Small cap stocks had a rough ride during the first quarter, as increases in market volatility and investor uncertainty from major macro catalysts weighed on performance. However, the Strategy’s focus on high-quality companies and flexible active management helped it to outperform the Russell 2000 Index, which fell 7.53% compared to the Strategy’s decline of 3.66%. We continued to see the rotation in investor preference for value drive the difference between the Russell 2000 Value index, which returned -2.40% but outperformed the Russell 2000 Growth index, which returned - 12.63%. The Russell 2000 Value Index has now outperformed the Russell 2000 Growth Index by over 1,750 basis points over the last 12 months but is still making up ground compared to the head- start growth has had over the last 12 years.
From 2000 to 2010, small cap stocks saw a much more moderate annual appreciation that favored growth over value. That was an unusual period, with markets subjected to events of the dot-com bubble and the Great Financial Crisis (GFC). However, the last 12 years have also been unusual, with markets experiencing highly stimulative monetary policy and very stimulative fiscal policy, first as a response to the GFC and, more recently, COVID-19. Prior to 2008, the 10-year Treasury rate essentially never broke 4% and the federal-funds rate rarely dipped below 3%. In contrast, since 2008 the 10-year rate has averaged 2.3% and federal-funds rate 0.5%.
We view this unusually low cost of capital as one, if not the, primary reason equity markets have experienced this incredible run. The relative unattractiveness of returns on cash and fixed income securities spurred investors to seek out higher returns in growth stocks, venture capital, private equity, etc. Investing styles based around long-term improvements in fundamentals and returning capital to shareholders via dividends took a back seat to the quest for growth because of minimal reinvestment opportunities outside of equities. This search for higher returns also devolved into investor speculation in non-productive assets, such as cryptocurrencies or non-fungible tokens, hoping someone would pay a higher price for those assets in the future. In retrospect, we find it unsurprising that 12 years of access to cheap and abundant capital would lead to a lot of unproductive investments.
This period appears to be coming to an end. The sharp rise of inflation over the past year has catalyzed the Fed to respond and initiate a rate hiking cycle that is ratcheting up the cost of capital. The result is that the cost of holding assets that generate no yield — such as commodities, pseudo-currencies and highly ambitious but low-quality growth stocks — is rising. We believe that this dynamic, reflected in investor fears that 10-year rates may again rise to 3% or 4%, has only just begun. If this is indeed the case, it will likely become less popular for public companies to chase growth potential at the expense of profitability.
While companies with immature business models and no profits exist throughout the market, there are certain sectors where they congregate more easily, such as health care. As access to cheap capital recedes, however, many of these specialty drug and biotech companies will likely find it challenging to dismiss long periods of unprofitability. While we have had limited exposure in the sector, our focus on finding high-quality companies at attractive valuations has yielded positive results. For example, Lantheus Holdings (LNTH) is a global leader in medical diagnostic imaging whose core business suffered during the COVID-19 pandemic due to a dramatic decline in hospital visits. As hospitals return to a level of normalcy, Lantheus’s core business has rebounded. Additionally, in late 2021 the company received approval for its new radio-pharmacological drug, Pylarify, for the treatment of prostate cancer, and initial sales have been well ahead of expectations. We believe it has a strong future in oncology diagnosis and treatment. As a result, Lantheus was our strongest individual performer for the first quarter.
However, this transition to a higher cost of capital has not been universally beneficial. Our biggest detractor in the quarter was Century Communities (CCS), a home builder whose stock price was subjected to inflation from labor and raw materials as well as concerns over whether the strong current demand for homes will persist as mortgage rates rise. While inflation is certainly a concern, the fact that home prices are at historic highs affords homebuilders the latitude to pass these increases through to homebuyers. We also believe demand from those looking to buy a home and obtain a mortgage will continue to persist despite rising rates, especially as inflation results in rising rents. We believe the housing cycle is far from over and have strong conviction in Century Communities.
We continue to be active in refining our portfolio positioning as we navigate through these periods of heightened uncertainty and volatility. Our charge of constructing a portfolio of high-quality companies at attractive valuations to achieve the strongest risk- return profile is a never-ending process, and we remain vigilant in searching for outstanding value. To that end, we made a number of adjustments during the quarter to better reflect where we see the greatest opportunities.
We initiated a new position in Sunnova (NOVA), in the energy sector. Sunnova is a residential solar and energy storage company that enables adoption through a network of installers with options for financing, service and broader home energy management. Rising interest rates and solar energy supply constraints weighed on the stock’s performance in the fourth quarter of 2021 but created a compelling valuation opportunity to buy this business when the market was embedding low growth expectations. We believe Sunnova will deliver value accretive growth for a much longer time, with its downside limited by the long-term, fixed-rate, high- quality contracts it has with customers.
We also initiated a new position in WSFS Financial (WSFS), in the financials sector. A savings and loan company, WSFS Financial provides various banking services including savings accounts, loans and consumer credit products. The company has made several acquisitions in recent years that have brought it into higher growth markets such as Washington DC and provided good cost savings. We believe it is well-positioned to maintain good loan growth, despite interest rate headwinds.
We exited our position in Switch, in the information technology (IT) sector, after it reached our valuation objective. The stock has re-rated significantly in the past two years, as the company announced it is considering converting to a REIT. While we believe it remains a top-tier data center operator, we believe its current valuation reflects that profile.
We believe we are at the precipice of significant shifts in long- term market trends. The process of ending a decade of cheap and available capital has begun, creating headwinds that pose a challenging appreciation period for the market as a whole. In the face of such uncertainty, our foundation of using fundamental analysis to invest in high-quality companies should leave us well-positioned to persevere through these challenges.
We have strong conviction in our portfolio companies and positioning, and we believe that rising rates and the shifting trends we currently see in the market will work to our advantage to find even greater opportunities.
The ClearBridge Small Cap Strategy outperformed its Russell 2000 Index benchmark during the first quarter. On an absolute basis, the Strategy had losses across six of the 11 sectors in which it was invested during the quarter. The leading detractors were the consumer discretionary, IT and financials sectors, while the leading contributors were the energy and health care sectors.
On a relative basis, overall stock selection and sector allocation contributed to performance. Specifically, stock selection in the health care, industrials, financials and real estate sectors and underweight allocations to the health care and IT sectors contributed to returns. Conversely, stock selection in and an overweight allocation to the consumer discretionary sector detracted.
On an individual stock basis, the biggest contributors to absolute returns in the quarter were Lantheus, HealthEquity (HQY), CNX Resources (CNX), Helmerich & Payne (HP) and Assured Guaranty (AGO). The largest detractors from absolute returns were Century Communities, 2U (TWOU), Goodyear Tire & Rubber (GT), Solo Brands (DTC) and SMART Global (SGH).
In addition to the transactions listed above, we initiated a position in HF Sinclair (DINO) in the energy sector, Itron (ITRI) in the IT sector, Group 1 Automotive (GPI) in the consumer discretionary sector and NovoCure (NVCR) and Ultragenyx Pharmaceutical (RARE) in the health care sector. We also exited positions in CSG Systems (CSGS) in the IT sector, 2U and Frontdoor (FTDR) in the consumer discretionary sector, International Seaways (INSW) in the energy sector, Covetrus (CVET) in the health care sector and Honest (HNST) in the consumer staples sector.
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Additional disclosure: Past performance is no guarantee of future results. Copyright © 2022 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 portfolio management team named above and may differ from other 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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Performance source: Internal. Benchmark source: Standard & Poor’s.