ClearBridge Small Cap Value Strategy Q1 2024 Portfolio Manager Commentary

By Albert Grosman & Brian Lund, CFA

Picking the Right Odds, Not the Right Horse

Market Overview

Spotting a secular trend and identifying the winners, as many small cap investors are trying to do with AI- and bitcoin-related beneficiaries, is a time-honored investment strategy that has made investors a lot of money but has also failed spectacularly depending on the valuation. People mostly remember the 2000 dot-com bubble as being marked by silly business models like Pets.com and Webvan, but there were also major secular themes in play around rising internet traffic increasing demand for fiber optics, networking equipment, web hosting, etc., supporting companies like JDS Uniphase, Level 3 Communications, Global Crossing, Lucent, Nortel, Cisco (CSCO) and EMC. This thesis was entirely correct, but the stocks drastically failed if you bought them near the top. Only one of those companies still remains, Cisco, and it still hasn’t gotten back to its 2000 highs. For many of the others, the problem wasn’t the theme but the lack of competitive advantage necessary to produce long-term excess returns.

Another theme of that era was mobile telephony. Qualcomm (QCOM) soared over 2,600% in 1999 on a very similar premise as Nvidia (NVDA) is seeing now — it was the brains behind the secular trend, so whoever won, Qualcomm would participate. The theme was spot on, the company was perfectly positioned, and it went on to perform massively well. From 1999 to 2023, Qualcomm’s sales rose more than 9x and EBITDA 12x, very impressive long-term growth rates. Investors who held the stock during that period, however, received a total return of only 154%, underperforming the 410% return of the S&P 500 Index.

This reminds us of a quote from famous horserace handicapper Steven Crist:

“This is the way we all have been conditioned to think: Find the winner, then bet. Know your horses and the money will take care of itself…. The problem is that we’re asking the wrong question. The issue is not which horse in the race is the most likely winner, but which horse or horses are offering odds that exceed their actual chances of victory. This may sound elementary, and many players may think they are following this principle, but few actually do. Under this mindset, everything but the odds fades from view. There is no such thing as ‘liking’ a horse to win a race, only an attractive discrepancy between his chances and his price.”¹

Rather than chase short-term outperformers, we continue to pursue investments where the potential future free cash flow valuation suggests fair value in excess of the current market price.

For the Strategy in the quarter, stock selection in the IT sector was the largest contributor to relative performance. Electronic memory and LED manufacturer SMART Global (SGH) proved our second-best-performing holding, rebounding from a disappointing fourth quarter. Contrary to the lowered expectations that management had previously guided to for its high-performance computing business, SMART Global saw accelerated demand beyond what both management and the market had previously anticipated, leading to improved margins and unexpectedly higher quarterly earnings. Likewise, network solutions company Itron (ITRI) was also rewarded for strong quarterly results and issuing 2024 guidance above market estimates. The company appears to have largely shrugged off the supply chain issues that have weighed on past performance and looks to continue to improve its margins by closing two weaker-margin factories this year and announcing several new partnerships to support growth in both its software and network segments.

“We continue to pursue investments where the future free cash flow valuation suggests fair value in excess of the current market price.”

Rising energy prices helped to support the performance of exploration and production (E&P) companies Magnolia Oil and Gas (MGY) and Matador Resources (MTDR) and increased demand for energy equipment services, lifting companies like Atlas Energy Solutions (AESI). We continue to have high conviction in Magnolia and Matador due to their strong and demonstrated ability to generate incremental returns on investment capital. Meanwhile Atlas continues to benefit from being the premier lowest-cost producer of materials needed by E&Ps in the Permian Basin. Building on its already strong distribution network and proprietary technology, Atlas’s recent announcement of its intention to acquire competitor Hi-Crush will make it the largest producer in the country of proppant, a material mixed with fracturing fluid for shale production, and solidify its position as a premier industry logistics provider. Expanding its product volume while maintaining its current fixed cost structure should support long-term returns.

