ClearBridge Fund Outperforms Without Any Megacap Tech Stars (2022)

The $197.4 million ClearBridge Mid Cap Growth Fund (LBGIX) is one of those thoroughbreds whose outperformance makes it one of the best mutual funds.

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It has galloped ahead of the pack by diversifying its bets.

Why do the fund managers think that's necessary? Because they are hard-nosed realists. "We operate from a skeptical perspective," said Matt Lilling, who runs the fund with fellow managers Brian Angerame, Aram Green and Jeffrey Russell. "We spend a long time de-risking (investments in) companies. We communicate with management. Our team talks with people in their industry. We speak with competitors. Our team talks with suppliers. We try to understand what can go wrong."

Lilling added, "It's important for us to do that because we often hold companies a long time."

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Best Mutual Funds: This Portfolio's Performance

Their process has worked well. ClearBridge Mid Cap Growth Fundbecame an IBD Best Mutual FundAwardswinner by topping the S&P 500 in 2020 and in the three, five and 10 years ended Dec. 31.

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This year through Nov. 30, the fund's 21.08% return lagged the S&P 500's 23.18%. The fund's midcap growth rivals tracked by Morningstar Direct were up 11.65% on average.

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Lilling, 38 years old, spoke with IBD about his investment approach from ClearBridge Investments' Manhattan offices.

Is The Fund's Focus On Midcaps A Headwind?

IBD: As a midcap fund, how much of a headwind is it for you to not be able to own megacap technology names that have been big drivers of the market?

Matt Lilling: There's much innovation in the midcap space. And the tech sector is an area where we outperformed in 2021. We don't consider our inability to own megacap names an issue.

IBD: What has worked best for this fund in 2021?

Lilling: Tech and health care. In tech, we saw strong performance from a variety of companies. Security providers like Fortinet (FTNT) (the fund's top holding) did well as there there have been a lot of security breaches. The adoption of the cloud created a strong imperative to protect corporate networks from attack.

IBD: Which midcap cloud themes worked well?

Lilling: Companies in IT like Datadog (DDOG). Digital proliferation resulted in success for cloud-based front-office software suite firms like HubSpot (HUBS)

What companies that outperformed for us have in common is that they provide value to their customers. And they continue to invest in R&D to press their core-product advantage as well as expand into adjacent products to become even more important to their customers.That's a recipe that creates value for shareholders.

Why One Of The Best Midcap Stock Funds Likes Health Care

IBD: What worked well in health care?

Lilling: Results were driven by investments in companies that are critical enablers of biopharmaceutical innovation, companies like Charles River Labs (CRL), Bio-Techne (TECH) and Avantor (AVTR). Investors are starting to realize the potential impact of mRNA, cell and gene therapy, proteomics and other new trends.

Why One Of The Best Mutual Funds Likes Three Types Of Growth Stocks

IBD: Your team invests in three types of growth stocks, right?

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Lilling: Yes. Think of them as tiers in a pyramid. The bottom is the broadest, with about 40% to 50% of the portfolio. Stocks in that group are steady growers, with high barriers to entry by rivals and lower volatility. They grow at a single-digit to high-single-digit pace.

The middle tier make up about 30% to 40% of the portfolio. They are established businesses with strong consistency in earnings. They grow at 10% to 20%.

The top tier grows faster than 20%. Those are earlier stage companies. They have large opportunities ahead of them. But they have lower earnings visibility. That's their risk-reward tradeoff.

IBD: Why invest in three types?

Lilling: By investing across the spectrum, you're building a portfolio that can protect capital in challenging markets and participate fully in strong markets.

This 'Dog' Is No Dog

IBD: Let's drill down into some of the names you've mentioned. Datadog runs a monitoring and analytics platform for software developers and IT departments.

Lilling: There are three important things. They are cloud natives. That's where growth is proliferating.

Second, it is a great example of product-led growth. Their product is strong, easy to use and has a great interface.

Third, their "freemium" strategy makes it easy for small- to medium-size customers to adopt them.

IBD: What's your outlook for them?

Lilling: In the March quarter, they had not turned profitable yet. Since, they've been accelerating top-line growth. They accelerated throughout the year. They're poised to materially improve bottom-line profitability going into 2022.

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IBD: HubSpot is a marketing firm that helps attract visitors to web sites. It also aims to turn visitors into paying customers, right?

Lilling: It's a great example of a company that did one thing really well. Then they expanded into adjacent products.

They started with their marketing automation product. As the pandemic drew businesses to that product, HubSpot was well-positioned to cross-sell its sales, CRM (customer relationship management) and service products.

Then earlier this year they released their operations hub. They cross-sell both up and down markets. It's a great combination of attributes.

Why This Fund Likes AppLovin

IBD: Mobile game-maker AppLovin (APP) enables app developers to monetize their apps. Is that the crux of the stock's appeal?

Lilling: At its core, AppLovin helps developers to monetize by selling ads and to acquire users by placing ads, primarily in mobile games. So the bigger they get, the more developers that do that, the more powerful their network effect of first-party data is. The more data they get, the more effective their user acquisition engine becomes.

They've entered the video game business themselves, buying small games, then using their software to increase monetization. That leads to enormous return on investment.We think they can compound high returns with extremely high cash conversion for many years, both within mobile gaming apps and then outside gaming.

IBD: Earnings per share in 2022 for Marvell Technology (MRVL) are expected to rise 57%, according to MarketSmith analysis. For you, what's special about this chipmaker?

Lilling: They're selling semiconductors to the networking and storage markets. They're exposed to some of the most exciting growth areas, including 5G infrastructure, the cloud and autonomous driving.

Their management is top notch. They have a tremendous record of capital allocation and retaining top engineers.Their cloud business in particular should continue to grow at a high rate as cloud providers upgrade networking technology to 400G, where Marvell is the clear leader. (400G refers to the 400 gigabit speed of data transfer in the cloud.)

They recently increased their target top-line growth to 15% to 20% a year, with 38% to 40% operating margins.

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How Charles River Helps One Of The Best Mutual Funds

IBD: What is your thesis for Charles River Labs (CRL), which provides research animals and preclinical services?

Lilling: They're the No. 1 provider of preclinical outsource trials. They are the first to benefit from an increasing number of studies coming from the massive amount of health-care innovation.

That leads to accelerating revenues and steady margin expansion. They're also investing in cell and gene therapy, which are fast growing. And Charles River has shown good capitalization acumen in acquiring other companies, then cross-selling to those companies' customers.

IBD: How does Chipotle Mexican Grill (CMG) whet your investment appetite?

Lilling: Given their investment in technology and digital ordering, they have the ability to open their next 3,000 stores at better cash economics than their first 3,000 stores.

Their focus on digital ordering made it a market share taker during the pandemic. Digital sales are now 50% of their total vs. 20% before.

Also, there's less labor per order. That's helpful in a labor shortage. And it's convenient for customers. Plus, many of their new stores have drive-through lanes for pickup orders. That can increase their unit economics.

Follow Paul Katzeff onTwitter at @IBD_PKatzefffor tips about retirement planning and actively run portfolios that consistently outperform and rank among the best mutual funds.

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