META - ClearBridge All Cap Growth Strategy Q1 2023 Portfolio Manager Commentary

2023-04-15 01:20:00 ET

Summary

• ClearBridge is a leading global asset manager committed to active management. Research-based stock selection guides our investment approach, with our strategies reflecting the highest-conviction ideas of our portfolio managers.
• Standout results for disruptors in the IT, communication services and consumer discretionary sectors enabled the Strategy to outperform in a risk-on quarter for growth stocks.
• In anticipation of a likely recession and to further support our risk management efforts, we added durable compounders with strong growth and profit margins and low financial leverage with purchases in the health care and IT sectors.
• The recent decline in rates that boosted growth equities could be short lived, causing us to remain cautious and fostering an ongoing focus on diversification and self-funding business models.

By Evan Bauman, Peter Bourbeau, Aram Green, & Margaret Vitrano

Disruptive Growers Stand Out

Market Overview

A rotation into mega cap equities in the first quarter obscured broader market weakness as a banking crisis and further monetary tightening by the Federal Reserve weighed on stocks down the market cap scale. The S&P 500 Index rose 7.50% while the small cap Russell 2000 Index ( RTY ) gained 2.74% as investors gravitated to larger companies deemed more resilient as the removal of liquidity accelerated. The benchmark Russell 3000 Growth Index advanced 13.85%, reversing the leadership trend of the last year and outperforming the Russell 3000 Value Index by nearly 1,300 basis points.

Reminiscent of the FAANG period of market leadership in recent years, performance was concentrated in a handful of the largest growth stocks in the benchmark. For example, Apple ( AAPL ), Microsoft ( MSFT ) and Nvidia ( NVDA ) were responsible for close to half its total return (6.47%). Despite the Russell 3000 Growth Index losing nearly 29% in 2022 and underperforming its value counterpart by 2,100 bps, the benchmark remains extremely concentrated (Apple and Microsoft alone account for 22.4% of the index). Meanwhile, a tighter financing environment created by the Fed’s aggressive rate hike campaign, and worsened by the March failure of Silicon Valley Bank and Signature Bank ( SBNY ), hurt small cap companies the most (Exhibit 1) while health care stocks also trailed due to higher funding costs.

Exhibit 1: Mega Caps Dominated First Quarter Performance

Despite limited mega cap exposure, the ClearBridge All Cap Growth Strategy held its own through the shift in market leadership. The combination of underweights to Apple and Microsoft, as well as the reclassification of payment providers PayPal ( PYPL ) and Visa ( V ) from IT to financials, caused the Strategy to finish the quarter close to 550 bps underweight IT. While diversification goals limit the Strategy from maintaining market weights in the index’s largest components, our positioning also reflects caution as we anticipate further multiple compression and earnings pressure among IT and shadow tech stocks due to exposure to economically-sensitive end markets.

Interest rates were on a downward trajectory prior to the failure of Silicon Valley Bank with efforts to contain bank contagion and stabilize the financial system increasing the likelihood of a slowdown in monetary action by the Federal Reserve. Despite a 25 bps rate hike in late March and rhetoric from Fed Chairman Jerome Powell that rates will stay higher for longer, the bond market is projecting rate cuts by the end of the year. We don’t see a pivot to looser policy short of a more serious shock to the banking system, a deeper than expected recession or a massive drop in inflation.

Instead, we believe rates fell in the first quarter for artificial reasons, namely flight-to-safety Treasury buying that pushed down yields, and the boost to longer-duration growth stocks in general could be short lived. The likely longer-term impact of the banking crisis is slower loan growth and less credit availability, reinforcing the importance of owning profitable growth companies with self-funding business models. This environment also continues to support our commitment to diversification and quality.

