ClearBridge Small Cap Value Strategy Q1 2024 Portfolio Manager Commentary

By Albert Grosman & Brian Lund, CFA

Choose the right odds, not the right horse

Market Overview

Spotting secular trends and identifying winners is a time-honored investment strategy that has made investors a lot of money, but has also failed spectacularly in some circumstances, as many small-cap investors are attempting to target AI and Bitcoin-related beneficiaries. . evaluation. Most people remember the 2000 dot-com bubble as being characterized by silly business models like Pets.com and Webvan, but there was also a major secular theme: increased Internet traffic increased demand for fiber optics, networking equipment, web hosting, and more. , JDS Uniphase, Level 3 Communications, Global Crossing, Lucent, Nortel, Cisco (CSCO), and EMC. This theory was entirely accurate, but if you bought the stock near the top, the stock failed spectacularly. Of those companies, only Cisco is still standing, and it still hasn’t recovered its 2000 highs. For many other companies, the problem was not the theme but the lack of the competitive advantage needed to generate long-term excess returns.

Another topic of the era was mobile phones. Qualcomm (QCOM) soared more than 2,600% in 1999 on a very similar premise to what Nvidia (NVDA) is seeing today. That means that whoever wins, Qualcomm will be involved, as it has become the brains of the secular trend. The topic was spot on, the company was perfectly positioned, and they went on to achieve tremendous results. From 1999 to 2023, Qualcomm’s revenue grew more than 9x and EBITDA more than 12x, resulting in very impressive long-term growth rates. However, investors who held these stocks during that period only received a total return of 154%, compared to the S&P 500 index’s 410% return.

This reminds me of the famous horse racing handicapper Steven Crist:

“This is the way we have all been conditioned to think: find the winner and then bet. If you know what you are talking about, money will take care of itself… The problem is that we are asking the wrong questions. The question is not which horse is most likely to be the winner of the race, but which horse offers odds that exceed its actual chances of winning. This may sound elementary, and while many players may think they are following this principle, very few actually do. In this way of thinking, everything except probability disappears from view. There is no such thing as ‘liking’ a horse to win a race, only an attractive difference between its chances and price.”^One

Rather than chasing short-term outperforming companies, we continue to pursue investments where potential future free cash flow valuations suggest a fair value that exceeds current market prices.

In this quarter’s strategy, stock selection in the IT sector contributed the most to relative performance. Electronic memory and LED manufacturer SMART Global (SGH) rebounded from a disappointing fourth quarter to post the second-best performance. Contrary to management’s previously low expectations for its high-performance computing business, SMART Global has seen demand accelerate beyond what both management and the market had previously expected, leading to improved margins and unexpectedly higher quarterly earnings. Likewise, network solutions company Itron (ITRI) was rewarded for posting strong quarterly results and issuing 2024 guidance that beat market estimates. The company appears to have largely ignored the supply chain issues that have weighed on its past performance, and plans to continue improving margins by closing two low-margin factories this year and announcing several new partnerships to support growth in both its software and networks segments. It appears to be. .

“We continue to pursue investments where future free cash flow valuations suggest a fair value that exceeds current market prices.”

Rising energy prices are supporting the performance of exploration and production (E&P) companies Magnolia Oil and Gas (MGY) and Matador Resources (MTDR) and boosting demand for energy equipment services, boosting companies like Atlas Energy Solutions (AESI) It helped me do it. We continue to have high confidence in Magnolia and Matador due to their strong, proven ability to generate incremental returns on invested capital. Meanwhile, Atlas continues to enjoy the advantage of being the best producer of materials for E&P in the Permian Basin at the lowest cost. Based on its already solid distribution network and proprietary technology, Atlas recently announced its intention to acquire its competitor, Hi-Crush, making it the largest domestic producer of proppant, a material mixed with fracking fluid for shale production. We plan to solidify our position as a leader. A leading industrial logistics provider. Long-term profits will be achieved by expanding product scale while maintaining the current fixed cost structure.

