ClearBridge Small Cap Value Strategy Q4 2023 Portfolio Manager Commentary

By Albert Grosman & Brian Lund, CFA

Small Value Rallies Amid Improving Outlook

Market Overview

Once upon a time, financial market prices were somewhat tethered to fundamental value. Sure, there were occasional bubbles or manias here or there, in tulips or regional shipping companies or internet stocks, but those were generally isolated to individual asset classes. Some purely speculative assets that generate no income and therefore are only worth what someone else will pay for them, i.e., gold or art or baseball cards, experienced price appreciation that couldn’t be ascribed to fundamental value but at least had some measure of utility. They were pretty or evocative or had unique metallurgical properties that attracted other buyers. Most of all, one could always count on the bond market, the most liquid and transparently valued market, to remain rational.

Those days seem to have ended. Now, in the time of high-speed, low-cost trading and immediate information dissemination, all markets appear to have devolved into speculation about what direction the next tick will be. The most absurd example of this phenomenon in the fourth quarter of 2023 was the 57% rise in bitcoin, a technology still in search of an application. It seems to have risen because there may be new, hopefully less fraudulent ways to trade the phantom “currency” through ETFs, which speculators believe will invite even more speculators to the party. Oh, the marvels of financial innovation.

More disturbing, however, was the behavior of the Treasury market in the fourth quarter. The yield on the benchmark 10-year U.S. Treasury bond (US10Y), one of the most liquid assets in the world, dropped 120 basis points (bps), almost 25%, from 5% to 3.8%. Was this move driven by fears of a weakening economy? Quite the opposite: GDP data for the third quarter was better than expected at 4.9% versus the 4.5% market consensus, payroll figures for October and November beat expectations, and U.S. stock markets boomed. No, the main driver was a press conference from Fed Chair Jerome Powell that perhaps signaled a more dovish monetary policy stance and the release of a new Fed dot plot that showed it anticipates cutting rates in 2024. No actual cut occurred, and many Fed governors subsequently talked down the odds and magnitude of rate cuts, but markets went ahead and priced in 150 bps of cuts, anticipating a federal-funds rate of 4.0% by the end of 2024. The drop in 10-year yields ironically makes it less likely that the economy will suffer a downturn that would necessitate Fed rate cuts, but we’ll worry about that when Powell speaks after the next meeting.

In classic reflexive fashion, stock markets took the lower-rate ball and ran with it. Which stocks get the most leverage from lower rates? Why, those with the most value in the distant future! Among small caps, both the Russell 2000 Growth and Value indexes rose sharply, but the biggest winners were the quintile of stocks with the lowest return on equity and those with no earnings. Stocks with no earnings remain a historically high percentage of the Russell 2000 indexes: 31% of the companies in the Russell 2000 are expected to have negative earnings in 2023, including 34% of the Russell 2000 Growth and 31% of the Russell 2000 Value indexes. This large number of money-losing companies throws off historical P/E valuation for the indexes because those companies are excluded from the earnings calculation. While the Russell 2000 Growth and Value indexes appear to be only about 20% and 14%, respectively, above their long-term average on forward P/E, accounting for money losers would make that 35% and 29% above their long-term average.

“The drop in yields ironically makes it less likely the economy will suffer a downturn that would necessitate rate cuts.”

The ClearBridge Small Cap Value Strategy underperformed its Russell 2000 Value Index benchmark for the fourth quarter, as detractors in the financials and consumer discretionary sectors overcame positive stock selection from our industrials holdings during the period.

Stock selection in the financials sector was the greatest detractor from relative performance. Several of our banking stocks, such as Bank OZK (OZK), saw their share price rise during the quarter as investors anticipated Fed rate cuts that would reduce deposit costs while retaining economic strength. However, this was not the case for some of our consumer finance companies that faced increased investor scrutiny despite economic optimism. This was particularly true of our worst-performing individual holding, Oportun (OPRT), and lease-to-own financier PROG Holdings (PRG). Both companies have substantial client bases among low-income customers with lower credit scores, and both saw share price declines after releasing reports showing rising credit losses in the third quarter. As a result, we made the decision to exit Oportun, while retaining PROG, as Oportun’s lower level of liquidity, longer path to profitability and relative size of customer losses reduced our confidence in the company. However, we maintain conviction in PROG’s strong credit underwriting decisions and relatively short portfolio duration, which we believe are contributors to a more resilient and profitable business than Oportun’s.