Such diversification includes exposure to a handful of growth companies aggressively taking share in their respective markets through disruption that participated well in the growth rally. The standout was graphics chipmaker Nvidia. Already the leader in the market for chips to power advanced computing, the positive sentiment around generative AI further highlighted the company’s opportunities among data center and hyperscale cloud providers reliant on Nvidia’s GPUs to empower digital transformation and new AI applications. We believe the secular drivers in certain parts of the semiconductor industry outweigh the cyclical risks and feel comfortable with our exposure through Nvidia, ASML and Broadcom ( AVGO ). Shares of information security providers Palo Alto Networks ( PANW ) and CrowdStrike ( CRWD ) rebounded on improved execution and success expanding their product suites into adjacent security markets.

Several other select growers delivered solid results due to progress in managing costs. During its fourth-quarter earnings call, Meta Platforms ( META ) announced sizable cuts to operating and capital expenditures and a commitment to improving efficiency. These moves come as the Instagram owner faces easier year-over-year comparisons as well as lessening competition and privacy risks. We are keeping a close eye on Meta’s capital allocation decisions to determine when cash flows and returns are likely to reaccelerate. Shares of cloud software maker Salesforce ( CRM ) also rose as management followed through on a leaner operating strategy that places greater focus on shareholder returns and expense management while de-emphasizing its previous growth by acquisition approach. Amazon.com benefited as well from a consolidation of its e-commerce workforce and fulfillment center expenditures, which should help offset an uneven outlook for consumer e-commerce spending and slowing growth in its AWS cloud business. Marketing automation software maker HubSpot surged after beating quarterly cash flow estimates due to effective cost management and its ability to generate more revenue per customer by cross selling additional functionality.

Being underweight mega cap growth stocks that gained the most in March’s flight-to-safety accounted for a portion of the performance shortfall in the quarter. The rest resulted from profit taking in UnitedHealth Group ( UNH ), a strong performer in 2022 that was also hurt by slightly disappointing initial reimbursement rates in its Medicare Advantage business, as well as our health care overweight.

Portfolio Positioning

Health care has been a primary area of repositioning activity over the last 18 months and we diversified our exposure to the sector with the purchase of drug maker and stable grower Eli Lilly ( LLY ), a company that faces less supply chain and inflation risk than our medical device holdings. After being out of the biopharmaceutical space for the last year, we took advantage of a 20% selloff in Lilly shares to establish a position in a company whose diabetes-obesity treatment Mounjaro represents a blockbuster opportunity. Diabetes and obesity are massive and growing markets that the U.S. payer system has a vested interest in treating. Positive clinical readouts for Mounjaro could expand its indications to include treatment of sleep apnea, cardiovascular and other conditions related to diabetes. Beyond diabetes, Lilly has a promising pipeline in Alzheimer’s, atopic dermatitis (eczema) and renal failure. A clinical readout for its Alzheimer’s treatment, likely in the second quarter, could create an opportunity to further build out the position.

We further added to our durable compounders with the purchase of Accenture ( ACN ) in the information technology ((IT)) sector. Accenture is a leading global professional services company that helps clients build their digital infrastructure and optimize their operations. With a diversified product set and client base, we see the company as a unique way to gain broad-based exposure to secular growth drivers such as rising cloud migration and digital transformation, as well as new, innovative technology deployments like cyber security, block chain, AI and machine learning. While IT spending is sensitive to the macro environment, the stock has historically been resilient through market cycles due to its durable earnings and cash flow, strong balance sheet and attractive returns on capital.

We apply a multiyear time horizon for our investments, but are cognizant that factors can change for both the better, or worse. Accordingly, when these factors cause the risk/reward to skew more negatively it is imperative we take the necessary portfolio action to protect client capital. While willing to own disruptive growth companies not yet profitable, we need to see a clear line of sight to future earnings. Recently that visibility has become clouded for 10X Genomics ( TXG ), a life science company that offers solutions for single-cell analysis and spatial profiling, causing us to exit the position. TXG remains a leader in single-cell genomics research via its Chromium platform, and the company is looking to expand into new product launches which have the potential to meaningfully increase its total addressable market. However, funding the pipeline for this growth is expensive and becoming increasingly more so in the current interest rate environment. In addition to near-term macro headwinds, TXG is also facing a decelerating core single-cell business. These issues call into question the FY23 cash break-even target and increase the potential for margin pressure. Given the current environment and these idiosyncratic issues, we believe the risk/reward is no longer compelling and sold into recent strength.

