WMT - ClearBridge All Cap Growth Strategy Q3 2023 Portfolio Manager Commentary

2023-10-16 00:45:00 ET

Summary

• ClearBridge All Cap Growth Strategy follows a focused, high conviction approach, actively pursuing the best growth ideas of its portfolio management team across market capitalizations.
• A sharp rise in yields and weakness in communication services weighed on relative performance, offsetting strong stock selection in the technology sector.
• We continued to reposition the portfolio into earnings reset names earlier in their growth cycle, funding new purchases by taking profits in several stable compounders.
• A soft landing could lead to a low GDP growth environment like 2014-2016, where a company’s ability to generate organic growth and self-fund future investments were important. We believe the portfolio is well-exposed to these types of fundamentally sound growth franchises.

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

Software Shows Strength Through Tough Rate Backdrop

Market Overview

Equities took a breather in the third quarter, pressured by rising bond yields, a hawkish turn by the Federal Reserve, and signs of late-cycle spending fatigue. The S&P 500 Index fell 3.27% while the Nasdaq Composite declined 4.10% as the Fed indicated that generationally high-interest rates could remain elevated well into 2024. The benchmark Russell 3000 Growth Index gave back some gains, dropping 3.35% and trailing the Russell 3000 Value Index (-3.15%).

The 10-year Treasury yield climbed 74 bps during the quarter, reaching its highest level in 16 years (Exhibit 1). Surging yields have resulted from resilient economic data and a rebound in inflation that caused the Fed to push out any hopes of a rate cut in the near future. While the central bank may be nearing or at the end of its tightening cycle, we believe the lagging impacts of 525 bps of interest rate hikes in the last 18 months will be felt on corporate and consumer balance sheets well into the future.

The ClearBridge All Cap Growth Strategy underperformed for the quarter, primarily due to weakness in communication services. Despite showing progress on subscriber growth and margin expansion in its second-quarter results, streaming provider Netflix ( NFLX ) reported disappointing average revenue per user (ARPU) numbers which weighed on the shares. The company continues to make progress in rolling out its ad-supported tiers and cutting down paid sharing and we believe it remains well-positioned to see ARPU inflect higher in the coming quarters. Not owning Alphabet, whose shares outperformed during the quarter, also hurt relative results.

Exhibit 1: Rising Yields Again Pressuring Growth Stocks

*Growth Outperformance indicates quarterly periods where the Russell 3000 Growth Index outperformed the Russell 3000 Value Index. Data as of Sept. 30, 2023.

Mega caps were a mixed bag. After powering the index and the overall market higher in the first half of the year, rising rates caught up with Apple ( AAPL ) and Microsoft ( MSFT ) over the last three months. The quarterly underperformance of those two stocks, where the Strategy is underweight, added to relative performance. Such results suggest that our focus on diversification and balance should keep the Strategy well-positioned in a market we expect to remain unsettled.

While the Strategy trailed the benchmark in the third quarter, the performance gap was narrow due to improvement among our information technology ((IT)) holdings, notably data monitoring software maker Splunk ( SPLK ), which rose on a takeover offer from Cisco Systems ( CSCO ), and cyber security software maker CrowdStrike ( CRWD ). Shares of Nvidia ( NVDA ), the clear leader in supplying graphics processing units to power AI applications, finished the quarter on an upswing and remained substantially higher for the year. Nvidia's multiple has actually compressed year to date due to better-than-expected earnings growth and, while we remain confident in the company's long-term growth trajectory, we trimmed the position for the third time this year to manage our overall portfolio risk.

Positive clinical trials showing cardiovascular benefits for GLP-1 diabetes and obesity therapeutic semaglutide boosted shares of portfolio holding Eli Lilly ( LLY ), which markets Mounjaro for these conditions. However, the potential for improved patient outcomes raised the risk of lower utilization for Insulet ( PODD ), a maker of insulin patch pumps. While the headline risk for Insulet is unlikely to go away soon, we believe any financial impact from GLP-1s will be restrained due to a limited current patient population and the need to continue to treat progressive diseases, like diabetes, through regular monitoring.

Portfolio Positioning

Investing in growth companies going through earnings resets has proved effective recently. New additions Target ( TGT ) and Union Pacific ( UNP ) are the latest examples of businesses that have likely seen their profit forecasts bottom.

Big box retailer Target provides early-cycle consumer exposure but with support from cash flow and a dividend. Target reset earnings in August by lowering its full-year outlook to account for weak sales and one-time cost issues, leaving its shares trading at a historically wide discount to peers Walmart ( WMT ) and Costco ( COST ). We see the company as a turnaround story, with better-than-expected margin and inventory controls leading to improved comparisons. In addition, we view the controversy around Target's Pride merchandise assortment, and consequent backlash, to be fixable. A deeper-than-expected downturn in consumer spending, a failure to reverse traffic declines, and recent market share losses are risks to our thesis, but we believe they are sufficiently accounted for in the stock's current valuation.

