CLEARBRIDGE SMALL CAP VALUE FUND

Transcription

1 3Q 2018 Product Commentary CLEARBRIDGE SMALL CAP VALUE FUND Tim Daubenspeck and Miguel del Gallego, CFA Portfolio Managers Average annual total returns and fund expenses (%) as of September 30, 2018 Class A 3-mo 1-yr 5-yr 10-yr Excluding sales charges Including effects of maximum sales charges Since Incept. (02/26/99) Gross Net Russell N/A - - Value Index Performance shown represents past performance and is no guarantee of future results. Current performance may be higher or lower than the performance shown. Investment return and principal value will fluctuate, so shares, when redeemed, may be worth more or less than the original cost. Class A shares have a maximum front-end sales charge of 5.75%.Total returns assume the reinvestment of all distributions at net asset value and the deduction of all Fund expenses. Total return figures are based on the NAV per share applied to shareholder subscriptions and redemptions, which may differ from the NAV per share disclosed in Fund shareholder reports. Performance would have been lower if fees had not been waived in various periods. Returns for less than one year are cumulative. For the most recent month-end information, please visit Gross expenses are the Fund's total annual operating expenses for the share class(es) shown. Net expenses are the Fund's total annual operating expenses for the share classes indicated and would reflect contractual fee waivers and/or reimbursements, where these reductions reduce the Fund's gross expenses. These arrangements cannot be terminated prior to December 31, 2019 without the Board s consent. In periods of market volatility, assets may decline significantly, causing total annual Fund operating expenses to become higher than the numbers shown in the table above. The Russell 2000 Value Index Russell 2000 Value Index is an unmanaged index of those companies in the small-cap Russell 2000 Index chosen for their value orientation. Please note that an investor cannot invest directly in an index, and unmanaged index returns do not reflect any fees, expenses or sales charges. Key takeaways Communications services and IT companies drove portfolio performance in the third quarter. Higher rates pressured some industrial names in the portfolio, which also suffered from concerns that the economy is entering the late innings. All eyes are on November s midterm elections and on issues such as infrastructure spending, tax cut extensions or modifications, and trade. Market overview The stock market generated a strong return in the third quarter, despite trade conflicts and numerous bouts of financial and political uncertainty across the globe. Concerns over the broad-based implications of U.S. trade policy continued to dominate the financial news flow. The first half of the quarter was marked by the U.S. dollar reaching highs not seen in over a decade, oil prices declining and the yield curve flattening. A trade settlement with Mexico, as well as China s intervention to stabilize the yuan in late August, settled the markets fears, resulting in little change in the dollar and oil for the quarter. The large-cap S&P 500 Index returned 7.7%, while, hampered by larger levels of debt and rising interest rates, the small-cap Russell 2000 Index advanced 3.6%. After beating small-cap growth as well as large-caps in the second quarter, the benchmark Russell 2000 Value Index trailed both in the third quarter, adding 1.6%. Communication services companies led portfolio performance, in particular Iridium, which operates a global system of satellites for voice and data communications and counts INVESTMENT PRODUCTS: NOT FDIC INSURED NO BANK GUARANTEE MAY LOSE VALUE

