Ipopba.
By Brian Angerame.
AI Adds Tailwinds to Strong Tech Fundamentals
Market Overview and Outlook
The second quarter was positive for mid cap stocks as signs of economic resilience, moderation in inflation and better than expected corporate earnings helped to spur equity markets higher. Mid cap stocks generated positive returns during the three-month period, but trailed the performance of large cap peers due to a surge in investor demand for large tech companies at the forefront of Artificial Intelligence. Growth over value stocks was propelled by the prospect of a potential end to interest rate hikes, with the benchmark Russell Midcap Growth index returning 6.21% compared to the 3.86% return of the Russell Midcap Value index. Growth has outpaced value so far this year.
The period saw an increase in investor optimism as fears of a recession were offset by hopes of a soft landing. The labor market and consumer spending show signs of resilience despite the high interest rates. The markets received a boost from better-than- expected corporate earnings in the second quarter, as our portfolio companies continued to benefit from price increases and declining costs. The strongest balance sheet and cash flow generating companies will be able to invest in R&D and sales even in uncertain times. The continued investment should lead to gains for the shareholders.
Timing and severity of the next recession are the biggest dramas for the markets right now. There was a consensus that there would be a recession in 2023. The slowing of inflation has lent credence to the idea that a terminal risk-free rate may be within sight. The return of a more normal economic expansion is what investors are looking for after the recent spike in inflation.
The industrials, information technology, communication services, materials, and consumer discretionary sectors all performed well. The real estate, financials, consumer staple, and utilities sectors generated positive returns, but trailed the benchmark. The health care sector detracted during the period.
"Investors are reclaiming the confidence to look to the return of a more “normal” economic expansion."
The IT sector's stock selection was the greatest contributor to relative out performance during the period, as investor enthusiasm for artificial intelligence and related companies helped to bolster some of the strong, idiosyncratic drivers within our IT companies. Marvell Technology, a networking and storage Semiconductor company, was our top individual performer during the quarter. The company is seen as one of the main beneficiaries of future data center build outs due to its key supplier position at the high-growth technology sectors. HubSpot is integrating artificial intelligence into their core products to drive increased value to their customers. Despite a challenging environment for small and medium size businesses, the company continues to execute well with net customer additions. In order to become an all-in-one customer relationship management solution, HubSpot has to cross sell to its customer base.
The health care sector had good stock selection. A key health care R&D industry is fading as capital markets funding activity builds off a low base. ICON, which manages clinical research studies and provides lab services to pharmaceutical companies, was added to the portfolio. As it continues to produce strong bookings growth, ICON has seen its backlog increase during the quarter. Positive returns were generated by STERIS, which provides infection prevention products and services to the health care and dental industries. The company reported strong earnings due to alleviating supply chain challenges and recovering numbers of health care procedures which require sterilizing instruments.
The energy sector was one of the positive contributors. As North America's leading natural gas provider, EQT had seen its share price slide as the lackluster reopening of China and a milder-than- expected winter weighed on natural gas prices. As fears of a recession have given way to optimism, the share price of EQT has rebounded. Global energy demand and the company's leadership position in the natural gas market make it a strong long term compounder for the portfolio.
Burlington Stores is an apparel and accessories retailer that offers a wide variety of products at discounted prices. The company's first quarter earnings highlighted challenges the company faced as its core, lower-income consumer demographic continues to be impacted by inflationary pressures. ETSY was negatively impacted by a shift in consumer spending from goods to services, elevated year-over-year performance comparables and fear of slowing growth in the second half of the 20th century. Much of the shift in consumer purchasing has already occurred and investor pessimism may be overblown.
Portfolio Positioning
As we continue to search the market for opportunities to add high-quality growth, we have built a watchlist of companies we review regularly to see if the current market conditions merit their inclusion in the portfolio. We added five positions in the quarter.
The trade desk is the leading trading platform for advertisers to buy programmatic ad space, such as the banner ads on a website or the commercials played while streaming TV. The Trade Desk enjoys meaningful network effects that make it the clear leader in the space and it is secularly taking share from traditional forms of advertising. We capitalized on the opportunity to buy a well-entrenched compounder in a large, growing market after the stock sold off.
We started a new position in the leading audio streaming music and podcasting platform. The market for audio streaming has a long runway for growth over the next 10 years due to rising penetration of smartphones and price increases. The company has shifted its focus towards improving profitability through winding down money losing podcast content investments. In the coming years, we believe these changes will lead to a rise in margins.
Syneos Health is a clinical research organization that provides clinical trial services to the pharmaceutical industry. Private equity investors took the company's share price out of their portfolio during the quarter.
Outlook
There is still a lot of uncertainty in the market and economic outlook. We are not overly influenced by the impact and outcomes of macro events and continue to take actions to maximize the risk of our portfolio. We focus on investing in high-quality companies with balance sheet stability and ample free cash flow generation, which results in the portfolio having a net debt to total capital ratio of 10.8, below the 15.9 for the benchmark, and on finding the most attractive growth at a compelling price. We look for sustainable competitive advantages and managerial competence that will allow these companies to generate and maintain attractive long-term returns.
Portfolio Highlights
The ClearBridge Mid Cap Growth Strategy was the winner during the second quarter. The strategy had gains in eight of the 10 sectors it was invested in during the quarter. The consumer discretionary sector was the main detractor.
Overall stock selection contributed to the performance. Stock selection in the IT, health care, energy, materials, communication services and real estate sectors as well as an overweight allocation to the IT sector helped performance. Performance was affected by stock selection in the consumer discretionary, financials and industrial sectors.
The biggest contributors to absolute returns in the quarter were Marvell Technology, Copart, and Palo Alto Networks. Mettler-Toledo International, Burlington Stores, Aspen Technology, and Five9 were the biggest detractors.
In addition to the transactions listed above, we also started new positions in Argenx and PINS in the communication services sector. We left our positions in Five9 and LYFT.
The portfolio manager is Brian Angerame.
The managing director is a portfolio manager.
MatthewLilling is a portfolio manager.
Jeffrey Russell is a portfolio manager.
| Future results are not guaranteed by past performance. ClearBridge Investments is a trademark of ClearBridge Investments As of the publication date, all opinions and data in this commentary are not the same. The opinions and views expressed are of the author and are not intended to be a forecast of future events, a guarantee of future results or investment advice. The only basis for making an investment decision is this information. The statistics have been obtained from reliable sources, but they can't be guaranteed. ClearBridge Investments, and its information providers are not responsible for any damages or losses that may arise from the use of this information. The performance source is internal. The benchmark is Russell Investments. The trademark, service marks and copyrights related to the Russell Indexes are owned by Frank Russell Company. Frank Russell Company is a trademark owner. No party may rely on any Russell Indexes and/or Russell ratings and/or underlying data contained in this communication if they have any doubts about the accuracy of the information. Russell's written consent is required for any further distribution of Russell data. Russell doesn't endorse the content of the communication. The performance source is internal. The benchmark is from Standard and Poor's. |
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