Clearbridge Small Cap Progress Technique Q1 2022 Commentary
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Small cap growth stocks struggled in the back half of 2021 and into 2022 as the prospects of reduced fiscal stimulus and monetary tightening were at hand. Cost and price inflation had become embedded in the US economy; the Federal Reserve’s narrative of “transitory” inflation proved incorrect partially due to the persistence of supply chain interruptions from COVID-19. The Omicron spike was an especially formidable challenge for business continuity and profitability.
Russia opened attack on Ukraine on February 24, triggering death and destruction, a humanitarian crisis and forces that threatened to engulf the superpowers. Markets headed lower until late March, when some speculation of a negotiated settlement to the war was mooted. While the NATO allies did not put “boots on the ground” in Ukraine, the torrent of sanctions, penalties and disrupted trade flows has caused significant shocks to the “world economic order” of the past many decades. Oil was one of many essential commodities to skyrocket in price.
Small cap growth stocks in the Russell 2000 Growth Index declined 12.63% as a result of the coalescence of these forces, entering “bear market territory” during the first quarter. The Russell 2000 index declined 7.53%, underperforming the larger capitalization market. Value indices continued to outperform growth indices given the multiple compression from higher interest rates and economic deceleration.
Innovation was out of vogue this quarter as investors had limited appetite for higher growth companies during this period of portfolio de-risking. The initial public offering market essentially ground to a halt after excessive supply in 2021.
On a sector basis, energy gained 36.92% and was the only sector in the black during a risk-off quarter. Other sectors that held up better than the benchmark included materials (-0.30%), industrials (-9.11%), consumer staples (-10.23%), utilities (-10.26%) and communication services (-11.68%). Consumer discretionary (-18.81%), information technology (IT, -14.98%), health care (-14.95%), financials (-13.79%) and real estate (-13.01%) underperformed for the quarter.
The weakness in traditional growth sectors, such as IT and consumer discretionary, reflects the rotation out of growth stocks. An aversion to the risky biotech industry hurts the health care sector but was beneficial for the ClearBridge Small Cap Growth Strategy due to its limited exposure.
Nevertheless, we are dissatisfied that the strategy underperformed its Russell 2000 Growth benchmark this quarter, declining over 14%. During a sharp downward move of prices, the strategy usually holds up better than the index. That proved not to be the case as many of our stellar stock performers during 2021 faced “tough comps” heading into 2022 and underperformed. Examples include Trex (TREX), Fox Factory (FOXF) and Trupanion (TRUP).
We eliminated six stocks during the quarter to keep the portfolio focused on companies where we have the highest conviction and manage risk through what could be an extended period of macro and business uncertainty. Invitae (NVTA) in the health care sector, Monro (MNRO) and Poshmark (POSH) in the consumer discretionary sector, Redfin (RDFN) in the real estate sector and Yext (YEXT) in the IT sector were sold for a variety of fundamental reasons, while Vocera Communications in the health care sector was acquired by Stryker (SYK).
We added two new investments, STAAR Surgical (STAA) in the health care sector, which received FDA approval for its implantable lens for myopia correction at quarter end, and Xometry (XMTR), in the consumer discretionary sector, a marketplace for buyers and sellers of manufacturing services.
We have many more questions than answers about the long-term implications of the Russian invasion and subsequent sanctions.
There is much supposition how the war will be resolved, but only time will tell when investors will begin to fully account for its impact and implications on economic growth. Companies have had to scramble to assure continuity of supply, to rethink manufacturing and service economy footprints and adjust safe inventory levels, with war-related economic sanctions adding to the uncertainties sparked by the pandemic.
Rather than make projections on which of many macro scenarios may play out, we can do best by our investors by maintaining the quality bias of a concentrated portfolio that offers exposure to a variety of growth opportunities. We continually examine the durability and magnitude of growth and returns by assessing the opportunity set and competitive advantage of each holding.
During the first quarter, the ClearBridge Small Cap Growth Strategy underperformed its Russell 2000 Growth benchmark. On an absolute basis, the strategy had losses across eight of the 10 sectors in which it was invested during the quarter (out of 11 sectors total), with the industrials, health care and IT sectors the primary detractors, while the energy sector was the primary contributor.
In relative terms, overall stock selection detracted from performance. Specifically, stock selection in the industrials sector was the primary headwind to returns. Selection in the financials, communication services, consumer discretionary and materials sectors and an underweight to the materials sector were also detrimental. On the positive side, stock selection in the IT, consumer staples and health care sectors and an underweight to consumer discretionary contributed to relative performance.
The leading contributors to absolute returns during the first quarter included Cactus (WHD), Vocera Communications, Pacira Biosciences (PCRX), Bloom Energy (BE) and Chegg (CHGG). Meanwhile, Trex, Fox Factory, Western Alliance Bancorp (WAL), Penumbra (PEN) and Trupanion were the greatest detractors from absolute returns.
Editor’s note: The summary bullets for this article were chosen by Seeking Alpha editors.