By Brian Angerame & Matthew Lilling, CFA
Mid Caps See Uneven Rally
Market Overview
Equity markets rallied in the first quarter as resilient corporate earnings, continued enthusiasm over artificial intelligence (AI) and the prospect of interest rate cuts spurred performance that surprised even the most optimistic investors. While large cap AI beneficiaries led markets, with the Russell 1000 Index returning 10.30% for the period, a broadening of market breadth helped bolster mid caps, with the Russell Midcap Index returning 8.60%. Growth stocks outperformed their value counterparts, with the Russell Midcap Growth Index returning 9.50% versus the 8.23% return of the Russell Midcap Value Index.
After a choppy four years, where stock performance was largely beholden to macro factors like supply chain problems, hyperinflation and a rapid rise in interest rates, we believe equities are finally showing signs of transitioning back to a more normal environment that favors fundamentals. Despite some profit taking early in the quarter, strong employment data, supportive consumer spending and inflation in-line with market expectations helped to calcify investors’ outlook for an economic soft landing and policymakers’ anticipation for rate cuts in 2024. In addition to buoying sentiment, these positive catalysts should help begin alleviating the unevenness of the post-COVID recovery across the economy.
With investor demand for AI stretching the valuations of certain information technology (IT) stocks beyond evidence of earnings improvement, we are dedicating more of our attention to areas of the market we believe are poised for a recovery, such as materials and health care. These sectors have struggled, but now show signs of stabilizing. We believe that many of these companies, having endured their own sector-specific recessions, are now poised to see an upward rerating due to improvement in their end markets and more optimistic guidance for the second half of the year.
From a sector standpoint, the industrials sector (+13.75%) generated the best performance in the benchmark during the quarter, followed by the financials (+12.50%), energy (+12.12%), consumer discretionary (+10.04%) and materials sectors (+8.90%), all of which outperformed the broader benchmark. The consumer staples (+6.88%), utilities (+6.67%), health care (+5.66%) and IT sectors (+5.17%) also generated positive returns during the period. Conversely, the communication services (-0.56%) and real estate (-0.03%) sectors suffered losses.
Stock selection in the consumer discretionary sector was the leading detractor from relative performance, driven by idiosyncratic issues within a handful of holdings. Automotive parts supplier Aptiv (APTV) faced pressure as headwinds to the broader auto-cycle and a slowing in electric vehicle adoption weighed on margins. However, we believe that the company’s above-market growth, combined with opportunity for margin expansion, are compelling at its current valuation as the auto-cycle rebounds. Online marketplace Etsy (ETSY) also saw weaker performance as consumer preferences for goods lagged market expectations. However, we think there is substantial opportunity for the company to reaccelerate growth and increase margins as it extracts greater economic rents from its two-sided marketplace for artisanal goods due to commanding market share, lack of direct competition and support from new activist investors.
Stock selection in the IT sector also weighed on performance. Investor excitement for AI has driven outperformance in hypergrowth companies but weighed on several of our holdings with more conservative outlooks, which are typically appropriate this early in the year. This included NCR Voyix (VYX), which provides software, consulting and technology services for digital commerce and automatic teller machines (ATMs). Under new direction since the spinoff of NCR Atleos (NATL) in the fourth quarter of 2023, the stock is still looking for solidification of its investor base. However, we are encouraged by the company’s focus on recurring revenue streams, which should allow it to grow at an attractive pace. Additionally, we believe that NCR Voyix’s current valuation is approximately equivalent to the value of its digital banking segment alone, which should merit further upward price movement.
We also found several compelling IT opportunities during the quarter, such as Freshworks (FRSH), which provides software-as-a-service products for applications such as customer service, operations and customer relationship management. By catering to the growing markets of small and medium-size businesses, the company is poised for a valuation rerating, in our view, as it captures greater market share and as revenue and margins continue to improve.