The top individual performer for the quarter was Eagle Materials (EXP), which manufactures a variety of building materials including cement, gypsum wallboard and recycled cardboard. The stock continued to rally on the back of a more optimistic economic outlook, and both sales and earnings exceeded quarterly expectations. We believe the Company’s continued strong pricing power in its cement business and its cost leadership over its competitors in its wallboard business will enable it to continue to maintain attractive returns on capital.

Stock selection in the healthcare sector was a major detractor during the period. QuidelOrtho (QDEL), a leading provider of in vitro diagnostic solutions for a variety of diseases and health conditions, suffers further declines in its highly profitable respiratory business and recently fired its CEO. While these catalysts are spurring our review of the investment case for QuidelOrtho, we continue to see a base wrap business that delivers strong and consistent free cash flow. AMN Healthcare Services, which provides healthcare staffing solutions, also saw a decline. The downturn in outsourced medical professionals continues as many hospitals focus on hiring full-time employees. Despite these headwinds, our argument for long-term demand for healthcare professionals remains intact, so we continue to own the company.

Portfolio positioning

After a particularly active fourth quarter, we entered the first quarter of 2024 satisfied with our positioning and determined to selectively capitalize on some of the evolving opportunities in the market.

We have launched a new position at Corcept Therapeutics (CORT), which engages in the discovery and development of drugs used to treat serious endocrinological, oncological, metabolic and neurological disorders in the United States. Since 2012, Corcept’s Cushing’s syndrome treatment Korlym has been making gains in the market. monopoly. Despite growing sales to $482 million in 2023, Korlym has since faced generic competition. However, management believes there will be no decline in sales because the rarity of the disease and specialized distribution channels make it difficult for pharmacies to change the brand names of generics. In addition, Cocept has a next-generation drug with fewer side effects than Corrim, so the available market is expected to expand. We believe that the results of the upcoming Phase 3 trial of our new drug will demonstrate approvable efficacy and safety, as well as the potential for expansion into other indications.

We left our position at Sterling Check (STER) in the industrial sector, specializing in technology-enabled background and identity verification services. The Company announced its intention to be acquired by our competitor, First Advantage (FA), and given the regulatory risks involved and the limited potential for a competing offer to the Company, we decided to sell the position.

eyesight

Despite investor enthusiasm for the IT hardware renaissance, we believe the market is competing for such a narrow range of stocks, creating risks for trend-followers but opportunities elsewhere. Instead of chasing market trends, we continually look for companies with strong balance sheets, attractive cash flows, and trading at attractive valuations. We believe that serving investors’ best interests over the long term means avoiding risking capital on things that could quickly fall out of favor in this turbulent market environment.

Portfolio Highlights

ClearBridge Small Cap Value Strategy outperformed the Russell 2000 Value Index benchmark during the first quarter. In absolute terms, the strategy delivered gains in seven of the 11 sectors invested during the quarter. The sectors that contributed the most were energy and industrial sectors, while those that contributed the most were telecommunications services and real estate.

Comparatively, overall stock selection contributed positively to performance, while the effect of sector allocation decreased. In particular, stock selection in the IT, materials, finance, and energy industries was found to be advantageous. Conversely, stock selection in the Healthcare, Consumer Discretionary and Industrials sectors and an underweight allocation to the Healthcare sector weighed on performance.

On an individual stock basis, the largest contributors to absolute returns this quarter were Eagle Materials, SMART Global, Primoris Services (PRIM), Magnolia Oil & Gas, and Itron. The biggest detractors were Forward Air 9fwrd), QuidelOrtho, Independent Bank (INDB), Gray Television (GTN), and NCR Voyix (VYX).

Albert Grosman, Managing Director, Portfolio Manager

Brian Lund, CFA, Managing Director, Portfolio Manager

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Editor’s note: The summary bullet points for this article were selected by Seeking Alpha editors.