years experience
15 Years at ClearBridge

Matthew Lilling, CFA

Portfolio Manager
15 Years experience
11 Years at ClearBridge

Jeffrey Russell, CFA

Portfolio Manager
40 Years experience
31 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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