The headline for the second quarter of 2022 was the stock market and the Federal Reserve began to take inflation seriously. For the Fed, the implications were clear: it needs to raise interest rates. The market, however, doesn’t have a straightforward course of action. The initial response in April and May was to push the Russell 2000 Growth index down more than the Russell 2000 Value Index. Higher inflation means higher discount rates, so that cash flows farther out in the future are worth less than they were when rates were low.
In June, however, growth outperformed value, as cyclical sectors like energy and materials began to price in a recession and defensive sectors like health care and utilities became relative safe havens. Which can investors expect for the foreseeable future — higher discount rates favoring value stocks, or higher recession risks favoring growth stocks?
While the standard answer — no one knows — certainly applies, perhaps a more satisfying answer is the odds are not even; one side of this trade earns a much higher return than the other. Rather than seeking to predict the future, our investment process gauges the impact of various scenarios on a company’s valuation and determines if the odds of a specific scenario have been misapplied toward one direction or another. Currently, the odds that inflation will continue above trend and that discount rates, including both the risk-free rate and equity risk premium, will be higher are quite high.
Although issues with global supply chains may begin to resolve themselves and the demand for labor may moderate alongside wage increases, inflationary forces are largely still in place. The labor market remains hot, oil prices are still elevated and inventories for big-ticket items such as autos and houses are depleted. These trends have a long way to go before the Fed will stop raising rates and/or profits at cyclical companies are seriously damaged.
Valuations, though, are tilted strongly toward a recession. While growth valuations have come off their 2021 extremes, they remain historically high. The enterprise value/sales ratio for the Russell 2000 Growth Index is above its long-term average, despite the huge number of IPOs and SPACs that went public in the past couple of years pushing the number of unprofitable companies in the index above 35%. Many of these growth companies, especially in biotechnology and IT, have very few physical assets and will need further funding from the capital markets over the next few years, catalysts that hurt valuations in an inflationary environment.
Cyclical stocks, on the other hand, often own hard assets that are appreciating in value (like land on a homebuilder’s balance sheet, which is worth much more today than when it was put on the books two or three years ago), are generating lots of cash and have low-cost debt that can be more easily repaid given inflation’s reduction in the dollar’s value.
Yet small cap homebuilders are trading below tangible book value despite finished inventory being completely sold out and gross margins being higher than ever, meaning the market thinks that not only is the value of their landholdings worth less than their book value, but also that the companies’ future operations will destroy value. The same is true for energy companies, currently trading at low-single-digit P/Es despite oil prices hovering around $100, a level much higher than most need to remain profitable.
People tend to react to data rather than analyze it. They see the odds of a recession rising and think, “I have to run the recession playbook.” These reactions often ignore current conditions (already high growth valuations relative to value) as well as the odds of that outcome happening. The economy may very well be headed to a recession, which will overwhelm the homebuilding and energy markets and make biotech and IT ultimately the better playbook.
However, this result requires a number of specific economic catalysts that we currently don’t observe as well as the hurdle of having to overcome the value of currently huge cash flows, to make them worth the current prices we see them trading at in the market. As such, we think that makes that bet pretty unlikely.
"People tend to react to data rather than analyze it."
The Strategy performed in-line with its Russell 2000 Value benchmark during the quarter, as positive contributions from our stock selection in sectors such as consumer discretionary and energy were offset by declines across a number of sectors, including industrials and financials.
Despite broad challenges to the sector’s overall performance, our stock selection within the consumer discretionary sector proved beneficial during the quarter. Specifically, positive performance was largely driven by our holding Murphy USA (MUSA), which operates a chain of retail gas stations across the U.S. offering retail motor fuel products and convenience merchandise. Murphy USA’s share price rose after beating market expectations for the first quarter, as the company’s strong cost discipline and exceptionally low fuel breakeven points relative to its peers have allowed it to earn higher margins from spiking gas prices.
Additionally, the company has a strong consumer loyalty program that has driven increased market share for Murphy in snack foods and other in-store categories. We have high conviction in the company and believe it will continue to be a long-term growth compounder for the portfolio.
The Strategy also benefited from our holding in International Seaways (INSW), in the energy sector, which owns and operates a fleet of oceangoing vessels for the transportation of crude oil and petroleum products. The company benefited during the quarter as a result of tightness in the oil market, particularly in Europe, as low global inventories and high demand have spurred greater need for transportation between states that are net energy producers with those that are net energy consumers.
