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By Brian Angerame, Jeffrey Bailin, CFA, Aram Green & Matthew Lilling, CFA
SMID Playing Catch Up in Growth Rally
Market Overview
Equity markets rallied in the first quarter as resilient corporate earnings, continued enthusiasm over artificial intelligence (‘AI’) and the prospect of interest rate cuts spurred performance that surprised even the most optimistic investors. The Russell 1000 Index returned 10.30%, which continued its streak of outperforming SMID stocks as the Russell 2500 Index returned 6.92%. Growth stocks outperformed their value counterparts, with the benchmark Russell 2500 Growth Index returning 8.51% versus the 6.07% return of the Russell 2500 Value Index.
After a choppy four years, where stock performance was largely beholden to macro factors like supply chain problems, hyperinflation and a rapid rise in interest rates, we believe equities are finally showing signs of transitioning back to a more normal environment that favors fundamentals. Despite some profit taking early in the quarter, strong economic data and investor enthusiasm for AI helped to calcify investors’ outlook for an economic soft landing and policymakers’ anticipation of rate cuts in 2024.
While large cap benchmarks get a lot of attention for a handful of mega cap stocks driving the lion’s share of performance, we would highlight even more extreme and unprecedented concentration in small cap benchmarks. Super Micro Computer (SMCI) and MicroStrategy (MSTR), a unique stock that is largely considered a bitcoin proxy, together accounted for 27.4% of the benchmark’s first-quarter return.
Currently SMCI is the largest constituent by weight in our benchmark and, at above 2%, represents the largest individual benchmark security weight since inception of the SMID Cap Growth Strategy. We are hard pressed to recall another instance where the largest constituent of our benchmark was also added to the S&P 500 Index (SP500, SPX), as SMCI was this March. We would note that SMCI was a $61 billion market capitalization company at the end of the first quarter and MicroStrategy boasted a market capitalization of $28 billion, both well above the $12.48 billion weighted average market cap of the Strategy.
“Enthusiasm for AI and bitcoin have fueled atypical concentration and performance distortion.”
Enthusiasm for AI and bitcoin have fueled this atypical concentration and performance distortion. Bitcoin rallied fast and furiously following the SEC’s approval of the first bitcoin ETF in early January, while the AI infrastructure build-out has had a narrow set of beneficiaries.
Against this backdrop, the ClearBridge SMID Cap Growth Strategy underperformed its benchmark. We are disappointed by this result, although a substantial amount of the relative underperformance was due to not owning these two large benchmark holdings, which have fundamental and governance factors that have caused us, as long-term investors focused on quality sustainable growth stories, to avoid them.
Several of our other IT holdings faced idiosyncratic headwinds during the period, resulting in three of our five worst-performing holdings being from the sector. This included security platform operator Dynatrace (DT), whose stock price slid despite beating third-quarter earnings estimates as management guided full-year annual recurring revenue lower due to larger and more complex deals taking longer to close. Software development company Freshworks (FRSH), whose products include customer service, operations and customer relationship management applications, also saw its share price drift lower as investors began to worry that Freshworks was no longer an AI beneficiary, though we don’t believe this to be the case.
Performance in the materials sector was the leading contributor to relative performance, led by our investment in construction materials supplier Summit Materials (SUM). Summit benefited from strong pricing, better synergies than expected from its Argos Cement acquisition, and the promise of improved volumes from a rebound in housing and federal infrastructure spending.
Stock selection in the industrials sector was also a positive contributor to performance, led by Vertiv (VRT) and XPO. Vertiv, a global manufacturer of power, precision cooling and infrastructure management systems for mainframe computer, server racks and critical process systems, rallied on continued demand for AI-related companies and beneficiaries and anticipation of greater demand for data center systems. XPO provides freight transportation services in the U.S. and Europe through its less-than-truckload (‘LTL’) services. The company saw its share price jump after fourth-quarter performance and earnings came in solidly above market expectations due to higher sales, and continued improvement in operating margins.