2 among its clients the U.S. Department of Defense. After a period of large capital expenditures necessary to successfully launch its next-generation satellite network, Iridium will soon begin to generate meaningful cash flow from its operations and delever its balance sheet. This quarter s success, marked by a strong second-quarter revenue beat and a deal by subsidiary Aireon to provide systems for commercial air traffic surveillance, is evidence to us that the business plan remains strongly intact. Information technology (IT) stocks also helped the portfolio, led by IT solutions provider PC Connection, which has benefited from good execution in a strong enterprise IT spending environment. Herman Miller was another encouraging third-quarter contributor. The designer and distributor of office furniture experienced cost inflation throughout the year due to aluminum and steel tariffs, but despite this, Herman Miller was able to post margin expansion on the back of strong sales across the board during the quarter. It was particularly nice to see success in its consumer strategy, after several false starts following the acquisition of Design Within Reach and major store redesigns. Channel mix some consumer products have done well in Herman Miller s corporate channel has also helped. Yields on the 10-year U.S. Treasury rose late in the quarter as investors gained confidence in the sustainability of a strong U.S. economy, overcame fears of slumps in emerging markets, and settled further in to a global monetary tightening cycle. The Federal Reserve raised the federal funds rate in June and again in September, making it three hikes so far in Higher rates pressured some industrial names in the portfolio, which also suffered from concerns that the economy is entering the late innings, and corresponding fears of lower demand. Higher rates are also sparking concerns that housing has peaked; homebuilding stocks have come under considerable pressure year to date and are suggesting that overall demand growth has slowed, though there has yet to be contraction. Two highly levered portfolio names in the housing business Foundation Building Materials, which sells nonresidential building materials and commercial and industrial pipe insulation, and Beacon Roofing Supply, which makes residential and commercial roofing materials suffered as a result. We are also overweight banks, which saw loan growth slow and the compounding effect of a flatter yield curve and rising funding costs. Texas Capital Bancshares, which is particularly sensitive to funding costs, bore the brunt of this in the portfolio this quarter. Meanwhile, U.S. economic indicators are uniformly powerful, and we believe the cycle has some legs. Unemployment at 3.7% in September continues to be strong, and jobless claims hit a five-decade low during the quarter. Unemployment is currently at levels below the commonly accepted noninflationary rate, putting the Federal Reserve on inflation watch. Wages rose 2.9% and 2.8% in August and September, respectively; levels not yet alarming but the highest of the current cycle. The powerful September ISM indicates real GDP growth of over 4%. Consumer confidence hit a new cycle high, and September s seasonally adjusted annual rate of auto sales was 17.4 million, the best in several months. Capital expenditures were also the highest of the business cycle, helped by incentives in recent tax reform. Share repurchases for the S&P 500 were $191 billion in the second quarter, the highest ever. During the quarter we found value across various stages of the value cycle. STAG Industrial represents a relative value play: the REIT company in the industrial subsector focuses on single-tenant industrial properties across the U.S., and its shares offer good value in a somewhat beleaguered real estate sector, whose yield focus has led it to suffer from higher bond yields. We also added specialty chemical company Tronox as one of our deep value names companies greatly out of favor or residing in any industry trading at distressed levels after a pullback in prices for TiO2, the pigment manufactured using Tronox s titanium-bearing minerals, led to what we believe was an overexaggerated discount on Tronox shares. Throughout the quarter we trimmed exposure where companies approached our price targets, as in the case of Iridium and Herman Miller. We also sold a pair of companies Diebold Nixdorf and Pitney Bowes where the stock price breached our downside targets and triggered a full review that resulted in a departure from our original investment theses. Looking ahead, all eyes are on November s midterm elections and how they will affect key issues such as infrastructure spending, tax cut extensions or modifications, and trade, where industrial names have suffered from higher input costs stemming from protectionist tariffs. We are cognizant of how developments in these areas may affect the portfolio. Fund highlights For the quarter ended September 30, 2018, the ClearBridge Small Cap Value Fund Class A shares had a cumulative return of -1.03%, excluding the effects of sales charges. In comparison, the Fund s unmanaged benchmark, the Russell 2000 Value Index, returned 1.60%. 2

3 On an absolute basis, the Fund had gains in three of the sectors in which it was invested for the quarter (out of 11 sectors total). The primary contributor to positive performance was the newly created communication services sector, which expands the telecommunication services sector to include select companies from the consumer discretionary and IT sectors, followed by the IT sector. The consumer staples, energy and financials sector were the main detractors from returns during the quarter. On a relative basis, the Fund underperformed its benchmark primarily as a result of stock selection decisions. Stock selection in the industrials and financials sectors detracted the most from relative returns. Meanwhile, stock selection in the communication services sector was the main contributor to relative performance. On an individual stock basis, the greatest detractors from absolute returns in the third quarter included positions in Diebold Nixdorf, Extraction Oil & Gas, Cross Country Healthcare, Modine Manufacturing and Foundation Building Materials. Iridium, Surgery Partners, PC Connection, Belden and Avid Technology were the largest contributors to absolute performance. During the quarter, besides new positions mentioned above, we established positions in Mesa Air, Bank7 and Hansa Medical. In addition to sales previously mentioned, we closed a position in Metropolitan Bank. Top contributors The top contributors to Fund performance for the quarter included: Iridium (IRDM), in the communication services sector, operates a global system of satellites for voice and data communications and counts among its clients the U.S. Department of Defense. After a period of large capital expenditures necessary to successfully launch its nextgeneration satellite network, Iridium will soon begin to generate meaningful cash flow from its operations and delever its balance sheet. This quarter s success, marked by a strong second-quarter revenue beat and a deal by Iridium subsidiary Aireon to provide systems for commercial air traffic surveillance, is evidence to us that the business plan remains strongly intact. results and updated guidance for the back half of the year suggest that the turnaround efforts implemented by the new management team are beginning to gain traction and offer a promising setup for more meaningful improvements in financial results for PC Connection (CNXN), in the IT sector, is an IT solutions provider. PC Connection has been benefiting from good execution in a strong enterprise IT spending environment. Top detractors The leading detractors from performance for the quarter included: Diebold Nixdorf (DBD), in the IT sector, is a security systems services company that provides approximately a third of the world s ATMs. In its latest earnings report, Diebold Nixdorf delivered a narrow revenue beat but missed earnings and lowered guidance. The company is in the midst of an executive transition, replacing its CFO, and implementing several actions to simplify operations. Extraction Oil & Gas (XOG), an exploration & production company in the energy sector, declined more than its peers after Colorado (where Extraction operates) put an initiative on its November ballot to reduce significantly the areas where hydraulic fracturing would be allowed in the state. While the initiative s terms would seriously impair Extraction s value, we believe it is unlikely to be implemented as written. Colorado is a major energy production state, deriving a significant amount of royalties and tax revenue from the business so gubernatorial candidates from both parties disapprove of the initiative. Even if passed, the initiative could still be reworded in the legislature. We continue to own the stock. Foundation Building Materials (FBM), in the industrials sector, sells nonresidential building materials and commercial and industrial pipe insulation. The company suffered as concerns that the economy is in late innings and that demand will slow pressured industrials stocks. Higher interest rates also weighed on the construction industry, and in particular on Foundation s highly levered balance sheet. Surgery Partners (SGRY), in the health care sector, is a health care services company that manages surgical facilities, physician-partnered hospitals and diagnostic labs, as well as offering anesthesia, pharmacy and optical services. Quarterly 3

