ClearBridge Select Strategy Q3 2024 Commentary

By Aram Green

Disruptors Get Boost from Easing Conditions – Market Overview

Signs of cooling inflation and an ambitious start to the Federal Reserve’s rate-cutting cycle drove equity markets to broad gains in the third quarter, led by smaller capitalization companies. The S&P 500 Index rose 5.89%, the benchmark Russell 3000 Index advanced 6.23% while the small cap Russell 2000 Index jumped 9.27%. Value shares outperformed for the period, with the Russell 3000 Value rising 9.47% compared to a gain of 3.42% for the Russell 3000 Growth Index.

Volatility spiked following a series of weak employment reports that saw the unemployment rate increase to 4.3%, its highest level since late 2021. In September, the Fed followed through on its concerns about labor market weakness by cutting interest rates by a half point, a move that sparked a stock rally through the end of the period. Combined with the increasing likelihood of a soft landing for the economy, the cuts, should they be measured and well telegraphed in their implementation, create easier financial conditions for consumers and small and medium-size businesses in need of financing.

Driven by strong stock selection in its largest sector – information technology – the ClearBridge Select Strategy delivered solid absolute returns and outperformed its benchmark for the third quarter.

A cohort of disruptors were among the top contributors, led by crisp execution from Latin America ecommerce platform MercadoLibre (MLI) and workflow software maker ServiceNow (NOW), two of the Strategy’s largest holdings. MercadoLibre has done an effective job of growing at scale with high levels of profitability while showing discipline in controlling costs and focusing investment. We believe management has made all the right decisions and investments in building a nascent ecommerce industry in the largest Latin American markets of Brazil, Argentina and Mexico, layering services such as logistics and payments on top of its ecommerce engine. ServiceNow has also seen the benefits of continuing to invest in new areas of growth beyond its core IT services, establishing the foundation for future revenue and earnings.

Also in IT, the Strategy saw strong performance from information security platform Fortinet (FTNT), which is participating well in a strong underlying growth trend in information security as its business normalizes from a post-COVID inventory hangover. Digital advertising software maker AppLovin (APP), meanwhile, is leveraging AI capabilities into its platform, translating into more effective take rates on clients’ mobile games and transactions.

We are also encouraged by results from several IT names that now fall into the evolving opportunities category as they recover from past headwinds. These include new addition CrowdStrike (CRWD), the information security software maker whose software content update in July caused widespread disruptions across its client base and caused the stock to derate. While the incident will depress revenue growth in the near term as CrowdStrike makes concessions to customers, we expect growth to reaccelerate in the second half of next year. To make room for CrowdStrike, we exited info security peer Palo Alto Networks (PANW), which experienced a similar selloff earlier this year as it updated customer contract terms before rebounding more recently.

E-signature software maker DocuSign (DOCU) and enterprise HR and finance software maker Workday (WDAY) are additional examples of evolving opportunities in IT where managements are making progress in reinvigorating the growth of their businesses.

Third quarter performance was further fortified by contributions from durable compounders KKR (KKR), a leading alternative asset manager at the center of accelerating growth in private credit investment, and CBRE Group (CBRE), an owner and operator of commercial real estate that should benefit from a more accommodative interest rate environment.

The Strategy regularly uses options strategies to support performance and manage portfolio exposures without having to commit the same amount of capital as purchasing specific stocks. In the third quarter, results were boosted by our options positions in Starbucks (SBUX). We sold puts and bought calls on the stock as activist involvement was increasing in the company and management changes appeared likely but before Chipotle’s Brian Niccol was named the new Starbucks CEO.

These broad contributions helped offset ongoing weakness among select industrial names. Residential deck maker Trex (TREX) and construction site office and storage provider Willscot (WSC) have been hampered by an extended higher-rate environment that has caused contraction in residential and commercial construction. We have trimmed position sizes of these names to reflect current conditions and a slow recovery, while adding to Lowe’s, a retail we see as better positioned to benefit from a housing and home improvement rebound.

Portfolio Positioning

Besides the swap of CrowdStrike for Palo Alto, activity was fairly limited during the quarter. We did sell out of Confluent (CFLT), which operates a data streaming platform. We had given the company time to commercialize an open-source technology, trying different commercialization models. But lack of clarity on how successful Confluent will be and the level of growth its efforts can generate while still lacking profitability caused us to move on. We remain overweight software and directed the proceeds to positions where we have higher conviction, including faster-growing data analytics provider Datadog (DDOG) and steadily compounding design software maker Autodesk.

Outlook

Large and mega cap stocks dominated market performance over the last 18 months through the second quarter, crowding out active strategies targeting companies down the market cap scale. We have seen green shoots of broadening leadership on several occasions over that span, only to have volatility or the latest positive AI-related news return the tech-heavy momentum names to favor. The latest rotation, however, could have more staying power as the Fed has communicated additional rate cuts are on the horizon and the chances of a soft landing for the economy continue to improve.

While the Strategy has limited exposure to the Magnificent Seven through an active weight in Nvidia (NVDA) and underweights in Apple (AAPL) and Microsoft (MSFT), we see their improvement from current levels as limited compared to the potential for companies indexed to currently depressed consumer spending and industrial activity. Mega caps should continue to do fine in a lower-rate environment, but the differentiation advantage they have enjoyed drops in a less restrictive rate environment, making them an attractive source of funds for investors looking to participate in a broader equity environment.

That the Fed cut rates by 50 bps and is projecting more action over the next year indicates all is not well in the economy. Consumers have become more selective in their purchases, small and medium-size business have pulled back on investment and job growth is slowing while the pending election adds further uncertainty. While remaining cognizant of these risks, we see lower rates as creating opportunity across the market. Massively lower rates are not needed for small and mid cap management teams to begin investing again for growth; rates just need to gradually move to a normal level without a lot of volatility. And as we get past the election, the IPO market should also see more activity, creating another potential source of new ideas.

Portfolio Highlights

The ClearBridge Select Strategy outperformed its Russell 3000 Index benchmark during the third quarter. On an absolute basis, the Strategy posted positive contributions across seven of the 10 sectors in which it was invested (out of 11 sectors total). The primary contributors were the IT and consumer discretionary sectors, while energy and industrials detracted the most.

Relative to the benchmark, overall stock selection contributed to performance. In particular, stock selection in the IT, consumer discretionary, financials, real estate and communication services sectors, an overweight to industrials and an underweight to communication services supported results. Conversely, stock selection in the industrials and materials sectors and an underweight to financials, an overweight to IT and a lack of exposure to utilities detracted from performance.

On an individual stock basis, the leading contributors were positions in MercadoLibre, ServiceNow, KKR, Fortinet and CBRE. The primary detractors were Progyny (PGNY), HubSpot (HUBS), Trex, Icon and Confluent.

In addition to the transactions mentioned above, we added a position in Alibaba (BABA) in the consumer discretionary sector and closed a position in MSC Industrial Direct (MSM) in the industrials sector.

Aram Green, Managing Director, Portfolio Manager

Click to enlarge

Original Post