Additionally, economic sanctions placed on Russia and its companies have reduced the global number of oil and petroleum transportation ships, resulting in greater demand for International Seaways’s services and allowing it to increase its shipping rates, to the benefit of its bottom line. We continue to view the company as a strong value play, as decades of underinvestment in maritime shipping has resulted in many ships approaching a forced retirement date with no obvious replacements.
As the number of available ships declines, particularly specialized ships such as International Seaways’s energy transports, it should help to bolster the company’s pricing and negotiation power with its customers. We believe the company’s shares are currently trading at substantially below the current book value of the company’s assets, and as a result we continue to have high conviction in International Seaways as a long-term value creation opportunity.
The financials sector proved a headwind to relative performance during the period, as growing concerns over the probability of entering a recession weighed on public perception of the sector. Our allocations to subprime lenders such as PROG and Oportun Financial (OPRT) were particularly impacted due to fears that a recession would result in a significant increase in credit losses, particularly at the lower end of the credit spectrum.
While we acknowledge that a recession would indeed result in an uptick in loss rates, prior economic downturns have shown these companies to be efficient and experienced operators within the subprime lending market and that economic downturns result in minimal impact to their overall earnings. As such, we believe PROG and Oportun Financial are victims of public perception rather than any meaningful change to their long-term economics and continue to maintain confidence in the positions.
Despite having strong conviction in our portfolio positioning, such periods of unprecedented market uncertainty and volatility require us to maintain vigilance for opportunities to strengthen our risk-return profile. We have a robust watchlist of high-quality companies that we maintain as possible inclusions to the portfolio, and we made several adjustments during the quarter where we encountered compelling opportunities.
We took advantage of the selloff in the financials sector to add a new position in Redwood Trust (RWT). The company operates as a specialty finance company within the residential mortgage banking and business purpose mortgage banking industries and capitalized as large investment banks shed their mortgage securitization businesses after the 2008 Great Financial Crisis (GFC). Redwood has since expanded to become the industry leader in distribution of loans through whole loan sales.
Additionally, its investment portfolio has been very strong historically, even in the GFC, and its expansion into banking has made it better. We believe that the company’s long-term value creation is substantially underrepresented in its current market price and look forward to it being a high-quality long-term compounder within the portfolio.
We exited our position in Enact holdings, in the financials sector, which operates as a private mortgage insurance company. We purchased the company at its initial public offering as we felt it was trading at a discount to its peers within the compelling private mortgage insurance industry. We believe this value gap has been narrowing since its IPO and finally reached our fair value assessment during the quarter. As a result, we exited the position and redeployed the proceeds from the sale into higher-quality stocks with greater liquidity, which we see as longer-term value creators.
We believe the market is pricing in high odds of a recession. However, while this remains a very real probability, we believe that continued tightness in labor markets, diminished inventories for big-ticket items, and current home sales means it is not necessarily a certainty. Even so, rather than lose perspective in trying to dictate the direction of macro market factors, we continue to rely on our fundamentals-based approach to identify companies with high current cash flows and compelling asset values trading at attractive valuations.
By basing our assessment on rigorous analysis and experienced management, we maintain a broad and objective perspective, balancing short-term challenges without losing sight of long-term opportunities.
The ClearBridge Small Cap Value Strategy outperformed its Russell 2000 Value Index benchmark during the second quarter. On an absolute basis, the Strategy had losses in all 11 sectors in which it was invested during the quarter. The leading detractors were the financials and industrials sectors, while the consumer staples and utilities sectors were the top contributors.
On a relative basis, overall stock selection contributed to performance. Specifically, stock selection in the consumer discretionary, communication services and energy sectors contributed to relative returns. Conversely, stock selection in the health care, financials and industrials sectors and an overweight allocation to the consumer discretionary sector detracted from performance.
On an individual stock basis, the biggest contributors to absolute returns in the quarter were TriCo Bancshares (TCBK), Murphy USA, International Seaways, Acadia Healthcare (ACHC) and Unum (UNM). The largest detractors from absolute returns were SMART Global (SGH), PROG, Oportun Financial, Hillman Solutions (HLMN) and Textainer (TGH).
In addition to the transactions listed above, we initiated positions in Essent Group (ESNT) in the financials sector and Photronics (PLAB) in the IT sector. We also exited positions in Constellium (CSTM) in the materials sector and Bloomin’ Brands (BLMN) and Everi (EVRI) in the consumer discretionary sector.
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