While retail sales have held up with continued healthy employment growth, we remain concerned about the lagged impact of quantitative tightening and an inverted yield curve on consumer spending, motivating our sale of auto parts and repair chain Advance Auto Parts ( AAP ). We had purchased AAP for defensive and self-help characteristics that have not been playing out as expected. The company’s revenue resilience is intact but with less margin expansion because of only modest operational improvements and rival O’Reilly Automotive discounting to gain share.

Outlook

Employment drives spending and the resilient job market continues to support sales. While the Fed can make it more expensive for companies to hire, policymakers cannot control jobs and when employment finally breaks, we believe spending will pull back meaningfully. Inflation has been persistent in the economy long enough to divide the growth universe between companies that have established and maintain pricing power (and subsequently revenue growth) and those that have not. We believe goods producers, particularly softline retailers, are particularly vulnerable at this stage in the economic cycle. While we do not own any of these companies, our concern about a rollover in consumer spending has caused us to become selective in what we do own across both the consumer discretionary and consumer staples sectors.

Another major risk we’re watching is the potential spillover effect of the bank crisis into other areas of the market. The Strategy has no direct exposure to money-center banks and is underweight IT, which represents a second-order risk to financing as many early-stage companies facing a cash crunch are likely to pull back on spending for IT products and services, stunting the innovation beneficial to companies across many growth sectors. Among larger IT and communications companies and the customers they sell to, we also anticipate slowing growth in cloud deployments and tepid overall revenue growth.

Exhibit 2: Leadership to and Through Recessions

We continue to orient the Strategy for a base case of recession, where growth companies able to maintain revenue and earnings visibility should thrive. We believe the portfolio balance we have achieved through active positioning moves and a consistent commitment to risk management should be supportive of performance both in difficult market periods as well as strong rallies like the one to start the year. And we believe a growth allocation will be important as the pandemic-era injection of ample liquidity and a more recent boost from inflation to revenue growth began to wane. Regardless of the timing of a recession, growth stocks have historically demonstrated resilience through an economic contraction (Exhibit 2).

Portfolio Highlights

The ClearBridge All Cap Growth Strategy outperformed its Russell 3000 Growth Index benchmark in the first quarter. On an absolute basis, the Strategy had gains in eight of the nine sectors in which it was invested (out of 11 sectors total). The primary contributors were in the IT, communication services and consumer discretionary sectors.

Relative to the benchmark, overall stock selection contributed to performance but was partially offset by the negative effects of sector allocation. In particular, stock selection in the industrials, communication services and IT sectors and underweights to energy and consumer staples drove results. Conversely, an overweight to the health care sector, underweights to the IT and consumer discretionary sectors and stock selection in consumer discretionary weighed on performance.

On an individual stock basis, positions in Nvidia, Meta Platforms, Amazon.com, Microsoft and Salesforce were the leading contributors to absolute returns during the period. The primary detractors were UnitedHealth Group, Advance Auto Parts, Liberty Media SiriusXM, Johnson Controls ( JCI ) and Sherwin-Williams ( SHW ).

In addition to the transactions mentioned above, we initiated a position in Tesla ( TSLA ) in the consumer discretionary sector and closed a position in Intel ( INTC ) in the IT sector.

Evan Bauman, Managing Director, Portfolio Manager

Peter Bourbeau, Managing Director, Portfolio Manager

Aram Green, Managing Director, Portfolio Manager

Margaret Vitrano, Managing Director, Portfolio Manager

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