Union Pacific also falls in our cyclical bucket of companies working through short-term headwinds. The rail operator provides the added benefit of a low correlation to the rest of the portfolio. As an efficient way to transport grain, coal, and autos and with networks that extend from Mexico through the U.S. to Canada, the freight rail industry generates high returns on invested capital and is positioned to benefit from reshoring. We have been researching rails for the last 18 months, waiting for earnings estimates to come down amidst a weakening macro backdrop. By the start of the third quarter, we believe estimates had declined enough to make us comfortable in establishing exposure. We chose Union Pacific as its risk-reward is compelling if the turnaround being led by new CEO Jim Vena is successful. Rail volumes are coincident with macro conditions, causing us to establish a minimal position that can be built opportunistically.

We have also sought to add growth companies with less earnings variability than the overall market. New purchase Starbucks ( SBUX ), the largest global coffee chain, fits this description. We view Starbucks as a quality compounder with strong free cash flow, operating in a segment and in dayparts that are very much routine-based and habitual, balancing the business's exposure to discretionary spending. Additionally, Starbucks is still in the early stages of its reinvention plan to help accelerate revenue growth over the next several years on the back of better same-store sales and unit growth. Coupled with the benefits of margin expansion, we believe the company can drive double-digit EPS growth at scale.

We have opportunistically taken profits in our largest holdings as a source of funds for these additions. Third-quarter activity included trims to Broadcom ( AVGO ) and UnitedHealth Group ( UNH ) as well as the sales of cyclical IT holding Western Digital ( WDC ) and Sea Limited ( SE ) in communication services. Sea has experienced headwinds in its gaming and e-commerce businesses since COVID-19 began to recede. The company began rapidly moving toward profitability in 2022 and we expected management to continue down that path. However, the company announced a pivot back to re-investing for growth in e-commerce early in the quarter which we believe makes for too many strategic pivots in a short time, causing diminished shareholder confidence and delays in the stock's value realization.

Outlook

The U.S. economy remains on the precipice of a recession or soft landing, with inflation and labor costs moderating. We are very late in the current cycle and expect stocks will bottom ahead of company fundamentals. We are already seeing this in areas like consumer discretionary as earnings have weakened, consumer credit balances are increasing and credit quality is worsening (Exhibit 2). The industrial complex is starting to normalize as pandemic supply dislocations and the benefits of inflation are going away. On the enterprise level, businesses are becoming more austere and managing budgets more tightly.

Exhibit 2: Rising Delinquency Rates Could Slow Spending

HELOC stands for Home Equity Line of Credit. Data as of June 30, 2023, latest available as of Sept. 30, 2023.

These worsening conditions support the goals of recent portfolio activity. A soft landing could lead to a period of low GDP growth like 2014-2016, where a company's ability to generate organic growth and self-fund future investments was important. We believe the portfolio is well-exposed to these types of fundamentally sound growth franchises.

One trend we are following closely is merger and acquisition activity. After a lull during the market downdraft last year, we are beginning to see green shoots in deal-making. The Strategy has a history of owning stocks with characteristics attractive to acquirers. We believe a healthier M&A market will be a boon to companies down the market cap spectrum with strategic value to larger enterprises.

Portfolio Highlights

The ClearBridge All Cap Growth Strategy underperformed its benchmark in the third quarter. On an absolute basis, the Strategy posted losses across the nine sectors in which it was invested (out of 11 sectors total). The primary detractor from performance was the IT sector.

Relative to the benchmark, overall stock selection detracted from performance. In particular, stock selection in the communication services, financials, industrials, and consumer staples sectors weighed on results. On the positive side, stock selection in the IT sector and an overweight in the healthcare sector contributed to performance.

On an individual stock basis, the leading absolute contributors were positions in Splunk, CrowdStrike, UnitedHealth Group, Eli Lilly, and Nvidia. The primary detractors were Apple, Netflix, Microsoft, Johnson Controls ( JCI ), and Insulet.

In addition to the transactions mentioned above, we closed a position in Liberty Formula One ( FWONA ) in the communication services 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

Past performance is no guarantee of future results. Copyright © 2023 ClearBridge Investments. All opinions and data included in this commentary are as of the publication date and are subject to change. The opinions and views expressed herein are of the author and may differ from other portfolio managers or the firm as a whole, and are not intended to be a forecast of future events, a guarantee of future results, or investment advice. This information should not be used as the sole basis for making any investment decision. The statistics have been obtained from sources believed to be reliable, but the accuracy and completeness of this information cannot be guaranteed. Neither ClearBridge Investments, LLC nor its information providers are responsible for any damages or losses arising from any use of this information.

Performance source: Internal. Benchmark source: Russell Investments. Frank Russell Company ("Russell") is the source and owner of the trademarks, service marks, and copyrights related to the Russell Indexes. Russell® is a trademark of Frank Russell Company. Neither Russell nor its licensors accept any liability for any errors or omissions in the Russell Indexes and/or Russell ratings or underlying data and no party may rely on any Russell Indexes and/or Russell ratings and/or underlying data contained in this communication. No further distribution of Russell Data is permitted without Russell's express written consent. Russell does not promote, sponsor, or endorse the content of this communication.

Performance source: Internal. Benchmark source: Standard & Poor's

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