Portfolio Positioning
We initiated a new position in Viking Therapeutics (VKTX), a clinical-stage biopharmaceutical company focusing on novel therapies for metabolic and endocrine disorders. While still early stage, the company has had positive Phase 2 data on a GLP-1/GIP agonist injectable candidate potentially differentiated in mechanism with encouraging results relative to existing approved/pipeline candidates. The company is also pursuing an oral obesity GLP-1/GIP treatment and has a Phase 2 compound to treat nonalcoholic fatty liver disease, or NASH. Given the strong growth potential in the obesity market, multiple potential products and scarcity value in the small cap universe, we believe this is an attractive potential opportunity with sufficient capital to support near-term clinical development goals.
We also added a new position in CONMED (CNMD), also in the health care sector, which is a medical device provider focusing on the orthopedic and general surgery categories. We believe the business is balanced globally with over 80% of revenues coming from single-use products and a large breadth of established stock keeping units. With a handful of particularly high-growth products that remain early in their penetration and competitively differentiated, we believe CONMED can drive above-sector-average growth while seeing steady margin expansion from mix shifts.
We exited a position in Maximus (MMS), in the industrials sector, which operates as a provider of government services in the U.S. and internationally. Given our concerns over difficult earnings comparisons expected in fiscal 2024 after the resumption of Medicaid determinations, disruption from a potential change in presidential administration, and new uncertainties over potential AI disruption to its services over the next 10 years, we made the decision to sell the position.
Outlook
Through the first quarter, we have seen signs of optimism with continued spending on innovation, particularly in growth areas like AI and health care. At a macro level, indicators offer crosscurrents with stickier elements of inflation and a still-hot labor environment balanced by more encouraging trends in other areas of the economy. Rate cuts from the Fed are expected this year with a possibility of policymakers navigating a soft landing. While acknowledging the increasing likelihood of such a scenario, we are mindful of government dysfunction, a looming contentious election cycle and geopolitical tensions, all of which could disrupt current optimism.
As capital markets reopen, we anticipate increased IPO activity to be a source of new investments for the first time since 2021. We continue to target SMID growth companies with the capital to foster high-return R&D innovation spending that can enable them to disrupt markets, take share and compound growth for multiple years through any economic environment.
Portfolio Highlights
The ClearBridge SMID Cap Growth Strategy underperformed its Russell 2500 Growth Index benchmark during the first quarter. On an absolute basis, the Strategy had gains across eight of the 10 sectors in which it was invested during the quarter (out of 11 sectors total). The leading contributors were the industrials and health care sectors, while the real estate and IT sectors were the detractors.
On a relative basis, overall stock selection detracted from performance while sector allocation contributed. Specifically, stock selection in the IT and real estate sectors weighed on performance. Conversely, stock selection in the materials, communication services, energy and industrials sectors benefited performance.
On an individual stock basis, the biggest contributors to absolute returns in the quarter were Vertiv, Wingstop (WING), XPO, Shockwave Medical (SWAV) and TREX. The largest detractors from absolute returns were Five Below (FIVE), Dynatrace, Freshworks, Smartsheet (SMAR) and Insulet (PODD).
In addition to the transactions mentioned above, we initiated new positions in e.l.f. Beauty (ELF) in the consumer staples sector, CyberArk (CYBR) in the IT sector as well as Roivant Sciences (ROIV) and Insmed (INSM) in the health care sector. We exited positions in Omnicell (OMCL), Karuna Therapeutics and Integra Lifesciences (IART) in the health care sector, Masonite International (DOOR) in the industrials sector and Topgolf Callaway Brands (MODG) in the consumer discretionary sector.
Brian Angerame, Portfolio Manager
Jeffrey Bailin, CFA, Director, Portfolio Manager
Aram Green, Managing Director, Portfolio Manager
Matthew Lilling, CFA, Portfolio Manager
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Past performance is no guarantee of future results. Copyright © 2024 ClearBridge Investments. 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. Performance source: Internal. Benchmark source: Russell Investments. Frank Russell Company (“Russell”) is the source and owner of the trademarks, service marks and copyrights related to the Russell Indexes. Russell® is a trademark of Frank Russell Company. Neither Russell nor its licensors accept any liability for any errors or omissions in the Russell Indexes and/or Russell ratings or underlying data and no party may rely on any Russell Indexes and/or Russell ratings and/or underlying data contained in this communication. No further distribution of Russell Data is permitted without Russell’s express written consent. Russell does not promote, sponsor or endorse the content of this communication. |
Editor’s Note: The summary bullets for this article were chosen by Seeking Alpha editors.
