ClearBridge Small Cap Progress Technique Q1 2023 Portfolio Supervisor Commentary

By Aram Inexperienced & Jeffrey Russell

Conserving Tempo as March Got here in Like a Lion

Market Overview

At year-end, we had hoped to quickly be previous the macro/information domination of inventory costs. Nevertheless, the primary quarter was marked by a banking deposit tsunami that broke with astonishing rapidity in March and resulted in additional gyrations of future rate of interest and inflation expectations. By way of this tumult, the ClearBridge Small Cap Progress Technique modestly outperformed the Russell 2000 Progress Index benchmark.

January started with a rally most unloved by strategists and plenty of traders. Whereas there are some indications of easing negativity, this stays a usually disdained fairness market given the prospect of additional rate of interest will increase and sure earnings shortfalls stemming from the financial slowdown. Nevertheless, we imagine there proceed to be missed positives out there, akin to materially improved provide chain frictions (“components and labor”) and slowing inflation (as evidenced by commodity costs considerably decrease versus a 12 months in the past).

Current knowledge exhibits that employment stays stubbornly excessive, a lot to the frustration of the Federal Reserve. Nevertheless, lots of our corporations, notably within the info know-how (IT) sector, comment that gross sales, engineering and different key expertise have shifted from “the Nice Resignation” to a way more secure “purchaser’s market.” That pattern doesn’t present up in short-term earnings estimates, but managing a progress enterprise is immeasurably simpler with decrease labor churn given the prices of recruiting, coaching and integrating new expertise.

“A lot of our IT corporations comment that gross sales and engineering expertise has moved from “the Nice Resignation” to a way more secure purchaser’s market.”

Unemployment unexpectedly dropped in January and long-term Treasury yields backed up rapidly in February, testing the market’s mettle. But because the outdated proverb suggests, March got here in like a lion, with a banking disaster precipitated by the rise of short-term rates of interest. This, mixed with usually poor asset/legal responsibility length matching throughout the business and the flexibility of depositors to instantaneously transfer cash with a mouse click on, proved poisonous and contagious.

The monetary failure and depositor run at SVB Monetary (SIVB) was beautiful. Whereas the Technique didn’t personal SIVB, we underappreciated the danger of fast depositor exodus at different monetary corporations, which grew to become engulfed by depositor outflows. Coverage response was stable, with depositor safety and liquidity packages for equally pressured establishments, but our funding in Western Alliance Bancorp grew to become considerably larger threat and extra risky than we had imagined. After appreciable debate, we offered the funding.

The near-term, second order impact of SIVB’s failure was the promoting of chosen know-how and well being care investments perceived to be part of the SIVB “ecosystem.” The inference was that the dislocation at SIVB may prohibit or blunt the expansion of innovation and financing in Silicon Valley. Whereas which may be true for various pre-public companies in deficit mode, we suspect these enterprise had already begun to ration money given the extra austere financing setting of the previous 12 months. The businesses during which the Technique has invested are usually not unduly depending on exterior financing within the close to time period; we proceed to imagine the monetary leverage of a few of our investments is suitable to the underlying enterprise stability.

Portfolio Positioning

We initiated three new investments through the quarter in Definitive Healthcare (DH), Ingredient Options (ESI) and Livent (LTHM):

• Definitive Healthcare is a extremely worthwhile knowledge and analytics provider to well being care suppliers and producers. Definitive’s analytics are “industrial intelligence,” helping salespeople to seek out the proper prospects and choice makers.
• ESI is a high-value specialty supplies producer, concentrating on primarily the contract manufacturing electronics business and metallic plating for automotive functions. ESI works intently with finish purchasers to configure customized supplies traits and the corporate’s merchandise are continuously in design specs of contract producers.
• Livent mines lithium compounds which, as soon as additional processed by prospects, are a key factor in batteries for electrical automobiles and different superior functions. Demand for lithium is predicted to develop materially over the following decade as the usage of electrical automobiles supplants inner combustion engines.

Along with exiting Western Alliance (WAL), we offered smaller positions in truck brokerage agency RXO, content material advertising visibility software program maker SEMrush (SEMR) and collaboration software program developer Smartsheet (SMAR).

Outlook

The broader implications of the March banking crunch are nonetheless unfolding, however a number of longer-lasting parts appear clear:

• The prices and regulation of regional banking will enhance, making the business in the end “safer” however with constrained returns.
• Financially-focused companies with restricted credit score publicity or depositor flight threat will turn into extra interesting to traders.
• The Fed’s inflation battle turns into even harder given systemic fragility.
• Rates of interest could peak sooner, favoring the visibility of progress shares over worth shares. Parenthetically, the mega-tech laggards of 2022 grew to become the rotational “secure wager” because the quarter ended.
• Transaction multiples shall be pressured and acquisitions shall be harder to impact if borrowing is important to consummate a deal or to drive transaction economics.

Portfolio Highlights

The ClearBridge Small Cap Progress Technique outperformed its benchmark within the first quarter. On an absolute foundation, the Technique posted good points throughout six of the 9 sectors during which it was invested (out of 11 sectors whole). The first contributors to efficiency have been within the IT and well being care sectors whereas the principle detractors included the financials and vitality sectors.

Relative to the benchmark, total sector allocation contributed to efficiency. Specifically, an chubby to IT, an underweight to vitality and inventory choice within the well being care and IT sectors drove outcomes. Conversely, inventory choice within the shopper discretionary, financials and industrials sectors and an underweight to shopper discretionary detracted from returns.

On a person inventory foundation, the main contributors have been positions in Allegro MicroSystems (ALGM), Lattice Semiconductor (LSCC), Penumbra (PEN), Fox Manufacturing facility (FOXF) and Monolithic Energy Techniques (MPWR). The first detractors have been Nationwide Imaginative and prescient Holdings (EYE), Western Alliance Bancorp, Silk Street Medical (SILK), Chegg (CHGG) and Xometry (XMTR).

Along with the transactions talked about above, we offered Aerojet Rocketdyne (AJRD) forward of its pending acquisition by L3Harris Applied sciences (LHX).

Aram Green, Portfolio Manager

Jeffrey Russell, CFA, Portfolio Manager

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