- Myriad externalities weighed on investor sentiment and sparked a rotation out of growth and momentum-driven stocks.
- Strength in the health care and industrials sectors, as well as favorable M&A activity, supported performance relative to the benchmark.
- We remained selective participants in the IPO market, adding several innovative companies in the health care and financials sectors.
Every quarter we comment about how the Small Cap Growth Strategy performed, various externalities affecting the markets, and our thoughts on new investments and the path forward. Perhaps it’s a variant of end of summer seasonal affective disorder, but the catalog of externalities overhanging markets this past quarter seems far fatter than usual:
- “Roulette” headline tweets on the U.S./China trade battle
- Global PMIs and other macro data decelerating/declining
- Global central bank accommodation and Fed arm-twisting by President Trump
- The oil supply chain drone and missile attack in Saudi Arabia
- The expanding Ukrainian/U.S. impeachment inquiry
- Massive flows into the perceived “safe haven” of U.S. Treasurys which drove 10-year yields down 55 basis points intra-quarter (close to July 2016 lows) and 34 bps by quarter end
Within the equity market, relevant trends included a rotation out of growth and momentum into value, which drove sharp individual stock dislocations. Within the small cap universe, the benchmark Russell 2000 Growth Index (-4.17%) underperformed the Russell 2000 Value Index by 360 basis points during the quarter. The initial public offering market (IPO), meanwhile, became challenged with several high-growth disruptors breaking deal price or not getting to market.
In a difficult small cap growth environment, the Strategy outperformed the benchmark modestly. Part of that can be attributed to two of our investments — Genomic Health and Cambrex — agreeing to be acquired by strategic and private equity buyers respectively. We also believe the high-quality bias that drives stock selection provides stability during a volatile market environment. In the health care sector, for example, we have generally avoided higher-risk companies in sub-sectors like biotechnology. While this approach can be a performance drag in risk-on periods, our health care holdings generated a positive return for the quarter (+3.0%) while the small cap growth health care sector lost 9.8%.
Despite generally downbeat sentiment for the asset class, our research of the public and private markets continues to identify compelling opportunities in innovative companies. We made four new investments during the quarter, three of which were IPOs. Overall, the IPO market has been a fertile source of new idea generation and has done well with year-to-date returns of 22.3% per Renaissance Capital. Results are weaker, however, on a cap weighted basis with a slew of disappointing debuts by this year’s class of “unicorns.”
The IPOs we participated in may lack the name recognition and glamour of the unicorns; all have built solid businesses by harnessing software and analytics to improve efficiency. AssetMark, a technology and asset management provider to independent financial advisors, offers solutions to streamline advisor workflow, running the gamut from relationship initiation, portfolio review and construction to reporting and account administration.
“The IPOs we participated in have all built solid businesses by harnessing software and analytics to improve efficiency.”
Health care technology is an area that has done well for the portfolio, as witnessed by the recent bid for Cambrex and the acquisition of longtime holding Medidata Solutions announced in the second quarter. We added to our health tech exposure through two IPOs. Phreesia is a technology provider which automates patient check-in at health care providers, improves collections and simplifies follow up administrative tasks such as scheduling and preventative notices. Health Catalyst, meanwhile, is a data analytics and professional services provider. The company collects massive patient data (i.e., electronic health records, claims, satisfaction surveys), primarily from hospital systems, and suggests measurable improvements which can improve the patient and provider experience as well as boost health system economics.
We also made an investment in Invitae, a low-cost genetics testing provider. The company offers a high-quality clinician and patient experience at a low price point focused on diagnostic testing, proactive inherited trait testing and family health (fertility and prenatal health). Provided company fundamentals unfold favorably, we would expect to build these positions over time as liquidity improves.
In addition to the takeouts mentioned above, we exited a position in Lions Gate Entertainment as the company’s strategic pivot to Starz hasn’t created value at a time when operating costs for talent creation are escalating. Information security platform Fortinet was also sold as strong compounding over the last several years has caused the stock’s valuation to surpass our upper size range.
The portfolio continued to demonstrate resilience in a period during which small growth stocks fell out of favor. Our attention to sustainable business dynamics backed up by robust capital discipline is a critical foundation that we will continue to apply to the existing portfolio and new growth opportunities that our team fosters.
The ClearBridge Small Cap Growth Strategy outperformed its Russell 2000 Growth Index benchmark during the third quarter. On an absolute basis, the Strategy had gains across three of the 10 sectors in which it was invested during the quarter (out of 11 sectors total). The primary contributors to performance were the industrials and health care sectors.
In relative terms, the Strategy’s outperformance was driven by stock selection and sector allocation. Specifically, stock selection in the health care and industrials sectors, an underweight to health care and an overweight to information technology (IT) drove results. Meanwhile, stock selection in the consumer discretionary and IT sectors had a negative impact on relative performance.
The biggest contributors to absolute returns during the third quarter included Insulet, Trex, Inphi, Monolithic Power Systems and XPO Logistics. Positions in Fox Factory, Chegg, Wix.com, National Vision Holdings and Penumbra were the greatest detractors from absolute returns.