LBRDP - ClearBridge Aggressive Growth Strategy Q3 2022 Portfolio Manager Commentary

Summary

• Strategy returns with a low correlation to mega cap growth companies, reflected in our high active share, proved beneficial in the third quarter.
• From a sector perspective, several long-standing biopharmaceutical positions as well as newer disruptive technology holdings drove outperformance versus the benchmark.
• An unprecedented set of global challenges makes it more important than ever to own cash-generative businesses with strong balance sheets that can take advantage of dislocations in the market and the economy.

Market Overview

Stocks endured a seesaw summer that ended with broad losses as macroeconomic headlines around inflation, interest rate hikes and continuing concerns about a slowing economy presented headwinds. The S&P 500 Index fell 4.9% for the quarter and is down 23.9% year to date, its worst showing at this point since 2002. Small caps showed more resilience with the Russell 2000 Index down 2.2% for the quarter.

Meanwhile, growth stocks held up better than value with the benchmark Russell 3000 Growth Index declining 3.4% for the quarter compared to a loss of 5.6% for the Russell 3000 Value Index. Growth, however, still trails value by nearly 1,300 basis points year to date.

While the first six weeks of the quarter saw equities rally, the last six weeks were dominated by efforts to quell inflation capped by a 75-basis point rate hike by the Federal Reserve in September, its third such move of the year. The 10-year U.S. Treasury yield climbed 82 bps to finish at 3.83%, near its highest levels in over a decade. Rising rates are particularly trying for long-duration growth companies that make up the largest weightings in the benchmark.

We manage the ClearBridge Aggressive Growth Strategy as long-term business owners and have historically delivered performance with a low correlation to the overall index. We look for durable and defensible business models that can withstand periods of economic stress like what we've been going through for the last several months, as well as the last few years. That divergence, reflected in the Strategy’s high active share, proved beneficial in the third quarter and led to outperformance versus the benchmark.

The biggest relative contributor to performance was our information technology ((IT)) exposure. Within the IT sector, we own companies like Snowflake ( SNOW ), a leader in the data analytics space, and Wolfspeed ( WOLF ), which is using silicon carbide to produce chips that enable and power electric vehicles, one of the largest addressable markets going forward. Similarly, disruptive names in other areas such as handcrafted goods e-commerce marketplace Etsy ( ETSY ), a relatively new position in the portfolio, executed well during the third quarter.

Our differentiated exposure in the health care sector also proved beneficial. These tend to be companies generally resilient to economic woes. While we continue to expand our health care coverage into higher-growth areas like diagnostics and clinical research, the bulk of our holdings remain in biopharmaceutical companies developing new or innovative treatments for unmet medical needs.

Biogen ( BIIB ) was the leading contributor among several biopharma names, boosted by positive, pivotal clinical data for its next-generation Alzheimer’s treatment Lecanemab. In a pivotal trial, the drug proved safe and efficacious in slowing progression of Alzheimer’s disease. Vertex Pharmaceuticals ( VRTX ), which has developed the leading treatments for cystic fibrosis, also saw meaningful positive developments in its pipeline in the third quarter around areas like pain, diabetes and blood disorders.

Vertex has been able to consistently grow revenues and earnings through the latest period of economic headwinds, enabling investment in R&D to target treatments in these new areas.

The Strategy was not completely insulated to macro headwinds and some companies saw tough comparisons after strong pull forwards in demand during the COVID-19 pandemic. Media companies including Comcast ( CMCSA ) were hurt by both factors in the quarter.

After extremely strong broadband growth during the early days of the pandemic, Comcast is now experiencing slowing to negative growth in its broadband business due to new competition and less consumer moving activity along with headwinds on the programming side, where advertising budgets have been more stressed. A tougher advertising environment has also hurt pure play programmers AMC Networks ( AMCX ) and Warner Bros. Discovery ( WBD ).

Within cyclical technology, disk drive makers Seagate Technology ( STX ) and Western Digital ( WDC ) were hurt by an inventory correction due to slowing growth in their core PC and server markets as well as uneven demand from hyperscale cloud providers who are watching their budgets. While these two stocks remain inexpensive on a valuation basis, they clearly saw a business slowdown over the last two quarters.

Portfolio Positioning

As we communicated last quarter, recent transactions have us in the later innings of the overall portfolio transition that we embarked upon in early 2021. The outcome of the repositioning is a more balanced and diversified portfolio of companies with a stronger growth profile that maintains a valuation discount compared to the benchmark. As a result, we did not make any outright purchases or sales during the third quarter, with most of our activity dedicated to adding to new positions and trimming names where business visibility has worsened.

The largest additions were to Diageo ( DEO ), a steady compounder in the consumer staples sector, Airbnb ( ABNB ), a disruptor in the consumer discretionary sector, and Snowflake, a disruptor in the IT sector. We also took some profits in Biogen after its rerating higher late in the quarter while reducing our weighting to Lyft ( LYFT ) and DocuSign ( DOCU ).

Outlook

We have seen a number of different bear markets over our tenure managing the portfolio. But the confluence of factors over the last three years has been unprecedented. The pandemic and subsequent supply chain disruptions, the war in Ukraine as well as inflation and subsequent rate hikes have all presented challenges to companies. These disruptions make it more important than ever to own good businesses that generate a lot of cash and with strong balance sheets that enable them to take advantage of dislocations in the market and the economy.

Given their balance sheet strength and their ability to generate cash and free cash flow, the companies we own can do this through actions like stock buybacks. They can also benefit from industry consolidation. The most recent activity has occurred in health care, where the largest cash-rich pharmaceutical companies have taken advantage of the valuation discounts in the market to target smaller players in need of financing to make acquisitions at nice premiums. This ultimately sets a new equilibrium in the market.

There has clearly been a rise in consternation and fear. However, as long-term investors, we can take advantage of these periods. Our goal is to outperform the market over a full three-to-five-year cycle. During these periods of stress we feel that good companies get better and emerge stronger financially and competitively. As high active share managers, these are times when we can add the most value.

Portfolio Highlights

The ClearBridge Aggressive Growth Strategy outperformed its Russell 3000 Growth Index benchmark in the third quarter. On an absolute basis, the Strategy had gains in three of the eight sectors in which it was invested (out of 11 sectors total). The primary contributors were in the health care sector while the main detractors came in communication services.

Relative to the benchmark, overall stock selection contributed to performance. In particular, stock selection in the IT, health care and consumer discretionary sectors drove results. Conversely, stock selection in the communication services and industrials sectors, an overweight to communication services and an underweight to consumer discretionary weighed on performance.

On an individual stock basis, positions in Wolfspeed, Biogen, Etsy, Autodesk ( ADSK ) and Twitter ( TWTR ) were the leading contributors to absolute returns during the period. The primary detractors were Comcast, Seagate Technology, Broadcom ( AVGO ), L3Harris Technologies ( LHX ) and Liberty Broadband ( LBRDK ).

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Editor's Note: The summary bullets for this article were chosen by Seeking Alpha editors.

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