Fivath Hopes
By Brian Engeram and Matthew Lilling
Bank crisis cuts midcap performance
Market overview and outlook
Equity markets generated positive returns in the first quarter, as the perception of a soft economic landing ahead of March’s banking crisis bolstered investor sentiment. The S&P 500 Index (SP500) rose 7.50% over the three-month period, while the benchmark Russell Midcap Index gained 4.06%. Signs of economic resilience and hopes of an end to Fed rate hikes helped growth stocks outperform value stocks for the period, with the Russell Midcap Growth Index returning 9.14% versus 1.32% for the Russell Midcap Price Index.
Stocks rose earlier in the quarter as a combination of inflation indicators and a resilient economy encouraged optimism that the Fed would end rate hikes and stabilize long-term interest rate expectations. However, in March, markets froze in the banking system after the collapse of Silicon Valley Bank (SVB), the 16th largest U.S. bank, and Signature Bank (OTC: SBNY ), days later, triggered a crisis of confidence in smaller ones. and medium-sized regional banks. Although contagion concerns largely subsided by the end of the quarter, the crisis raised investor fears of a severe recession.
Macro factors continue to play an external role in market performance. As a result, good companies with strong balance sheets and financial flexibility find their share prices more subject to volatile investor sentiment than fundamental valuations. This turbulent environment and the divergence between fundamental valuations and market value resulted in the Clearbridge mid-cap strategy underperforming the benchmark for the quarter.
From a sector perspective, Communication Services (+15.42%) was the top performer in the benchmark during the quarter. The IT (+14.46%), Consumer Discretionary (+8.21%), Industrials (+7.72%) and Materials (+4.10%) sectors also outperformed the Russell Midcap Index. Meanwhile energy (-7.89%), financials (-6.33%) and utilities (-1.71%) sectors all posted negative returns, followed by real estate (+0.54%), consumer staples (+3.32%) and healthcare (+3.32 %) are +3.44%) areas.
“SVB’s collapse had a ripple effect on the system, creating a panic that weighed on even the most fundamentally-sound banks.”
Stock selection in the financial sector was a major critic during this period. Entering the quarter, we deliberately chose to underweight the sector and invest in high-quality banks with sticky customer bases and minimal credit risk that will allow them to remain resilient as the US enters a recession. For example, First Republic Bank (FRC), focused on providing excellent service to high-net-worth customers, had a strong loan portfolio with a history of minimal credit write-offs. Similarly, we have high confidence in Western Alliance Bancorp (WAL) due to the diversity of depositors. However, the collapse of SVB had a substantial and rapid ripple effect throughout the banking system, creating a panic that weighed down even the most fundamentally-sound banks. Depositors transferred money from medium-sized banks to large banks with the ability to transfer deposits instantly and overnight, creating a vicious cycle of declining liquidity.
Faced with such unrealistic risk and low income prospects from large capital requirements, we moved quickly to exit these two positions in the early stages of the transition. We also reviewed other holdings that we felt could be adversely affected by the high probability of a recession and reduced credit availability, and sold our holdings in Starwood Property Trust (STWD), America’s largest commercial mortgage REIT. The upheaval also created entry prices into high-quality super-sectors that could be long-term beneficiaries of this deposit shuffle. This prompted us to add new positions in PNC Financial Services (PNC) and US Bancorp (USB), both of which have strong brands, diverse geographic and funding footprints and smaller expense growth than their regional peers.
A stock selection strategy in the industrials sector was a significant contributor to returns as many companies that struggled in the fourth quarter returned to solid earnings. ATS, which provides automation services to manufacturers around the world, saw its share price rise due to increased orders for equipment to produce electric vehicle (EV) batteries. We recognized the opportunities the EV battery market represented for the company when we made our initial investment and felt it would be a long-term driver of returns. Another top-performing holding, API Group (APG), provides security solutions for industrial services such as fire protection, air conditioning and infrastructure maintenance. The stock rebounded from fourth-quarter declines as investors got more visibility into its contract revenue and the company released expected guidance for 2023. We believe APi’s internal initiatives will continue to drive fundamental improvements, keeping it on track to meet forecasts.
