By Aram Green & Jeffrey Russell, CFA
Progress on Obesity Weighs on Health Care Names
The third quarter was marked by elevated macro influences on portfolio performance. While short-term risk-free rates inched higher, the 10-year U.S. Treasury yield increased 74 basis points, a notable headwind for smaller cap growth stocks. The benchmark Russell 2000 Growth Index declined 7.32% during the quarter, more than double the 3.13% decline of the large cap Russell 1000 Growth Index. Losses were widespread across the small cap growth market, with just two of the 11 sectors in the benchmark (energy and financials) managing gains for the quarter.
Concerns about U.S. consumer spending swelled as 1) oil and gasoline prices increased materially during the quarter, 2) the college student debt holiday ended September 1 and 3) the bolus of COVID consumer savings dwindled. Anxiety about a narrowly averted Federal government shutdown and Congressional inaction grew over the course of the quarter. Company guidance during the second-quarter earnings season was appropriately guarded given the extant uncertainties.
The Strategy underperformed the benchmark, mostly due to weakness in the health care sector. The early August revelation that the GLP-1 diabetes and obesity treatment semaglutide has potentially important cardiovascular benefits led to pervasive selling of a plethora of medical technology stocks. While the longer-term implication was most pointedly felt among diabetes stocks, which could suffer from reduced medical device utilization, reverberations were felt across the gamut of cardiovascular, orthopedic and surgery-related stocks. Directly influenced health care laggards in the portfolio included Surgery Partners and Insulet, while Penumbra (reversing gains from earlier in the year), Silk Road and Omnicell were also notable detractors.
Another significant detractor was freight company Forward Air, whose decision to propose a complex and financially leveraged transaction led to a sharp drawdown in the stock. We have since trimmed the position.
We began eight investments this quarter, including Klaviyo, which made the transition from a private placement in the Strategy through the initial public offering process. We intend to augment these initial investments and build positions, provided company execution and market prospects remain vibrant.
Klaviyo is a founder-led software and database platform that provides marketing automation solutions primarily to smaller e-commerce customers. Leveraging a tight integration with e-commerce enablement provider Shopify and a disruptive technology architecture, Klaviyo has experienced rapid growth in a sizable core market, with opportunities to add additional products and customer groups, including the fitness/wellness market, and to expand internationally. Throughout its history, Klaviyo has managed to balance a robust growth rate with disciplined investment and has a path to meaningful long-term profitability.
Also in information technology (IT), we added nCino, another founder-led, modern banking cloud platform for commercial lending management. With a sticky, vertical software-as-a-service model, the company has increased its potential customer base by expanding into retail, mortgage and international markets. We believe the company is well-positioned to expand margins and re-accelerate sales as the backdrop for its banking customers normalizes after the regional banking crisis.
New addition McGrath RentCorp is a scaled operator in the attractive modular office and portable storage market. The company can follow industry leader Willscot Mobile Mini’s strategies in price leadership, value-added products/services, delivery/installation profitability improvements and accretive capital allocation in rolling up smaller players. McGrath generates about 70% of operating earnings from modular space rental and 30% from its electronic test equipment rental portfolio.
We also made an investment in Lantheus, which offers a portfolio of diagnostic health care products, primarily serving the complex nuclear imaging market. The company also has a pipeline of disruptive nuclear therapeutics (radiopharmaceuticals), creating a unique combination of strong profitability and cash flow generation with attractive growth opportunities in pipeline and existing products. The operational and logistical challenges of operating in nuclear medicine provide Lantheus a durable moat in this emerging therapeutic market.
The Strategy had two investments which were the subject of takeovers this quarter. We trimmed our position in fixed annuity provider American Equity Life after it agreed to be acquired by Brookfield Reinsurance and exited application platform software provider New Relic after it agreed to be acquired by a consortium of private equity sponsors. Syneos Health, the target of a previously announced private equity acquisition, also exited the Strategy. In addition, we continued to reduce or eliminate positions which have increased in capitalization, including marketing automation software provider HubSpot.
The ClearBridge Small Cap Growth Strategy remains committed to the guiding principles that have also informed our investment process and philosophy. We will continue to exercise “judgment and patience” to ensure that we have 1) the right balance of opportunity and risk in the Strategy and 2) appropriately capitalized investments with substantial intermediate to long-term growth opportunities.
The ClearBridge Small Cap Growth Strategy underperformed its benchmark in the third quarter. On an absolute basis, the Strategy posted gains across three of the nine sectors in which it was invested (out of 11 sectors total). The primary contributors to performance were the energy and consumer staples sectors, while the health care sector was the main detractor.
Relative to the benchmark, overall stock selection detracted from performance. In particular, stock selection in the health care, communication services and consumer discretionary sectors had the most negative impact on results. On the positive side, stock selection in the consumer staples and IT sectors and an overweight to consumer staples contributed to performance.
On an individual stock basis, the leading absolute contributors were positions in BJ’s Wholesale Club, New Relic, Casey’s General Stores, XPO and Cactus. The primary detractors were Penumbra, Surgery Partners, Allegro Microsystems, Forward Air and Iridium Communications.
In addition to the investments mentioned above, we initiated positions in Moog in the industrials sector, NMI Holdings in the financials sector, Novanta in the IT sector and Oddity Tech in the consumer staples sector.
Aram Green, Managing Director, Portfolio Manager
Jeffrey Russell, CFA, Managing Director, Portfolio Manager
Past performance is no guarantee of future results. Copyright © 2023 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.
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