Financials were the leading contributor to relative performance during the quarter, despite our being significantly underweight relative to the benchmark. Much of the gains were driven by our insurance holdings Hartford Financial Services (HIG) and Arch Capital (ACGL), which have benefited from a harder insurance market and increased pricing power. Hartford has improved its return on equity from low-double digits into the mid-teens through a strong industry pricing environment, rolling over investments at higher returns, and internal improvement efforts. The increase has come with a commensurate increase in earnings and its multiple, reflecting investor appreciation of businesses we have thought undervalued for quite some time. We believe the trajectory of these insurance companies is a strong one and that continued pricing power should help propel their stock prices higher in the face of interest rate cuts and market volatility.
Portfolio Positioning
We trimmed several of our holdings during the period, such as Vertiv (VRT), our top performer for the quarter. We reduced the size of the power, precision cooling and infrastructure equipment supplier, and AI beneficiary, to capitalize on its strong recent performance and due to concerns of overextended valuations in the IT sector. We also added to existing holdings in sectors we feel are well-positioned to outperform as they rebound off current lows. This included Alexandria Real Estate Equities (ARE), which should benefit from a narrowing in the spread between capitalization rates and financing costs, and a potential relief in funding costs as interest rates move lower.
We initiated a new position in PPL, in the utilities sector, which provides electricity and natural gas to approximately 3.6 million customers across Kentucky, Rhode Island and Pennsylvania. In addition to operating in strong regulatory regimes, the company has a demonstrated history of resiliency, growing earnings 8% in 2023 despite a $120 million decline in revenue due to warmer winter weather and storm costs. With a strong balance sheet and no foreseeable need to raise equity, we believe the company is well-positioned to benefit from incremental demand for new data center build-outs and reshoring.
We also added a new position in Ferguson (FERG), a leading distributor of plumbing supplies and other products to plumbing and mechanical contractors, in the industrials sector. The company commands the largest market share in the industry, and primarily competes against small and localized competitors, creating a compelling opportunity for growth through a combination of market share gains and accretive acquisitions. We believe the company is uniquely positioned to win opportunities on nonresidential “mega” projects, as well as participate in any potential rebound in residential construction.
We exited our position in Pioneer Natural Resources (PXD), a vertically integrated oil and gas exploration and production company with primary shale operations in the Permian Basin. The company announced its intention to be acquired by Exxon Mobil (XOM) and, not anticipating a better offer for the company, we elected to sell the position.
Outlook
After four tumultuous years, we are on the precipice of re-entering a more normal economic environment that will favor active managers and fundamental research. We are increasingly seeing opportunities in sectors that have experienced their own recessions and the companies that have emerged stronger from them. These opportunities are most apparent among chemicals, life science R&D supply chain and building materials companies exposed to repair and remodel – all of which saw heavy inventory destocking in 2023, have stabilized, and look poised to grow by the second half of 2024. We believe that these overlooked opportunities, with strong balance sheets and attractive cash flows, will help drive attractive long-term performance.
Portfolio Highlights
The ClearBridge Mid Cap Strategy underperformed its Russell Midcap Index during the first quarter. On an absolute basis, the Strategy had gains across nine of the 11 sectors in which it was invested during the quarter. The leading contributors were the industrials and financials sectors, while the consumer discretionary and IT sectors detracted the most.
On a relative basis, overall stock selection and sector allocation effects detracted from performance. Specifically, stock selection in the consumer discretionary, IT, energy and utilities sectors weighed on performance. Conversely, stock selection in the financials and communication services sectors and an underweight to the real estate sector benefited performance.
On an individual stock basis, the biggest contributors to absolute returns in the quarter were Vertiv, Hartford Financial Services, ICON, Masonite (DOOR) and Regal Rexnord (RRX). The largest detractors from absolute returns were ATS (ATS), NCR Voyix, Crown, Workiva (WK) and Freshworks.
In addition to the transactions listed above, we initiated new positions in Coterra Energy (CTRA) and Diamondback Energy (FANG) in the energy sector, PTC (PTC) and AppLovin (APP) in the IT sector and NNN REIT in the real estate sector. We exited positions in NCR Atleos in the financials sector, Masonite and Advanced Drainage Systems in the industrials sector, Doximity (DOCS) in the health care sector, Americold Realty Trust (COLD) in the real estate sector and Ameren (AEE) in the utilities sector.
Brian Angerame, Managing Director, Portfolio Manager
Matthew Lilling, CFA, Managing Director, Portfolio Manager
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