4 Top 10 equity holdings (%) Surgery Partners Inc 4.2 Western Alliance Bancorp 3.0 Wintrust Financial Corp 3.0 WesBanco Inc 2.5 Urstadt Biddle Properties Inc 2.4 Superior Industries International Inc 2.4 Gray Television Inc 2.4 Iridium Communications Inc 2.2 Real estate investment trusts (REITs) invest in real estate or loans secured by real estate and issue shares in such investments, which can be illiquid. The Russell 2000 Index is composed of the 2,000 smallest companies in the Russell 3000 Index. An investor cannot invest directly in an index, and unmanaged index returns do not reflect any fees, expenses or sales charge. Russell 2000 Value Index is an unmanaged index of those companies in the small-cap Russell 2000 Index chosen for their value orientation. S&P 500 Index is an unmanaged index of common stock performance. U.S. Treasuries are backed by the full faith and credit of the United States government and offer return of principal value if held to maturity. The yield curve shows the relationship between yields and maturity dates for a similar class of bonds. Avid Technology Inc 2.2 Starwood Property Trust Inc 2.1 Sector allocation (%) Financials 30.2 Industrials 11.8 Real Estate 10.9 Information Technology 10.3 Health Care 7.5 Consumer Discretionary 6.7 Energy 6.4 Consumer Staples 5.3 Communication Services 4.6 Materials 2.6 Utilities 0.0 Cash/Other 3.7 Percentages are based on total portfolio as of quarter end and are subject to change at any time. For informational purposes only and not to be considered a recommendation to purchase or sell any security. Definitions and additional terms: Dividends and yields represent past performance, and they can fluctuate, and there is no guarantee they will continue to be paid. Please note that an investor cannot invest directly in an index, and unmanaged index returns do not reflect any fees, expenses or sales charges. Capital expenditures ( capex ) are funds used by a company to acquire or upgrade physical assets such as property, industrial buildings or equipment. Federal funds rate is the interest rate at which a depository institution lends funds maintained at the Federal Reserve to another depository institution overnight. Gross domestic product (GDP) is the market value of all final goods and services produced within a country in a given period of time Institute for Supply Management (ISM), formerly known as the National Association for Purchasing Management, is an association representing more than 48,000 purchasing and supply management professionals. It conducts regular surveys of purchasing and supply managers to determine industry trends. 4

5 Brandywine Global Clarion Partners ClearBridge Investments EnTrustPermal Martin Currie QS Investors RARE Infrastructure Royce & Associates Western Asset leggmasonfunds.com Youtube.com/leggmason Legg Mason is a leading global investment company committed to helping clients reach their financial goals through long-term, actively managed investment strategies. A broad mix of equities, fixed income, alternatives and cash strategies invested worldwide A diverse family of specialized investment managers, each with its own independent approach to research and analysis What should I know before investing? Over a century of experience in identifying opportunities and delivering astute investment solutions to clients Equity securities are subject to price fluctuation and possible loss of principal. Smalland mid-cap stocks involve greater risks and volatility than large-cap stocks. International investments are subject to special risks, including currency fluctuations and social, economic and political uncertainties, which could increase volatility. Short selling is a speculative strategy. Unlike the possible loss on a security that is purchased, there is no limit on the amount of loss on an appreciating security that is sold short. Derivatives, such as options and futures, can be illiquid, may disproportionately increase losses, and have a potentially large impact on Fund performance. The manager s investment style may become out of favor and/or the manager s selection process may prove incorrect, which may have a negative impact on the Fund s performance. Any information, statement or opinion set forth herein is general in nature, is not directed to or based on the financial situation or needs of any particular investor, and does not constitute, and should not be construed as, investment advice, a forecast of future events, a guarantee of future results, or a recommendation with respect to any particular security or investment strategy or type of retirement account. Investors seeking financial advice regarding the appropriateness of investing in any securities or investment strategies should consult their financial professional. Portfolio holdings and sector allocations may not be representative of the portfolio manager's current or future investment and are subject to change at any time. ClearBridge Investments, LLC and Legg Mason Investor Services, LLC are subsidiaries of Legg Mason, Inc Legg Mason Investor Services, LLC. Member FINRA, SIPC CBAX D /18 BEFORE INVESTING, CAREFULLY CONSIDER A FUND S INVESTMENT OBJECTIVES, RISKS, CHARGES AND EXPENSES. YOU CAN FIND THIS AND OTHER INFORMATION IN EACH PROSPECTUS, AND SUMMARY PROSPECTUS, IF AVAILABLE, AT PLEASE READ THE PROSPECTUS CAREFULLY. 5