Our investments in the consumer staples sector also generated positive relative returns for the period and included the top individual performer, COTY. The global beauty and fragrance company continues to deliver strongly on both its short-term goals and strategic mission to improve its brand profile. Coty has several strong growth drivers, including its strong market share within the reopening Chinese market and further penetration of its mass market cosmetics business. The company’s continued success should allow it to reduce debt, which should act as a share price catalyst.
Portfolio position
We have been very active over the past six months, using high levels of volatility to add value stocks with high quality growth and attractive valuations. We maintain an extensive watchlist of companies that would be excellent additions to a portfolio under the right circumstances and move decisively when they are under significant pressure. As a result, we added eight new positions and shed seven existing holdings during the quarter.
We have initiated a new position in Paylocity (PCTY), an IT sector provider of cloud-based human capital management and payroll software solutions. As the Fed’s rate hikes begin to weigh on the economy, we believe Paylocity should benefit from rate hikes by earning higher returns on customer payroll deposits. Additionally, Paylocity maintains a long-term growth runway as it attracts new customers and gains market share against larger, mature industry incumbents.
We also added CoStar (CSGP) in the industrial sector, which provides information, analysis and online market services in the commercial real estate market under brands including its flagship Apartments.com. As a provider of a robust, real estate tech platform, CoStar is poised to capitalize on the downturn in commercial real estate as the primary leasing and listing resource for real estate brokers seeking greater visibility. Additionally, the company is leveraging its expertise and economies of scale to build a similar database and listing resource for the residential housing market, Homes.com, which could prove to be a substantial, long-term growth driver. The company is well positioned as a counter-cyclical option for the rest of the commercial real estate industry.
We moved out of our position at ON Semiconductor, in the IT sector, which designs, manufactures and markets semiconductor components. The company has been a strong performer in the portfolio, and we are gradually trimming positions to capture gains during its stock run-up and manage position size. However, we believe that meeting expectations surrounding the company’s silicon carbide business will be challenging, further complicated by the need to delicately balance increased capacity without increased demand, and ultimately, we decided to close the position in favor of other opportunities.
Outlook
The first quarter proved tumultuous, as fears of a banking crisis and fear of a banking crisis proved to be the primary driver of market performance. Rather than trying to follow short-term changes, we strongly believe that combining active management with an investment process focused on high-quality companies will generate attractive returns over the full market cycle. As such, we will continue to view these gyrations as opportunities to improve our portfolio and focus on investing in companies with strong balance sheets, attractive cash flows and earnings visibility.
Portfolio Highlights
The Clearbridge MidCap Strategy underperformed its Russell MidCap Index in the first quarter. On an absolute basis, the strategy made gains in six of the 11 sectors invested in during the quarter. The major contributors were the industrial and IT sectors, while the financial sector was the main detractor.
On a relative basis, overall stock selection detracted from performance while sector allocation effects contributed positively. In particular, stock selection in the financials, IT, consumer discretionary, healthcare, communications services, real estate and materials sectors weighed relative returns. Conversely, stock selection in the industrials and consumer staples sectors, an overweight to the IT sector and an underweight allocation to the financials sector contributed to returns.
On an individual stock basis, the biggest contributors to absolute returns in the quarter were Coty, ATS, APi, Aptiv ( APTV ) and Regal Rexnord ( RRX ). The biggest detractors by absolute return were First Republic Bank, Western Alliance Bancorp, Alexandria Real Estate Equities ( ARE ), Pioneer Natural Resources ( PXD ) and Hartford Financial Services ( HIG ).
In addition to the transactions listed above, we also initiated new positions in Atkore ( ATKR ) and Clean Harbors ( CLH ) in the industrial sector and Teleflex ( TFX ) and IDEXX Laboratories ( IDXX ) in the healthcare sector. We exited Zurn Elke Water Solutions (ZWS) in the industrial sector, Petco Health & Wellness (WOOF) in the consumer discretionary sector and Definitive Healthcare (DH) in the healthcare sector.
Brian Angerame, Portfolio Manager
Matthew Lilling, CFA, Portfolio Manager
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