Stock selection in the consumer discretionary sector also weighed on performance during the quarter. Outdoor sports and recreation product manufacturer Vista Outdoor (VSTO) sold off after the company announced its deal to sell its sporting products business for lower than what the market anticipated. We believe the final price is heavily discounted to the intrinsic value of the business and ultimately elected to exit the position in order to consolidate our exposure in higher-conviction holdings. Everi (EVRI), which provides casino games, cash access and customer relationship technologies to the gaming industry, also faced headwinds from a weaker than anticipated product cycle leading to lower third-quarter revenues. However, we believe these product cycle challenges are not atypical for the company periodically and are confident that management can successfully navigate the near-term environment to generate attractive long-term returns.

Stock selection in the industrials sector was the leading contributor to performance during the period, largely driven by the performance of cargo container purchaser, leaser and reseller Textainer (TGH), one of our top portfolio holdings. Our analysis indicated the company’s share price was tremendously discounted to its fair business value. We believe this was validated after the company announced it agreed to be acquired at a premium by infrastructure fund Stonepeak early in the quarter. As we did not foresee other market participants making a better offer for the company, we elected to sell the position and capture the premium.

Portfolio Positioning

We continued to be highly active in the fourth quarter, adding several new positions with strong balance sheets, compelling earnings drivers and attractive valuations, while also exiting positions where we felt our investment thesis weakening. Ultimately, we added nine new positions and exited eight.

Our largest new position during the quarter was Visteon (VC), an automotive technology company in the consumer discretionary sector that designs and manufacturers automotive electronics and connected car solutions such as informational displays, voice-automated assistants, telematic controls and wired and wireless battery management systems. We believe that neither Visteon’s revenue growth potential nor the resulting margins and profits are accounted for in the current stock price. Visteon continues to win new business at an accelerating rate as many of its solutions address key points of vehicle differentiation, performance, safety and efficiency.

We added AMN Healthcare Services (AMN), which provides health care workforce solutions and staffing services to hospitals and health care facilities. We believe the company’s current stock price represents a compelling investment opportunity as it overestimates a level of cyclical decline in staffing, particularly when compared to the normalization of health care service demand, the relatively high age distribution of existing health care providers and the company’s exciting new initiatives in areas such as language services.

We exited our position in Real Matters (OTCPK:RLLMF), in the real estate sector, which offers residential mortgage appraisals and title services for refinancing and home purchases, as well as insurance inspection services to property and casualty insurers. Higher rates have created headwinds for the company in the form of less demand for refinancings and title insurance. Ultimately, we elected to sell the position in order to reduce our exposure to the existing home transactions market and redeploy the proceeds into other, higher-conviction investments.

Portfolio Highlights

The ClearBridge Small Cap Value Strategy underperformed its Russell 2000 Value Index benchmark during the fourth quarter. On an absolute basis, the Strategy had gains across eight of the 11 sectors in which it was invested during the quarter. The leading contributors were the financials and industrials sectors, while the energy and health care sectors were the largest detractors.

On a relative basis, overall stock selection and sector allocation effects detracted from performance. Specifically, stock selection in the financials, consumer discretionary, health care, real estate, energy and communication services sectors weighed on performance. Conversely, stock selection in the industrials sector positively contributed to returns.

On an individual stock basis, the biggest contributors to absolute returns in the quarter were Textainer, Bank OZK, Photronics, Meritage Homes (MTH) and Western Alliance Bancorp (WAL). The largest detractors were Oportun Financial, SMART Global (SGH), Gambling.com (GAMB), Atlas Energy Solutions (AESI) and Vista Outdoor.

In addition to the transactions listed above, we initiated new positions in Wintrust Financial (WTFC) in the financials sector, Lantheus (LNTH) in the health care sector, Alaska Air (ALK), Forward Air (FWRD) and Tecnoglass (TGLS) in the industrials sector, Academy Sports and Outdoors (ASO) in the consumer discretionary sector and Vivid Seats (SEAT) in the communication services sector. We exited positions in Cara Therapeutics (CARA), CareMax (CMAX) and Amarin (AMRN) in the health care sector, and First Busey (BUSE) in the financials sector. During the period, existing portfolio holding NCR was renamed NCR Voyix (VYX) and spun-off NCR Atleos (NATL), both of whose shares we retained in the portfolio.

Albert Grosman, Managing Director, Portfolio Manager

Brian Lund, CFA, Managing Director, Portfolio Manager

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