SMID Stocks Expected to Benefit from Loosening Financial Conditions in Q4
Stocks in the small and mid-cap (SMID) range are anticipated to receive a boost from looser financial conditions in the fourth quarter. The combination of plunging bond yields and growing optimism about the U.S. economy’s soft landing has contributed to this positive outlook. The decline in inflation and the slowdown in the labor market have reversed the upward trend in yields and increased the likelihood that the Federal Reserve has finished its tightening cycle. As a result, the S&P 500 Index and the Russell 3000 Index experienced significant gains during the quarter.
Easing financial conditions have also led to improvements in market breadth, with the small-cap Russell 2000 Index rising notably. While larger cap stocks favored growth, the majority of the ClearBridge Select Strategy portfolio consists of small and mid-cap stocks. During the quarter, value outperformed growth in this segment of the market.
The Strategy’s performance in the fourth quarter was supported by contributions from various sectors and categories of growth companies. The balanced portfolio construction approach, which focuses on promoting consistent results across different market conditions, played a significant role in achieving this success.
High-growth disruptors such as ServiceNow, MercadoLibre, and Shopify, along with durable compounders like Apple and emerging opportunities like KKR and Burlington Stores, were top performers during the quarter. These companies provided the necessary upside momentum to outperform the overall market.
One of the primary goals of the Strategy is to deliver performance through high active share, which means generating alpha without depending on the market leadership of the day. By identifying opportunities beyond the commonly known Magnificent Seven stocks, the Strategy aims to diversify its holdings and capture potential returns in companies that may be overlooked by other investors.
While the Strategy opportunistically initiated a position in Microsoft during the quarter, it maintained exposure to just three of the seven popular stocks. The Strategy’s main active weight came from its position in Nvidia. This diversification strategy allows for a more comprehensive portfolio that can weather changing market dynamics.
During the quarter, the Strategy added several new positions that aligned with its focus on four secular growth themes: data and analytics, onshoring/reshoring, information security, and e-commerce. These new additions, including Trade Desk, Monolithic Power Systems, and Model N, provided further opportunities for growth.
In addition to these disruptors, the Strategy also added a position in Intercontinental Exchange. As an operator of securities exchanges, fixed income and data services, and mortgage technology solutions, Intercontinental Exchange offers diversification across asset classes and has strong competitive advantages.
To optimize the risk/reward profile of the Strategy, several positions were closed during the quarter. Takeouts by strategic acquirers led to the exit of New Relic and Horizon Therapeutics, while excess supply issues in the residential solar market led to the closure of SolarEdge Technologies. The Strategy’s focus on evolving opportunities also led to the exit of certain positions that did not show the progress expected.
Overall, the broadening participation in the market during the fourth quarter was seen as encouraging, particularly in small and mid-cap stocks. These segments continue to be attractively priced relative to the overall market and historical trends. As inflation cools and the Federal Reserve maintains its current stance, financial conditions are expected to remain loose, providing a tailwind for both growthier and smaller cap stocks.
Improving liquidity in the market is also anticipated to unfreeze the IPO market, allowing fundamentally-sound businesses to explore the possibility of going public. The Strategy sees the IPO market as a fertile source of idea generation and expects to derive further value from opportunities in this space.
The ClearBridge Select Strategy outperformed its benchmark during the fourth quarter, with gains recorded across most sectors. Stock selection in the IT, consumer discretionary, consumer staples, real estate, health care, and energy sectors, as well as an overweight position in IT, contributed significantly to the positive results. However, an underweight position in financials and stock selection in the industrials sector detracted from overall performance.
The top contributors to the Strategy’s performance included ServiceNow, MercadoLibre, Shopify, KKR, and Apple. On the other hand, Shoals Technologies, ON Semiconductor, Fox Factory, HealthEquity, and argenx were the primary detractors.
As part of its risk management approach, the Strategy exited its position in Morgan Stanley during the quarter, in line with its analysis of the financial sector.
As the market continues to evolve, the ClearBridge Select Strategy remains focused on identifying and capitalizing on opportunities across various sectors and growth categories. With a balanced and diversified portfolio, the Strategy aims to generate consistent results for investors in different market conditions.