Our top individual performer for the quarter was Eagle Materials (EXP), which manufacturers a range of construction materials including cement, gypsum wallboard and recycled paperboard. The stock extended its gains on a more optimistic economic outlook and after it exceeded quarterly expectations on both revenue and earnings. We believe the company’s continued strong pricing power in its cement business and cost advantages versus its peers in its wallboard business should allow it to continue to maintain attractive returns on capital.

Stock selection in the health care sector was the main detractor during the period. QuidelOrtho (QDEL), a leading provider of in vitro diagnostic solutions for a wide range of diseases and health conditions, saw its share price retreat after another weak quarter and disappointing 2024 guidance due to further declines in the high-margin respiratory business and the recent dismissal of its CEO. While these catalysts have spurred a review of our investment case for QuidelOrtho, we continue to see its base labs business providing strong and steady free cash flow. AMN Healthcare Services, which provides health care workforce solutions, also detracted. The downturn in outsourced medical professionals continues as many hospitals focus on full-time hiring. Despite these headwinds, we continue to own the company as our thesis for long-term demand for health care professionals remains intact.

Portfolio Positioning

After a particularly active fourth quarter, we entered the first quarter of 2024 satisfied with our positioning and chose to be selective in taking advantage of some of the evolving opportunities in the market.

We initiated a new position in Corcept Therapeutics (CORT), which is engaged in the discovery and development of drugs used to treat severe endocrinologic, oncologic, metabolic and neurologic disorders in the U.S. Since 2012, Corcept’s Korlym treatment of Cushing’s Syndrome has benefited form market exclusivity. Despite sales rising to $482 million in 2023, Korlym has since encountered generic competition. However, management believes they will not see a decline in revenue, as the rare nature of the disease and specialty distribution channels make it difficult for a pharmacy to swap out the brand name for the generic. In addition, Corcept has a next-generation drug with fewer side effects than Korlym, which should increase its available market. We believe the new drug’s Phase 3 trial results, due very soon, will show approvable efficacy and safety, as well as possible extension into other indications.

We exited our position in Sterling Check (STER), in the industrials sector, which specializes in technology-enabled background and identity verification services. The company announced its intention to be acquired by rival First Advantage (FA) and, given the regulatory risks involved and limited likelihood of a competing offer for the company, we elected to sell the position.

Outlook

Despite investor enthusiasm over the IT hardware renaissance, we believe that the market’s clamoring over such a narrow subset of stocks creates risks for those following the trend but opportunities elsewhere. Rather than chasing market trends, we continue to seek companies with strong balance sheets and attractive cash flows that are trading at compelling valuations. We believe serving the best interest of our investors over the long-term means avoiding risking capital on things that could just as quickly fall out of favor in this tumultuous market environment.

Portfolio Highlights

The ClearBridge Small Cap Value Strategy outperformed its Russell 2000 Value Index benchmark during the first quarter. On an absolute basis, the Strategy had gains across seven of the 11 sectors in which it was invested during the quarter. The leading contributors were the energy and industrials sectors, while the greatest detractors were the communication services and real estate sectors.

On a relative basis, overall stock selection positively contributed to performance, while sector allocation effects detracted. Specifically, stock selection in the IT, materials, financials and energy sectors proved beneficial. Conversely, stock selection in the health care, consumer discretionary and industrials sectors and an underweight allocation to the health care sector weighed on performance.

On an individual stock basis, the biggest contributors to absolute returns in the quarter were Eagle Materials, SMART Global, Primoris Services (PRIM), Magnolia Oil & Gas and Itron. The largest detractors were Forward Air 9fwrd), QuidelOrtho, Independent Bank (INDB), Gray Television (GTN) and NCR Voyix (VYX).

Albert Grosman, Managing Director, Portfolio Manager

Brian Lund, CFA, Managing Director, Portfolio Manager

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Editor’s Note: The summary bullets for this article were chosen by Seeking Alpha editors.