ClearBridge Small Cap Strategy: Q3 2025 Commentary

Instructions

The ClearBridge Small Cap Strategy demonstrated positive absolute performance in the third quarter of 2025, yet modestly trailed its benchmark. The market saw a significant rally in small-cap equities, fueled by strong earnings revisions, Federal Reserve rate cut expectations, and enthusiasm for high-beta, high-growth companies. Despite this broad market strength, active managers faced challenges due to the concentrated nature of market leadership. The strategy maintains its focus on high-quality businesses with robust fundamentals, anticipating a future market environment that will increasingly reward such disciplined investment approaches.

Key contributors to the strategy's performance included the materials and information technology sectors, while communication services and consumer discretionary holdings detracted. New positions were initiated in companies like Quaker Houghton and Avidity Biosciences, reflecting a commitment to undervalued growth prospects and innovative platforms. Conversely, positions in companies such as Vivid Seats were exited due to intensifying competitive pressures. The strategy remains steadfast in its bottom-up investing approach, confident that market cycles will eventually favor quality and sustainable business models.

Small-Cap Market Dynamics and Investment Strategy

In the third quarter of 2025, small-cap equities, as measured by the Russell 2000 Index, experienced a substantial surge, advancing by 12.4%. This impressive rally not only surpassed the performance of large-cap counterparts but also established a new all-time high, breaking a three-year plateau. The market's upward trajectory was underpinned by several key factors: a notable improvement in earnings revision breadth, ongoing anticipation of Federal Reserve interest rate reductions, and a sustained investor appetite for speculative growth and high-beta stocks. Retail investors played a crucial role, injecting momentum into a select group of companies, which amplified both the overall breadth and concentration of returns. Despite this overall positive trend, value-oriented and profitable companies continued to underperform, extending a historical pattern of divergence. The quarter, however, presented complexities for active managers due to the prevalence of speculative winners and a narrow market leadership, making it challenging for strategies driven by fundamental analysis to match the pace of the benchmark.

Amidst these dynamic market conditions, the ClearBridge Small Cap Strategy, while achieving positive absolute returns, modestly lagged its benchmark. The strategy's performance was significantly influenced by broad participation across various sectors. The materials sector emerged as a primary driver of relative strength, benefiting from exposures to crucial supply chains and favorable commodity cycles. A standout performer within this sector was MP Materials, North America's sole large-scale producer of rare earth elements. Its shares saw a significant increase following new supply agreements with the U.S. Department of Defense and continued governmental support for domestic rare earth production, essential for electric vehicles and clean energy technologies. Warrior Met Coal, a metallurgical coal producer, also contributed positively, buoyed by successful expansion of its low-cost Blue Creek mine. Eagle Materials, a supplier of cement and building materials, also thrived due to the sustained resilience in construction activity. These successes highlight the strategy's ability to identify and capitalize on fundamental strengths within specific industries, even in a market influenced by broader speculative trends.

Portfolio Performance and Future Outlook

The information technology sector also proved to be a strong positive contributor to the portfolio's performance. Several holdings within this sector delivered robust relative results. TeraWulf, a vertically integrated bitcoin mining and energy infrastructure firm, was a top performer, driven by a rebound in cryptocurrency prices and significant investment from Google. TeraWulf is strategically shifting its focus from crypto mining to becoming an AI infrastructure provider, positioning itself for future growth. Penguin Solutions, specializing in high-performance computing and AI infrastructure, also saw substantial gains, benefiting from the surging demand for AI-related hardware and data center solutions. Additionally, Photronics, a leading manufacturer of photomasks for the semiconductor industry, advanced due to the sustained strength in the semiconductor cycle and ongoing demand for advanced chips. Conversely, the communication services sector was the primary detractor from relative performance. This was attributed to an uncertain outlook stemming from cyclical and structural shifts in media, advertising, and consumer engagement. Criteo, a digital advertising technology provider, struggled amidst sector-specific challenges and competitive pressures, despite reporting better-than-expected earnings. Gambling.com also experienced a decline after lowering its full-year outlook, citing impacts from changing search algorithms and fears that AI could affect search engine optimization, along with potential earnings dilution from its Spotlight.Vegas acquisition.

Consumer discretionary also represented an area of relative weakness for the portfolio. Murphy USA, a prominent operator of gas stations and convenience stores, notably detracted from performance. The company's shares faced headwinds as it reported lower-than-anticipated earnings, primarily due to reduced fuel volumes, increased operating expenses, and a decline in same-store sales, even though total merchandise sales saw an increase. In terms of portfolio adjustments, a new position was established in Quaker Houghton, a global specialty chemicals company, identified as being near the bottom of its estimate revision cycle with overly pessimistic market expectations relative to its long-term growth potential. Another addition was Avidity Biosciences, a development-stage biotechnology firm with a proprietary RNA-based therapeutic platform, whose pipeline offers significant upside potential. Conversely, the position in Vivid Seats, an online ticket marketplace, was exited due to increasing competitive pressures and uneconomic pricing strategies from larger platforms. Despite the current market environment favoring speculative and high-beta companies, the ClearBridge strategy remains committed to disciplined, bottom-up investing, focusing on high-quality businesses with strong balance sheets and sustainable growth drivers. The fund managers believe that the market cycle will eventually re-emphasize fundamentals, rewarding patience and rigorous research for long-term client value.

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